Page 347 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 6. Employee Benefits and Perquisites 333

As with either the defined-benefit or defined-contribution pension plan, the benefits
from tax-qualified plans are limited by the Internal Revenue Code. However, if the benefit
“lost” by the IRC restriction is made up in a nonqualified plan, the executive is very interested
in plan design. To illustrate hybrid plans, let’s examine cash-balance, floor-offset, pension
equity, profit sharing, and target-benefit plans.
Cash Balance. A cash-balance plan is a defined-benefit plan that looks like a defined-
contribution plan. Each employee has an account that is credited with an employer contri-
bution and a specified interest rate. The company absorbs investment gains and losses,
thereby determining its contribution to the plan (as opposed to the employee’s account). The
employer contributions may be a flat dollar amount but more typically are a percentage of
the employee’s pay. This makes it look like a career-average, defined-benefit plan. It looks
like a defined-contribution plan because the employee can look at any time to see what is in
his or her account. Payout could be either a lump sum or an annuity.
A conversion from a defined-benefit plan to a cash-balance plan can be set up by doing
a lump-sum calculation of benefits that would be paid out under the old plan. Depending on
the discount rate used, the new benefit could be less than the old one. If it is less, an employee
could work several extra years with essentially no increase in pension benefits until the cash-
balance plan catches up with the old plan. Of course, if the person left before this happened,
the individual would receive the amount from the old plan. Money in the old plan is
either converted by some type of lump-sum equivalent or kept in a separate account earning
interest.
Cash-balance plans typically produce greater benefits for younger employees because the
flat-rate contribution is higher than would be accrued under a defined-benefit plan. Older
workers lose under a conversion to a cash-balance plan. The reason is simple. Since defined
benefits are a function of pay, years of service, and a discount for early retirement, a person
leaving at normal retirement age probably earns half of the pension in the last 5 to 10 years
of work. In switching to a cash-balance plan, one loses the heavy weight of those last years of
earnings typically used in a final-pay formula. For that reason, many plans transition the
conversion, permitting employees above a certain age and service cutoff to remain in the old
plan (e.g., age 50 and 10 years). Even with this cut-off option, those ineligible (i.e., below the
cutoff) may be forced to take lower future benefits.

Floor Offset. A floor-offset plan combines a defined-benefit plan and a defined-contribu-
tion plan. The defined-benefit plan sets the minimum benefit that will be paid. If the defined-
contribution plan exceeds this “floor,” no payment is made from the defined-benefit plan. If
it is less than the floor, the defined-benefit plan makes up the difference. This hybrid plan is
attractive for those who like the defined-contribution plan but are concerned about downside
risk. The defined-benefit plan provides a safety net by the “floor offset.” Some of these plans
were developed by companies that had provided pension benefits through profit-sharing
(defined-contribution) plans. Unfortunately, several years of bad market experience resulted
in employees retiring with smaller pensions than they would have been eligible to receive
years earlier. Attaching a defined-benefit plan to the bottom of the defined-contribution
plans provides a floor, or stop-loss guarantee, for employees.

Pension Equity. A pension equity plan is similar to a cash-balance plan except that the
benefit is expressed as a percentage of final average pay. This can be defined in the same
variety of ways that final-pay formulas define “final average pay.” The individual is credited