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Benefits and Beyond Chapter 4 – Retirement – Evolution and Design Thomas E. Murphy
Benefits and BeyondChapter 4 – Retirement – Evolution and Design
Thomas E. Murphy
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Retirement . Which is it?
On the road? Feed the pigeons?
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Sources of Retirement Income
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Social Security – the safety net
Employer sponsored retirement
Personal savings and investments
Objective: provide retirement income for life.
Tax favored treatment
Who assumes the three risks?
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Retirement
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Remember the Risks
Who bears the risk? Employer or employee?
Longevity Investment Inflation
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Will I have enough? How
many years do I have?
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What are the design features of a Defined Benefit Plan (DBP)?
What is a final pay plan? What are typical benefit formulae for a DBP? What HR strategies does a final pay plan
serve?
Retirement
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DBPs R Not Dead
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Alternatives to “Final Pay”
Unit Benefit Flat Benefit
Modify the definition of “Final Pay.”
Unit Benefit – multiply a set dollar amount times years of service. ($50 per month X 30 years of service = $$1500 per month)
Flat Benefit: Set amount per month is paid once employee has requisite age and years of service. (Reach age 60 with 30 years of service, benefit is $2500 per month)
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Where are the DBPs and DCPs?
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Demographics of workforce Age and sex of workforce Financing of benefits Use of capital markets to finance Allocation of risks (longevity, investment,
and inflation) Job tenure – encourage or not relevant? Tax qualified status and fund protection Legal compliance issues (ERISA, IRC, PPA
HRM Issues and DBP design
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The Benefits Model?
Let’s look at DBP design features and see how Benefits Model applies?
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Factors affecting DBP design
Encourage retention?
Sufficient retirement income?
Competitive?
Fair?
Cost effective?
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Design Features of DBP
You Must Know these! Drivers: Fig. 4.2 at 90.
Coverage Eligibility Vesting Calculating the benefit Typical Final Average
Pay Formula COLA? Separated vested
Funding and Protection
Investment strategy Beneficiaries Calculating
participating service Normal and Early
retirement ages Distribution options* Death before
retirement
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DBP – Some Distribution Options*
The Choices Adverse Selection Risk?
Annuity Named beneficiary Lump sum (Discount
rate and Present Value) Disability Retirement
(103) Deferred Benefit Level Income Option
(Table 4.2, at 102) 10-15 year certain (98)
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What is covered compensation? Social security integration and offsets (101) Restoration benefit Breaks in service (102) What You Should Know about Your Retirement
Plan! (U.S. DOL. See site below) http://www.dol.gov/ebsa/publications/wyskapr.ht
ml Disability retirement (103) Non-portability (104) §415 limits on income and benefit Cap on years of participating service?
More Design Features of DBP
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Maximum Pension- $195,000
Maximum Compensation to be included in formula- $245,000
And more . . .
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DBPs §415 Limits - 2010
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And, what about ACTUARIAL REDUCTIONS?
How and why do they apply to a DBP?
How are DBPs administered?
Let’s do some calculations!
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Design Features of DBP
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How to allocate risks?
Should employer be sole source of financing?
Aggressive use of capital markets?
Funding with other assets?
What is a reasonable income replacement goal?
Can we measure the effectiveness of our retention and loyalty objective?
What are design levers we can use to adjust? (See: Exercises Nos. 3, 4, 6, 7, 8, 13 (pp.129-131)
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Some Financing Issues for DBP
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Defined Contribution Plans- What is the Goal and what are they?
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Defined contribution plans
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Allocation of risks – DCP – Employee!
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Allocation of risks - DCP
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What was driving force leading to transition to DCP?
What is relative contribution of employers?
Simplicity, portability, and ownership oriented employee
Very favorable tax treatment!
Advantage of compounding
Portability No actuarial
reductions!
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DCPs
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Coverage Eligibility Portability Vesting Employer matches Why no Actuarial
reductions? §415 limits on cont
ributions
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Design features of DCP (401k, 403b)
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Elective deferrals - $16,500
Catch –ups over 50 years - $5,500
Maximum total contribution - $49,000
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DCP – There are §415 Limits
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More Design features
Note: fiduciary liability Note: restrictions
Investment choices- self directed
What is employer’s obligation here?
What are lifestyle, target funds?
What about too much company stock?
Loans and withdrawals Plan administration
and fees How are funds
distributed? Lump sum or Annuity?
What about retirement age?
Early and Minimum Distribution Rules (see infra)
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Sufficient for retirement
Retiring early? Retiring later?
Will I have enough? What’s my number? Impact of recession Will I have to get a
part-time job after retirement?
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Early and minimum distribution rules of IRS
Discrimination testing! What is this?
What is non-elective enrollment?
What is a “safe harbor” plan? (See chapter 9 and Blog)
BIG ISSUE: are employees saving enough for retirement?
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401(k) Issues Happy Birthday: Age 59.5 and 70.5
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Evolution of Pension Plans
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What would result if the pension formula were based upon current pay instead of final pay?
It’s a Cash Balance Plan How does this change the risk allocation? What impact would this have on length of
service? Don’t forget to apply the Benefits Model
The evolution continues
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Cash Balance Plan – design features
No actuarial reductions Employee receives his account balance!
Employer calculates a benefit annually and credits to account
Credited amount is based upon a percentage of current pay
Account earns employer established rate of annual interest
Account balance can be viewed by employee
Account is portable Vesting applies (3
year cliff) Benefit paid in lump
sum or annuity Favorable tax
treatment
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No employee contributions Employer can pool account balances and
invest and obtain higher yields than those annual investment returns promised to participants
Risks – investment risk is on the employer but is nominal (short term). Longevity and inflation risks are on the employee.
Do these plans encourage long term or mid term service? (See: key design features at p.120 of the text)
Design features – CBP
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What happens in a conversion from a DBP to a Hybrid (cash balance plan)?
Who goes into new plan and who stays in DBP?
What is opening balance? Do such conversions violate Age
Discrimination laws? What about “wear away” and
“whipsawing?” (See: text pp 121, 122.) How do CBPs comport with Benefits Model?
Cash balance plans - issues
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Query: how would you change design of CBP to encourage longer service?
The Pension Protection Act resolves many legal issues.
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Cash balance plans - issues
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DCPs – Profit Sharing Retirement Plans
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There are profit sharing cash and profit sharing retirement plans.
The retirement plan is essentially a DCP! It is a unique concept – results based
funding of a retirement plan. If the company does well, so will you. Reserves maximum flexibility to employer –
unlike a DBP How would you assess the risk allocation?
Profit Sharing Plans
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Favorable tax treatment There are limits on total amount allocated
to plan and to individuals. What about Benefits Model? The distribution occurs at retirement. How is the employee’s amount typically
calculated: (W-2 Earnings of employee ÷ total earnings) × Annual Profit $$ allocated.
Or, it may involve % of salary, or age and service weighted
Profit Sharing Plans
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Profit Sharing plan designs
What about Risks? Benefits Model?
No monies distributed until retirement.
Can use age or service enhancements
Early and mandatory distribution rules apply
Vesting
Frequently company stock is placed into account.
Employee is given diversification option at age 55.
Stock price and dividends increase so does account balance.
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Employee Stock Ownership Plans
What about Risks? Benefits Model?
ESOPS Company Stock is
allocated to employee retirement account.
Expected to create alignment.
Vesting Minimum and Early
distribution rules apply
Contributions made regardless of profits
Favorable tax treatment.
If leveraged ESOP it is even better for employer.
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ESOP – Leveraged Traditional
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What about small employer?
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Nos. 1-21at pages130-131.
Read the Blog and look especially at efforts to ameliorate the risks in DCPs.
Should the government sponsor a GRA?
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Don’t Forget the Blog and Exercises!
