Best bets for retirement; innovative ways to design a retirement program that best suits your organizational needs

Time after time, studies have shown that an employee's are greatly affects his or her perception and understanding of different types of retirement plans. As a general rule, older, longer tenured employees tend to prefer defined-benefit plans in which the employer assumes the investment risk and commits to providing a retirement benefit of a specified amount for the lifetime of the employee.

In contrast, younger, more mobile employees tend to exhibit a marked preference for defined-contribution arrangements whereby the money contributed to an existing account can be seen to grow year after year.

Partly because of this dichotomy in the workforce, large employers have tended to provide both types of retirement plans, with the defined-benefit plan serving as the base of providing retirement income and one or more defined-contribution plans adding a supplemental layer. In fact, in 1991, about 85 percent of more than 1,000 major U.S. employers surveyed maintained a defined-benefit pension plan. Of these, the majority also offered one or more defined-contribution plans - typically, a savings or profit-sharing plan with a 401(k) salary-reduction feature for employee contributions.

However, not all employers are large enough or otherwise able to support a multiple-retirement plan structure. Many companies want the simplicity and convenience of a single plan, especially if that structure can combine the best attributes of both types of plans - the certainty and precision of defined benefit, plus the individual account characteristics of defined contribution). Today, much of the innovation in retirement plans involves such "hybridization" of traditional retirement-plan structures. Following is a review of four different types of retirement plan approaches attracting considerable attention today. [TABULAR DATA OMITTED]

Target plan

A target plan is a type of defined-contribution vehicle that mimics a defined-benefit pension plan. The plan's objective is to build an account for an individual that will equal a specified amount - the "target" - at retirement. The targeted amount is intended to be enough to provide an income stream (based on the plan's formula) at retirement.

For instance, a typical formula might provide 1 percent of pay times years of service. Each year, the company would determine how much to set aside in the plan so that each employee would accumulate a large enough account balance to produce the targeted amount at retirement.

  Formula of 1 percent of pay times years of service,
Contributions assume 8 percent interest, level pay level
premium-funding method
          Past      Target     Contributions
Age      Service   Benefit %   as a % of Pay
25          0         40           1.4
35          5         35           2.9
45         15         35           7.1
55         25         35          22.3

SCENARIO:

Exhibit 1 provides a simple example of a target plan, taking into account the employee's past service. Under this particular design, the company's contribution as a percentage of pay varies by employee based on age and number of years until retirement. For example, the current year's contribution might be 1.4 percent of pay for a 25-year-old employee, versus 22.3 percent for the 55-year-old employee with only 10 years in which to build a sufficient account before retirement. However, for both employees, the end result is almost identical: a target benefit of a 1 percent of pay times years of service at retirement.

CONSIDER THIS PLAN:

This retirement plan might appeal to a relatively young company with strong future-growth prospects but some concern about the ability to support a defined-benefit plan on a permanent basis. The company might already have a matched savings plan in place and although no one has yet retired, the organization in concerned that the existing plan may not prove sufficient to meet the needs of long-service employees.

The target plan functions like a defined-benefit plan in allowing the company to "make up" for past service. Also, this type of plan structure commits the organization to a contribution each year (although future contributions can be discontinued at any time). Unlike a traditional pension plan, however, no Pension Benefit Guaranty Corp. (PBGC) premiums are required and the plan is relatively easy to terminate, should that be necessary.

Although technically a defined-contribution plan, a target plan differs from the more typical defined-contribution plan in that annuities must be offered alongside the lump-sum distribution option at retirement, and no in-service withdrawals are permissible.

Cash-balance plan

A cash-balance plan is almost the mirror image of a target plan. Technically, it is qualified as a defined-benefit plan but in many major respects, it has the characteristics of a defined-contribution plan. The special appeal of this type of plan is that the employer funds for projected benefits on an aggregate basis (just like a pension plan), but the participants sees an individual account established in his or her name.

For instance, the formula might be 5 percent of pay contributed each year, plus a specified interest credit such as a minimum of 8 percent. As in a traditional pension plan, the employer assumes responsibility for investment performance - which means lower plan contributions in "good" investment climates and the reverse in "poor" years. However, the participant is shielded from market fluctuations. Cash-balance Plan

Age at hire, 25; Contribution, 5%; Interest credited, 8%; Salary increases, 6%; Current pay, $30,000.

                                         Annuity %
Age at        Account at     Account     Per Year
Termination   Termination   at Age 65   of Service
35            $ 27,605      $277,780       1.31
45            $109,442      $510,104       1.20
55            $323,937      $699,356       1.10
65            $857,910      $857,910       1.10

SCENARIO:

Exhibit 2 provides an illustration of how a cash-balance plan would work for an employee hired at age 25 and earning $30,000. Assuming 6 percent salary increases, the plan would provide a substantial account at retirement age, with annuity values nearly comparable to a typical defined-benefit pension plan.

However, note the substantial account balances that would accrue for employees who terminate in the middle years of a career. Cash-balance plans provide substantially more to employees in the middle years than would be the case under at traditional defined-benefit pension plan.

CONSIDER THIS PLAN:

Cash-balance plans are proving attractive in a variety of start-up situations, as well as in mature companies where the employer would like to retreat in some capacity from the open-ended promise of a final average-pay pension plan. Moreover, the employer might be unable to terminate the current plan without undue employee relations or financial repercussions (e.g., an overfunded position would trigger an excise tax, but an underfunded position would require any shortfalls to be made up).

Converting to a cash-balance plan would allow the employer to retain the defined-benefit plan (and the funding advantages accorded these plans) but control the rate at which benefits grow in the future. In addition, the plan would allow the employer to capitalize on the inherent appeal to employees of individual-account plans. However, PBGC premiums would still be required.

Mobility bonus pension plan

A mobility bonus plan represents something of a unique response for employers in special circumstances. These plans are defined-benefit pension plans, and there are no individual accounts maintained. However, they function like defined-contribution plans, because the payment focus is on a single-sum amount rather than an annuity stream.

Mobility Bonus Pension Plan
Lump sum = 10% of FAP x service; Age at hire 25;
Salary at hire, $30,000; FAP at age 65, $309,583.
  Age at            Annuity      Percentage of Pay
Termination       at Age 65      Per Year of Service
  30              $ 36,838              2.38
  35                66,937              2.16
  40                91,211              1.96
  45               110,196              1.78
  50               124,300              1.61
  55               133,721              1.44
  60               138,635              1.28
  65               138,619              1.12

SCENARIO:

An employer might structure a plan to provide a lump sum of 10 percent of final average pay (FAP) for each year of service. So an employee terminating after 10 years of service would receive a lump sum of 100 percent of pay, or 150 percent of pay after 15 years, and so forth. Exhibit 3 provides an illustration of the concept, expressed in the "retirement" language of annuity values at age 65 and as a percentage of pay earned with each year of service. Note the heavy skewing of amounts toward younger, shorter service employees.

CONSIDER THIS PLAN:

Such a plan appears to be relatively unconventional if the typical employer is assumed to be an industrial or financial institution where employees are likely to remain for a full 25-year or longer working career. However, many employers are in entirely different circumstances and if not encouraging turnover, at least recognize that a full "career" may be on the order of 10 or 15 years.

Professional service firms, high-tech, research and scientific fields are examples of the types of industries in which these plans might have appeal. Also, these kinds of plans can prove attractive in highly competitive-for-people-talent industries in which getting retirement dollars to employees is an industry problem, and an efficient means of doing so may enable one employer to differentiate itself from others in the same industry - for example, hospitals competing for nurses. These plans are also easy to communicate and administer.

Age-weighted profit-sharing plan

Only recently have IRS regulations effectively created this new type of arrangement that allows profit-sharing plans (with their inherent flexibility in defining the employer contribution) to allocate benefits with a defined-benefit type of "weighting" for older employees.

In concept, age-weighted retirement plans are similar to target plans in that both are defined-contribution vehicles and both permit the employer to direct more of the employer contribution to older employees. But the plans are dissimilar as true profit-sharing plans in that contributions may vary from year to year based on profits.

As a result, an age-weighted, profit-sharing plan has significant appeal in situations in which the employer wants to improve the efficiency of a defined-contribution plan as a retirement income vehicle by concentrating allocations on those employees nearer retirement; the company also wishes to retain the flexibility to determine contributions annually based on profits.

Age-weighted plans pass muster with the new nondiscrimination requirements for several reasons. The rules permit defined-contribution plans to prove nondiscrimination by demonstrating that the defined-benefit accrual created by the allocation does not discriminate in favor of highly paid employees.

This testing approach allows a relatively modest allocation for younger employees to generate a much higher defined-benefit value. Therefore, plans that provide relatively small allocations for younger employees can still prove that, on crossing-over to a defined-benefit basis for non-discrimination testing purposes, the plans do not discriminate in favor of highly paid employees (who may be the older employees with an organization).

SCENARIO:

Exhibit 4 provides an illustration of the way age-weighted, profit-sharing plans work, including passing the nondiscrimination tests. In this particular example, the flat line represents the value of the current year's allocation amount converted to an annuity at age 65. The benefit rate is the same for all employees - in this case, just under 4 percent of pay. The curved line represents the actual allocation to participants in the current year, based on age. For instance, the current contribution might be worth 1 percent of pay for the 20-year-old employee, climbing to upwards of 20 percent for the 60-year-old employee.

CONSIDER THIS PLAN:

How are age-weighted plans being used today? Among smaller employers concerned about the administrative costs associated with defined-benefit plans, these defined-contribution plans are an effectively way to allocate funds in cases in which the employer's primary concern is emphasizing retirement income for older employees. Among large employers, the attraction is entirely different - as "special needs" retirement income tool.

For example, an age-related formula might be used when an employer needs to make significant reductions in retire medical benefits but also wishes to make a pool of funds available to older employees caught in the transition. Or, the plans might be used to assist employees in creating an additional fund to purchase long-term-care benefits. Still another use would be on fill in on an interim basis for any cutbacks in an underlying defined-benefit pension plan.

Conclusion

Historically, the range of approaches for providing retirement income could be plotted neatly on a spectrum. At one end would be traditional defined-benefit pension plans and at the other, traditional defined-contribution vehicles. Today, things are no longer so tidy. Newer plans have been created - and some older ones reinvigorated - so that employers have vastly wider possibilities for meeting the obligations of plan sponsorship, as well as responding to the needs of employees for retirement income.

COPYRIGHT 1992 Society for Human Resource Management
COPYRIGHT 2004 Gale Group