Lecture 22: Pension Benefit Formulas Approaches to retirement plans Defined benefit plans –Elements of defined benefit formulas –Non-pay-related formulas –Pay-related formulas –Social Security integration –Accrual rules –Benefit forms –Miscellaneous benefits Defined contribution formulas

Approaches to Retirement Plans Defined benefit –Plan formula defines the benefit that will be paid to the employee –Employer bears investment risk –Generally favors older, longer service employees –Benefits may or may not be portable –More complicated to communicate –Complicated administration Defined contribution –Plan specifies the amount the employer will contribute to the plan –Employee bears investment risk –Provides portable benefits –Better for younger workforce –Easier to communicate –Relatively easier administrative and government regulations

Elements of Defined Benefit Formulas Benefit service –Elapsed time Date of hire Date of participation –Hours Earnings –Base pay only –W-2 pay –Bonuses –Commissions Averaging of pay –Final average earnings (FAE) –Career average Benefit approach –Annuity –Lump sum

Non-Pay Related Defined Benefit Formulas Flat-amount –$500 per month Unit-benefit –$50 per month times years of service

Pay-Related Defined Benefit Annuity Formulas Career average pay plans –Benefit is a function of earnings over entire career with the employer 2% of career earnings Final average pay –Flat-percentage 50% of compensation at retirement –Unit-benefit 1.5% of final five year average earnings (FAE(5)) times years of service

Pay-Related Account Balance Defined Benefit Formulas Cash balance –Pay credit = % of each year’s pay placed into an “account” 8% of pay paid into an “account” each year –Interest credit Rate equal to one-year Treasuries credited to the account each year –Account balance paid at termination or retirement Pension equity –% are accumulated each year –Accumulated credits are multiplied by final average earnings and amount is paid as a lump sum 10% given per year of service

Social Security Offset Method Offset limitations –No more than.65% of pay up to covered compensation (CC) may be offset Limit service to 35 years Further reduced for subsidized early retirement –Cannot reduce more than 50% of gross benefit Example: –1% of FAE(5) times service -.65% of FAE(5) up to (CC) times service up to 35 years

Social Security Excess Method Excess Limitations –Maximum difference between the base % and the excess % is.65% –Limit service to 35 years –Further reduced for subsidized early retirement Examples –2% * FAE * SVC +.65% * FAE > CC * SVC –2% * FAE CC * SVC

Defined Benefit Accrual Rules Must pass one of the following –3% rule Accrual must be at least 3% of total benefit –133 1/3% rule Rate of accrual must be < 4/3 of earlier accrual –Fractional rule Use a service prorate to determine the benefit 1% of pay for 10 yrs + 1.5% for next 10 yrs –Projected benefit = 25% of pay, AB > 3%*25% =.75% --> passes 3% rule –1.50%/1.0% = > fails 133 1/3% rule

Forms of Payment for Defined Benefit Plans Life annuity Lump sums Joint and survivor –50% joint and survivor required by law Social Security leveling option Certain and life options

Miscellaneous Benefits Paid Under Defined Benefit Plans Preretirement survivor annuity Incidental death benefits Disability benefits –Reduced accrued benefit –Continued accrual –Definition of disability –Age/service requirements Early retirement supplements

Defined Contribution Formulas Money purchase plans –Amount contributed to an individual account –Account grows with interest Target plans –Amount contributed is based on the amount necessary to accumulate to a target benefit Social Security integration -- excess only –Usually integrate on wage base –Maximum difference = 5.7%