Hybrid pension schemes
A hybrid pension scheme is one which is neither a full defined benefit (DB) scheme nor a full defined contribution (DC) scheme, but has some of the characteristics of each. In a DC scheme, the member generally bears the full risk (of paying higher costs or receiving reduced benefits) if investment return or pension costs are not as good as expected. In a DB scheme, the employer usually takes that risk and pays higher contributions in order to maintain the agreed level of benefits. In hybrid schemes, the risk can be shared between the employer and employees.
There are many possible types of hybrid schemes.
In a combination scheme, a member may be accumulating two types of benefit simultaneously. This would typically be a DB element for a portion of income and a DC element on any earnings over that amount.
Self-annuitising DC schemes operate identically to DC schemes until a member retires. At that point, the accumulated fund is converted to pension income, not at the market rate for pension costs (annuity rates), but in accordance with a process which is set out in the rules of the scheme. The pension is then paid from the scheme.
Under final salary lump sum schemes, the retirement benefit is expressed as a lump sum at retirement, rather than as a pension. For example, the rules of the scheme may provide a lump sum at retirement of 20% of final salary for each year of service. If a member retired with 40 years’ service, a lump sum of 20% times 40, i.e., 800% (or eight times) final earnings would be used to buy a pension for that member at the market cost at that date.
In an underpin scheme, there is both a DB and DC basis for benefits. At retirement, the member receives a benefit based on whichever calculation provides the better result. For instance, a scheme may have an employer and employee contribution rate of 6% each, with a guarantee that at retirement, a pension of at least 1% of earnings per year of service would be paid as a minimum.
In a cash balance scheme, a member’s benefit is an entitlement to a lump sum at retirement, in a similar fashion to a traditional DC scheme, which is then converted into an annuity. The difference is that the amount in the member’s account is not directly related to the returns achieved on the underlying investments. The returns may be guaranteed, or smoothed (to offset any high or low peaks) or subject to some form of underwriting by the scheme. As a result, member benefits may be slightly more predictable.
Fixed benefit/benefit unit schemes are DB in nature but without any link to earnings – a member usually accumulates a fixed monetary amount of annual pension every year.