Variable Pay Design Considerations

Wednesday, September 29, 2010

If, as we have seen, traditional merit and salary plans no longer work to achieve the desired results of many organizations and are currently funded at 2% to 3%, what options do organizations have? Organizations could attempt to re-engineer their merit based pay plans to obtain a more closely aligned outcome with their organizational needs. However, traditional merit and salary plans represent fixed overhead costs, which are present regardless of whether the organization achieves its goals or not. Furthermore, they bring into question both the reliability and validity of their measurement systems and that of the rater’s bias, the supervisor. What is needed is a plan that focuses attention on the desired organizational issue of the day and are variable costs resulting in expenditure only when the desired organizational goal is met using a priori quantifiable statistics.

While variable pay may be called by any number of names, e.g., incentive pay, pay for performance, bonus, reward, profit sharing, and may be any combination of financial and non-financial payments, variable pay is designed in a way to overcome many of the issues associated with merit pay.  Variable pay plans have been around since the 1930’s; however, over the decades they have evolved and become much more widespread both across and down the organizational structure.

In “Rewarding Performance: The Role of Variable Pay” by Joseph R. Bellavary and Robert W. Allen of the Graduate School of Business Alumni Management and Human Resources at California State Polytechnic University, Pomona, the authors point out that costs, efficiency, and the ability to differentiate among employee performance levels are several of the key drivers associated with the variable pay plans.

Cost: when considering the cost of any reward system, thought must be even to both how will the system pay for itself and how will it be administered. Since variable pay, plans can be significantly more complex than a single dimensional bonus plan, the tracking, recordkeeping, payment, and possible legal issues need to be addressed. The desired cost structure should be a variable cost rate which decreases both as a dollar amount and percentage per unit designed, produced, sold, financed, shipped, etc. While it is possible to build a system that will meet the objectives of the organization, it is also possible to design a process that is too cumbersome to administer.

Efficiency: the organization will want to make the best use of its human, capital, physical, and financial resources. Un-moth-balling an old out of date factory and re-tooling it may not be the best application of any of the organization’s resources. However, re-tooling a current plant or mill to take advantage of a new product manufactured from what was previously waste might be a project that is appropriate for variable pay. At one time, sawmills burned their wood wastes for fuel, now much of that ends up in particleboard, plywood, oriented strand board, medium-density fiberboard, and various paper products. Someone had to conceive, design, manufacture, market, distribute, and sell these products; variable could have been used to reward those tasks.

Performance differentiation: a major criticism of merit and simple bonus pay systems are that they fail to identify the top performers among a group of employees. While supervisors often state they “know” who their top performers are their perceptions are often based on bias. An organization’s variable pay plan must be able to ferret out performers by achievement level. That means being able to identify and track those statistical measures that can be used objectively to reward behavior. It will be essential that an organization can track who sold what, when, where, to whom, in what quantities, was it a repeat sale to the same or a new client, how as it financed, did the client default on the financing, was the sale profitable, and was a single product sold or multiple products sold. A variable pay plan at a large health insurance company included an incentive pay to include sales representatives from other product lines and an incentive for cross selling clients with multiple lines from health, life, 401(k), and FSA product lines. Since performance is differentiated at the employee, group, plant, mill or organization level, top performing employees, groups, plants, mills or organizations become apparent.

Variable pay, as the term implies, is flexible enough to be altered midstream if business or economic conditions change requiring are re-alignment of organizational objectives. Although care and caution should be practiced here, least the organization loses creditability with its employees. While there is no sin in raising the expectations bar periodically, great attention should be paid to the timely and communications of such changes. I once lived in a community with a shoe factory. Each time the workers met their production goals, the goals were moved upward with no notice and without giving credit for meeting their earlier goals. It was not long before the plant was unionized.

Variable Pay in Lean Salary Budget Times

Monday, September 27, 2010

With frozen salary budgets, staff reductions, plants closures, and high rates of unemployment, any kind of significant employee salary increases are far and few in between. One area where organizations appear to be willing to continue to provide financial reward is variable pay. While variable pay has been around for decades, its use has become increasingly widespread. Variable pay may also be recognized by other names, including “incentive pay” and “pay for performance”.

Variable pay is a reward that is focused on a specific achievement, goal attainment or accomplishment such as changes in organizational productivity, profitability, teamwork, safety, quality, or some other measureable factor. Organization could be an individual employee, a group or groups of employees, a department, plant, mill, office location or the entire company. Variable pay (financial and non-financial) may be awarded in a number of methods and includes many familiar arrangements such as; formal profit sharing plans, bonuses, commissions, deferred compensation arrangements, cash, and even in-kind merchandise as in paid vacation trip.

Where variable pay differs from a simple bonus is that payment of the reward is often based on multiple factors. It  is just not acceptable to sell 10,000 units of X to a client. The sale needs to be the right client, the sale needs to be highly profitable, and it needs to be a client that will provide repeat business. Selling 10,000 units below cost, to a client that will never provider repeat business or selling to a client that defaults on the credit arrangements is not going to meet the organization’s needs. I once worked for a large insurance company whose sales representatives might sell a group contract below actuarial cost, or to a group that would not renew, or fail to cross sell multiple product lines, resulting is a lost opportunity. Finally, variable pay should never be guaranteed, rather variable pay is always at risk.

The risk associated with variable pay should be substantial. It has to be more than just the loss of a few dollars. It would not be unusually for variable pay to make up 25% to 50% of an employee’s total earnings potential. The design of a variable pay plan in complicated and detailed but an example might be: base pay is set at 75% to 70% of the average market wage rate for a position and the variable pay potential is set at 25% to 50%. This potential allows the employee to opportunity to earn back to a point where they are at the average market wage rate for their position, plus up to an additional 25% above that rate.

Since variable pay could be directed at any organizational achievement and not just sales. Consider a variable pay plan directed at the reduction or production errors or waste, addressing plant or mill safety issues and injuries, reduyction in fuel usage in fleet vechiles, on time, under-budget software project implementation. I once reviewed a variable pay plan for a small steel mill near Tampa Florida where even the administrative staff pitched in during the annual maintenance furlough.

Variable pay plans have seen a significant growth in the last 20 years, and why is that? Organizations are finding that “merit” pay plan do not work, especially in a down cycle. Since variable pay is generally tied directly to organizational performance, variable pay plans have the ability to for themselves.

Promotional Increases, an Alternative to Merit Increases

Saturday, September 25, 2010

While very modest increases in the range of 2% to 3% in salary and merit budgets have surfaced in the last 12 months as the economy slowly recovers, one bright spot is promotional adjustments. It appears that organizations are willing to grant larger increases to those employees who are willing to take on higher-levels of responsibilities. As organizations reduced their staff, many surviving employees were expected to accept additional duties. In some cases, those additional duties were simply more of the same. However, in other situations, those extra duties included higher levels of responsibilities, and even supervisory assignments. Thus, it is only reasonable that many organizations are willing to pay more for employees who have the ability and willness to accept new roles.

The WorldatWork 2010-2011 Salary Budget Survey, published by WorldatWork on July 06, 2010, analyzed 2,724 submissions from the United States and Canada. Alison Avalos, research manager for WorldatWork commented that, “… promotion could mean an additional 7% to 8% increase …”. In additional, the survey also revealed that organizations where to pay out some 5% to 15% in variable pay, depending on the employee’s job classification. While survey respondents are willing to set aside only 2.5% on average for merit pay, those same organizations are willing to 7% to 8% for a promotion and 5% to 15% for variable pay. So why are organizations willing to recognize employee attainment of higher levels of responsiblity and reach higher levels of production and/or productivity with pay two to three times that for merit performance?

In the case of promotional increases, organizations are willing to reward attainment or acceptance of higher levels of responsiblity since it often brings with such achievement a significant gain in productivity. It is often a real possibility that a promoted employee will retain some portion of their old duties while taking on new ones. Even if a new employee is hired to replace the promoted employee, the promoted employee is often on hand to help “bridge the gap”. Furthermore, the promoted employee is also able to provide continuity so no customer service, product or client knowledge is lost.

At the same time, a promoted employee may be less likely to leave the company and even in these times, it is still difficult to retain top performers. Handled correctly, a promotion of a well-qualified performer sends a strong message that “I too” may have such as opportunity in the future. I once worked for a large ($1 billion +) southern bank, we knew that as our customers opened new accounts and purchased new products from us, the likelihood of that customer leavening was lessened. The same can be said for an employee, if the organization can retain the an employee long enough (3-5 years) to vest in the 401(k) plan, receive an increase or two, earn a promotion, and build a social network within the organization, like my bank’s customers, the likelihood of that employee leavening is lessened.

A 2006 research paper by Kiyoshi Takahashi an associate professor at the Kobe School and Business Administration found that “promotion fairness” and “development opportunity” carried the greatest value in effecting the levels of motivation associated with a promotion. This effect was true for both “white” and “blue” collar jobs.  An earlier study by Charlie O. Trevor, Barry Gerhart, and John W. Boudreau of Cornell University reported that promotions had a significant role in employee retention and that the lack of promotional opportunities could lead to increased turnover.

Salary Trends 2010-2011

Thursday, September 23, 2010

In January 2008, a Towers Perrin’s (now Towers Watson) 2008 Global Compensation Planning Report of 4,000 plus companies in 60 countries, Towers projected an average salary increase of 3.9% for all employee levels for 2008.  A January 2009, a Towers Perrin’s (now Towers Watson) U.S. Companies Make Deeper Cuts in Pay Programs as the Economic Crisis Continues of 1,150 companies, Towers projected an average salary increase of 3.0% for all employee levels for 2009.  An August 2010, report by Towers Watson, U.S. Employers Planning Larger Pay Raises for 2011, of 1,046 companies, projected an average salary increase of 2.3% for all employee levels for 2010.

A survey of 2008 salary increases for health care was reported in 2008 Healthcare Salary Outlook, and commented on by John Rossheim, a Monster Senior Contributing Writer, reported a salary increase range of 3.5 to 4.0%.  The survey of 2009 salary increases for health care was reported in 2009 Healthcare Salary Projections, and commented on by Georgia Price of AllHealthcare, a Monster Community, reported a salary increase range of 3.5 to 4.0%, unchanged from 2008.  The 2010 Hay Group Healthcare Survey sponsored by TIAA-CREF, released on July 12, 2010, reported a continuation in the slowing of increased for health care workers. The survey projects a 2.5% increase in base pay in 2010.

In a 2008 survey of some 7,000 readers, posted on November 10, 2008, Computerworld, reported that most readers’ salaries had been negatively impacted by the economic downturn.  The 2009 survey of some 5,000 readers by Computerworld, reported that salaries were frozen, benefits were being reduced, and workloads were increasing. 

WorldatWork a not-for-profit professional organization reported in its May 2008, 2008-2009 Salary Budget Survey of 2,479 employer submissions that 2008 actual salary increase ranged from 3.8 to 4.0 percent.  The WorldatWork May 2009, 2009-2010 Salary Budget Survey of 2,644 employer submissions that 2009 actual salary increase ranged from 2.0 to 2.3 percent.

In a 9/16/2010 report posted by Culpepper and Associates on the website for the Society for Human Resource Management titled, “Global Salary Increase Budgets for 2010 and 2011”, 2011 US base salary increases are expected to be in the range of 2.38% to 2.91%

Although salary increases are improving as the economy strengthens, 2% to 3% is still a small merit budget. Even using traditional merit techniques and limiting increases to those at or above “meets” and only those below the mid-point, most organizations will only be able to squeeze a few extra percentage points out of the budget. With such low merit budgets available and few internal promotional opportunities available to them, some employees may be awaiting a job offer to jump ship. Organizations might be well advised to look for non-financial means to retain the talent left after several rounds of staff cuts.

While training budgets did not fare any better than salary budgets during the downturn, providing training now may position the organization’s top talent to take advantage of better times. Following multiple rounds of staff reductions, the remaining staff may be performing significantly higher-level duties or duties not normally found in their nominal job classification. Organization may want to re-evaluate those positions to determine if an upgrade in warranted. Attention should be paid to the FLSA exempt vs. non-exempt classification of any re-evaluated positions. An organization may be tempted to misclassify a position only to be faced with unpaid overtime claims in the future.

Talent Management in a Recovering Economy

Tuesday, September 21, 2010

Indications are that the current economic recovery will be prolonged and will produce only modest job growth over the next two to three years. While this does not bode well for job seekers, it also holds out a number of challenges to organizations attempting to recruit and retain top talent. It may seem like a win-win for organizations with significant numbers of highly qualified talent on the market and possibly at very reasonable wage rates compared to few years ago. However, organizations need to be watchful and practice good hiring techniques in order to the best qualified and best fit for their needs.

Deloitte LLP, a firm specializing in audit, financial advisory, tax and consulting suggests that there is a distinction between those organizations who are preparing for recovery and those that may be “left behind”. “Hunkering down” may have seemed like the right thing to do two years ago but may result in “losing the increasingly critical fight for talent”.

A survey In September, 2009, by the talent development and retention firm talentRISE LLC indicated that “80% expect post-recession recruiting to begin by second quarter of 2010”.  Accountants International, a Burlingame, CA-based provider of accounting and finance staffing and recruitment, reports that 25% of the 3,500 respondents to their April 2010 Compensation, Benefits and Workplace Trends Guide indicated that “felt their accounting and finance departments were understaffed and they anticipate hiring”.

Kelly’s Outsourcing & Consulting Group recommendation a number of technology tips and tools:

“1. Use niche websites, 2. Make social media a part of your toolbox , 3. Set up a company or recruiter-specific LinkedIn profile, 4. Author or sponsor industry-specific white papers, 5. Create a webcast that showcases your company, culture, product or a best practice, 6. Blog where potential candidates are listening, 7. Automate your sourcing efforts, 8. Revisit and use your own applicant tracking system (ATS), 9. Join online groups and participate, and 10. Build a passive candidate database though online searches.”

Tali Arbel, an Associated Press Business Writer, in an article posted to ABC’s News and Money website on June 15, 2010, commented that there are other ways to retain employees who might otherwise look for employment opportunities elsewhere as the economy recovers. Among those techniques are: employees are motivated when they are noticed for doing a good job, look for ways that you can express you gratitude to an employee who went above and beyond, and allow employees to acquire new knowledge’s, skills and abilities.

It is clear, that as the economy meanders alone its slow road to recovery, an organization needs to position its talent to take full advantage of even the smallest amount of uptrend. To do that, the organization must have its talent base in place, engaged, and ready to deliver to its customers. While there may be a perception that talent is standing on the corner just waiting to be hired, the actuality is that top talent has a job; and you do not want that job to be at your competitor.

Executive Compensation Trends for 2010

Sunday, September 19, 2010

On Thursday, October 22, 2009, following the economic downturn in 2008 and US governmental intervention on behalf of several US companies. Included were, American International Group, Citigroup, Bank of America, Chrysler, General Motors, GMAC, and Chrysler, the Federal Reserve issued a number of rulings that would curtail executive compensation practices at employers who participated in the assistance from the Troubled Asset Relief Program (TARP). The changes affect a cash cap on annual compensation of $500,000 or more, the immediate vesting in stock options, and a limit on incentive stock compensation. The restrictions cover the five most executives and the other 20 highest paid employees at the TARP participating companies.

A Society for Human Resource Management (SHRM) report released on December 17, 2009, authored by Stephen Miller, and quoting from a survey by the compensation consultancy firm of Pearl Meyer & Partners, indicated that “… even companies that believe they are outperforming their peers project only modest salary increases. Survey respondents indicated that they were taking a cautious approach to design and payout levels of short-term and long-term incentive rewards.”

In a special report published by the New York Times on April 3, 2010 and authored by Devin Leonard, titled: “Executive Pay: A Special Report, Bargain Rates for a C.E.O.?”; it was disclosed that CEO pay declined by 13% in 2009, this followed a 9% drop in 2008. The article’s analysis was based on survey data provided by Equilar Inc., a research company involved in “benchmarking and tracking executive compensation, board compensation, equity grants and award policies and compensation practices.”

A July 2010 report from Towers Watson, an HR consulting firm, “companies remain focused on shareholder perceptions and the alignment between executive pay and business performance in the economic recovery.” According to the survey of 251 mid-sized and large US companies, Towers reports that as “Say or Pay” intensifies, few responding companies are ready to put their executive compensation practices to a vote by their shareholders.

Issues concerning executive compensation are not isolated to the US. In a 2010 report by the Hay Group, an HR consulting firm, Shine More Light on the issue: Top Executive Compensation in Europe 2010, Hay announced that executive “pay has reached a crossroads”. During the last two years, employers have been reluctant to take action on executive pay in spite of increased legislation and public concern over the issue. Hay goes on to say that “a fundamental rethink of executive pay“ must take place. Not too diffectient than what is being heard in the US.

Clearly, the recent two years have shown that organizations can expect greater involvement by governmental, shareholder, and public interest in the management of executive compensation. The public is coming to expect a higher degree of transparency in corporate dealings with top pay being only one of many area of concern.

Fair Labor Standards Act Recordkeeping Regulations

Friday, September 17, 2010

Issues with what records to keep and for what duration are common concerns with the Fair Labor Standards Act and often problematic when employers attempt to defend their actions on why a job is classified as exempt. non-exempt or whether time was paid time or not paid. Even for those organizations with formal policies covering hours of work, such policies must be carried routinely out by line supervisors and managers.

As recently as June 7, 2010, the Kentucky State Auditor, reported that the Barren County’s Library Board failed to maintain adequate time records under both Kentucky state law and Fair Labor Standards Act’s recordkeeping regulations, 29 CFR Part 516. The Act requires employers to maintain a list of basic records, including: time and day of week when employee’s workweek begins; hours worked each day; and total hours worked each workweek. While such recordkeeping seems fundamental to the operations of almost any business, failure to do so can be a time consuming and costly endeavor.

While it appears to be a simple task to track employee days of work, work times, hours, and pay rates; consider an organization that has several locations, operating at different times, may be with split shifts, and on different days. Now consider that such as organization lacks computerized or electronic means of tracking start/stop times, hours, and days worked. Under such a condition it would be easy for both the employer and employees to be unable to know, with certainty, what hours were worked and when.

 The City of Fort Wayne, Indiana, employed a gardener at the Lawton Park greenhouse. Part of the gardener’s responsibilities at the greenhouse involved spraying pesticides containing toxic chemicals, some of which required quarantine. Accordingly, for a period the gardener was required to clock-out of work several hours early and then return in the evening to perform spraying after other employees had left. The City's obvious motivation for utilizing this system was to limit exposure to dangerous chemicals by completing pesticide spraying after hours, but at the same time avoid paying overtime to the gardener. In such an arrangement, failure to track starting and stopping times, hours worked during each portion of the split shifts, the total hours worked could lead to significant legal action, and it did when the gardener eventually filed for overtime.

Often at issue when employers fail to keep time, hours, pay, and other labor records is who to rely upon for those records. It is not out of the question for the courts to turn to employee dairies, journals, employee testimony, and other non-employer records for determining the hours worked and when.

How expensive can it be to pay for a few “off the clock” hours and work not handled correctly in the first place?.

It has been reported that Walt Disney Parks and Resorts U.S. in Orlando, Fl paid $433,819 in back wages to employees after a DOL WHD investigation found that workers were not paid for work before and after their shifts and while working from home. Although Walt Disney had rules associated with off-clock work, the report concluded that company managers failed to adhere to company policies.  The DOL’s WHD also recovered $868,443 in wages for employees of Central Florida Investments, a company that operates timeshare resorts in Florida.

Are these isolated events where a few supervisors or managers ignored their company’s rules? Hardly, according to the DOL’s WHD news releases, several millions of dollars in unpaid hours and overtime have been recovered in 2010 alone. While no employer wants to be faced with the payment of unplanned expenses, employers certainly do not want the loss of community goodwill, increased recruitment difficulties, and months, if not years of litigation.

Employee Retirement Planning 2.0

Employee Retirement Planning 2.0

So, if traditional Defined Benefit pension plans are evaporating, Defined Contribution plans are being frozen, and inflation is so low that Social Security beneficiaries face one or more years of no benefit increases, how do employees plan for retirement? If employees have access to a Defined Benefit pension plan, even one that has been frozen with respect to newly hired employees; they need to understand its features. If employees have access to a Defined Contribution plan even if there is no employer match or the match has been temporality frozen, they need to understand its features. Many publicly held stock companies have Employee Stock Purchase or Ownership plans, participation, in which is often low, even though some employers match the employee’s purchase up to a certain amount or percent. Employees should seek out the opportunities they have, even if they are limited.

In many of my prior roles, I have had responsibility for informing, educating, and communicating the availability of Defined Benefit, Defined Contribution, and Employee Stock Purchase and Ownership plans. I was always amazed at the failure of employees to attempt to understand the value that such plans bring to the financial well being of covered employees. Certainly, the technical, legal, actuarial, and financial aspects of these plans can be intimidating even to a well-trained employee. Nevertheless, those employers with whom I have been associated made a concerted effort, beyond regulatory requirements, to inform and educate employees.

Even when employees are not covered a Defined Benefit, Defined Contribution or Employee Stock Purchase and Ownership plan; employees do have the ability to take advantage of Traditional or Roth Individual Retirement Accounts. While these plans are not matched by any employer, contributions and they have significant limits on their funding and deductibility features. However, coupled with other forms of savings, individuals who do not have access to employer-sponsored plans do have the ability to save significant amounts for retirement.

The one thing that most have employees have recognized over the last 20 years, is that employers have become increasingly less paternalistic in their roles in many employee benefit plans including those related to retirement. As such, employees must become more knowedlabe of all of the benefit plans to which they have access. Furthermore, as noted above, employees must rely on their own initiative in the development of retirement savings and investment plans.

Employees should seek out professional advice from certified financial planners, attorneys and others in the preparation of retirement plans, wills and other important planning documents.

Social Security Administration Announces, No Benefit Increase in 2011

Social Security Administration Announces, No Benefit Increase in 2011

It seems timely that as we have been reviewing the retirement models for American workers, the Social Security Administration announced that there would be no increase in the Social Security benefit amounts for 2011. The announcement came as no great surprise, since benefit amounts are indexed to inflation; most observers correctly anticipated that with low inflation, 2010 benefit amounts would remain in place. The announcement was published in the Federal Register, Vol. 75, No. 206, on Tuesday, October 26, 2010.

The logic of tying annual Social Security benefit increases to inflation appears to be quite rational on the surface. If there is a significant increase in the cost of living as measured by a national measure, such as the Consumer Price Index (CPI) for Urban Wage Earners and Clerical Workers, benefit levels should be offset to account for that increase. The issue is that any measure such as the CPI is a gross statistic averaged across the entire nation and all socioeconomic levels. As such, the CPI fails to account for regional and even local variations in the economic environment. Furthermore, the market basket of goods and services that go to makeup the CPI contains many items, which may not be appropriate for “retired” individuals.

That market basket is composed of 200-item categories; eight of the major groups of items are listed below:

1. Food and Beverages
    (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks)

2. Housing 
   (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)

3. Apparel 
    (men's shirts and sweaters, women's dresses, jewelry)

4. Transportation
    (new vehicles, airline fares, gasoline, motor vehicle insurance)

5. Medical Care
    (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)

6. Recreation 
   (televisions, toys, pets and pet products, sports equipment, admissions);

7. Education and Communication
    (college tuition, postage, telephone services, computer software and accessories);

8. Other Goods and Services
    (tobacco and smoking products, haircuts and other personal services, funeral expenses).

It does seem strange that items such as “bedroom furniture, new vehicles, college tuition” have found their way into an index used to determine benefit increases for individuals who, for the most part, are over 65 years of age. Conceivable, bed frames and mattresses have to be replaced, automobiles do have to be replaced, and even a 65-year-old accountant may want to earn a teaching degree.

Even the Congressional Budget Office questioned the use of the CPI as an overstatement of the cost of living, pointing out that it, “… may seriously distort private and public economic decisions.”. Interesting enough, this question was raised by the CBO in 1994 and we are still using the CPI to adjust Social Security benefits and a host of other payment systems.

American Retirement Model – Private Savings

American Retirement Model – Private Savings

Traditional Defined Benefit plans now cover only about one fourth to one third of US workers. However, significant numbers of workers are eligible for Defined Contribution plans in one of several forms. Most workers are also eligible for some form of Social Security benefits once their reach their normal retirement age. What is missing is the former third leg of the Three Legged Stool i.e., Private Savings. The concept was that workers relied on a combination of Private Pension, Social Security, and Private Savings to provide income during their post-employment years. However, since the late 1980’s, Traditional Defined Benefit plans have steadily been replaced by Defined Contribution plans. Combined with stagnate to very low real wage growth, many Americans lacked the disposal income to both participant in Defined Contribution plans and fund Private Savings. Thus Americans, as a whole, have saved significantly less than their foreign cohorts have. The result is not many Americans will have a substantially lowered standard of living during their retirement years.

At the same time that Traditional Defined Benefit plans were being replaced with Defined Contribution plans Americans became increasingly more mobile in their employment. This was due to employees switchinmg employers as well as workforce reductions, company mergers, failures, downturns, and changes in the make-up of the industrial base and workforce of the American econonmy. None of these actions were conducive to sustained long-term employment capable of supporting savings. Compounding this situation was a lack of real wage growth by most workers.

In reality, most middle-income wage earners are left with a “Two Legged” stool consisting of a Defined Contribution plan and Social Security. The result being that many workers will need to delay retirement for several years or even continue working well past even their delayed retirement age. While working past the normal retirement age for many may be seen as highly desirable and a means of making significant contributions to society, for others will be a matter of necessity. Additionally, it has the potential of continue to “gray” the current workforce and limit upward opportunities for those subrogates awaiting their boss’s retirement. Unfortunately, as the recent recession has shown, sometimes an employee’s willingness or desire to remain in the workforce is overshadowed by the employer’s desire to reduce that same workforce.

While early retirement might sound attractive, many of those early retirees are accepting reduced benefits in the form of lowered Social Security benefits and early withdrawals from there, Defined Contribution plans. Even for those who planned and saved well, early withdrawal of monies by several years could change how long the remaining funds will last. Faced with an economy that may not recover for several years, many workers may not have any choice but to accept early retirement, under-employment, and a lowered lifestyle.

American Retirement Model – Social Security

American Retirement Model – Social Security

The German government under Chancellor Otto von Bismarck in 1889 introduced a national statutory health insurance system, which is credited with being the “prototype of a ‘social insurance state’”. As such, it combines public plans, financed through compulsory payroll deductions with public administration. Bismarck’s motivation was to support the welfare of German workers in a way that would maintain the German state working at utmost effectiveness, and to block efforts at “more radical socialist alternatives”.

Forty-Six year later, and following six years of a devastating national economic depression, then President Franklin Delano Roosevelt signed the American parallel to Germany’s social security insurance into law on August 14, 1935. In his remarks at the signing, he stressed the hope that this law would:

"… lessen the force of possible future depressions, to act as a protection to future administrations of the Government against the necessity of going deeply into debt to furnish relief to the needy--a law to flatten out the peaks and valleys of deflation and of inflation--in other words, a law that will take care of human needs and at the same time provide for the United States an economic structure of vastly greater soundness." President Franklin Delano Roosevelt, August 14, 1935

Since its enactment, the American social security system of has provided a safety net of income to millions of citizens. Established as a system of payments and benefits for: old-age workers, victims of industrial accidents, unemployment insurance, aid for dependent mothers and children, the blind, and the physically handicapped. http://www.archives.gov/press/press-releases/2010/nr10-128.html

The origins and concept of the “Three Legged Stool” are somewhat obscure. In basis, the Three Legged Stool refers to the financial security derived from an employee’s private pension plan from their employer, the employee’s own private investments and savings, and benefits from Social Security, thus “three” legs of support. Initially, the employee’s private pension plan was in the form of a traditional defined benefit pension plan; however, today that most often takes the style of a defined contribution plan, i.e., 401(k). http://www.ssa.gov/history/stool.html

While Social Security was never intended to provide for 100% of a retired or disabled employee’s needs after employment, it was envisioned at a safety net and to provide a significant portion of their prior income and benefits. While opinions vary, many authorities perceive that a retiree will need 70-80% of their pre-retirement income in order to maintain a similar lifestyle they enjoyed prior to retirement. Currently, depending on the retiree’s pre-retirement income, Social Security will replace something in the range of 15-25% for a typical non-highly compensated employee. The remainder has to come from the other two legs of the stool.

American Retirement Model – Defined Contribution Plans

Tuesday, September 07, 2010

Although Defined Contribution Plans have been around in various forms for decades, the form that most people are the familiar with is the 401(k) plan. So called since it is named after section 401(k) of the Internal Revenue Code. Similar, but slightly less familiar are the 403(b) and 457(b) plans related to employment in the nonprofit, state or local governments, and their agencies and organizations. Defined Contribution Plans are designed around the front-end “contributions” made into the plan rather than the benefit accrued on the back end of the plan. They are most typically funded through a combination of employer and employee periodic contributions over the employment period of an employee. While employee contributions may be matched with employer monies, it is possible to have plans where the only contributions come from either the employer or employee but not both. Contributions may be in the form of fixed dollar amounts or percentages of employee compensation. These plans work much like a personal savings account except monies are usually taken from the employee’s periodic payroll earnings on either before or after tax basis, and deposited into a segregated trust fund. The fund in overseen by a “trustee”, which could be a bank, investment brokerage firm or other financial institution. Monies are withdrawn at retirement or under special rules for certain and selective financial hardships.

Since Defined Contribution Plans define the contributions rather than the benefits of the plan, there is no guarantee that the accrued account balance available to the employee upon retirement will be any specific amount. However, Defined Benefits Plans guarantee that the employee will have a specific benefit available to them as defined by some formal benefit formula. With Defined Contribution Plans, the employee bears the full responsibility managing the account and funding it to the desired desired retirement level. While the employer may match some, all or none of the employee’s contributions, the employee must make up for any financial short falls due to poor market conditions or poor investment selections by the employee. With Defined Benefits Plans, if market conditions are unfavorable, or workforce demographics change, the employer is responsible for additional funding to maintain the “minimum funding” levels.

Oddly enough, many employees actually prefer Defined Contribution Plans to Defined Benefit Plans. One obvious reason is they are simple to understand, as in the earlier example of the savings plan model. Every payroll monies are deducted and deposited into the employee’s account, within a few days; the deposit can be viewed and verified. Most modern Defined Contribution Plans allow employees to go online, view and manage their accounts much like another investment account. Thus an employee can view their account balance daily and see the gains and losses accrue daily. While this is not recommended, it allows the employee to have a sense of control not experienced with Defined Benefit Plans.

Another reason why many employees preferred Defined Contribution Plans is portability of accounts whenever the employee separates from the employer. Most Defined Contribution Plans allow the employee to roll account balances into another plan, an IRA or other qualified retirement plans. This feature took on increased importance in the 1980’s and 1990’s as employee mobility increased. Unfortunately, many employees “cash-out” their Defined Contribution Plans when they leave their current employers. An October, 2009 report titled, “Those who cash out 401(k) plans are at risk” explained that a $5,000 account balance cashed out at age 25 would have a value close to $75,000 at retirement age. Since many 401(k) plan participants lack professional financial advice, they often make poor choices concerning their retirement planning. Even when professional advice is available, many fail to take advantage of such advice.

American Retirement Model – Defined Benefit Plans

Thursday, September 03, 2010

Retirement and planning for retirement are often overlooked or delayed by most American workers. Whether out of procrastination, fear or lack of information, many Americans incorrectly assume that their employers, Social Security or someone will take care of them in their retirement years. The Employee Benefit Research Institute (EBRI) is a Washington based organization whose mission, “is to contribute to, to encourage, … the development of sound employee benefit programs … through objective research and education.” In July 2010, the EBRI released The EBRI Retirement Readiness Rating™, a status report outlining the preparedness for retirement of various employee groups. Not surprisingly, the report paints a negative image of the state of retirement readiness for most American workers.

Until the 1980’s, many employees were covered by their employer’s pension plan, which often took the form of a Defined Benefit plan.   Defined Benefit plans are operated by the employer, or sometimes unions, to provide for a fixed benefit at retirement. Funding of such plans come from the employer, gains or losses from investments, and occasional, from employees. Employees usually have little control over the plan's management of funding and administration, except through those operated by unions and that control was only remote at best. Employees vested in Defined Benefit plans in a manner like employees vest in 401(k) and similar Defined Contribution plans.  Defined Benefit plans are required to maintain certain “minimum” funding levels and are insured by the Pension Benefit Guaranty Corporation (PBGC).  If the plan’s financials are positive, the employer or union might not be required make any additional contributions into the plan. However, if the plan’s financials are negative, the employer or union might be required to make substantial contributions into the plan to pay for current and future benefits.  In either case, it was generally not a concern of the employee, except they might see higher union deductions. If additional employer funding was required, that funding is usually deductable as a normal cost of doing business from the employer’s annual tax returns.  As the name might imply, a Defined Benefit (DB) plan defines the benefit the employee might except to receive upon retirement from the employer. This definition usually came in the form of a very detailed formula, example:

70% of Final Average Pay Less 100% of the Employee’s Socia Security Payment

If the employee retires early, i.e., before Normal Retirement Age (NRA) and or prior to completing the Maximum Years of Creditable Service (Max), the benefit is reduced to reflect a younger retirement age and fewer years of service. Final Average Pay (FAP) might be defined, as the average of the employee's highest five out of the employee’s last 10 years of service. Most employers also take a credit (offset) for Social Security (SSA) taxes paid in for the employee in the form of a Social Security Offset (SSO). Of course, each employer could have vastly different formulas, which are often varied by industry segments.

Thus, an employee could predict, within a degree of certainly, what their retirement pension payment might be, example:

• Normal Retirement Age: 65
• Early Retirement Age: 55
• Maximum Years of Creditable Service: 35
• Minimum Years of Creditable Service: 10
• Final Average Pay: average of highest three out of last 5 years of service
• Social Security Offset: 100%

An employee who retired with 25 years of service and at age 55 whose Final Average Pay was $45,000 per year could expect a pension payment of:

Annual Pension Benefit = (70% X FAP X 55/65 X 25/35) – 100% X SSO (FAP * 30%)

Annual Pension Benefit = $5,538.46 = (0.70 X $45,000.00 X 0.85 X 0.71) - $13,500.00

If the employee worked another 5 years, they would have 5 more years of service and be 5 years older and their Annual Pension Benefit would be:

Annual Pension Benefit = (70% X FAP X 60/65 X 30/35) – 100% X SSA

Annual Pension Benefit = $11,423.08 = (0.70 X $45,000.00 X 0.92 X 0.86) - $13,500.00

Finally, if the employee worked another 5 years, they would have 5 more years of service and be 5 years older and their Annual Pension Benefit would be:

Annual Pension Benefit = (70% X FAP X 65/65 X 35/35) – 100% X SSA

Annual Pension Benefit = $18,000.00 = (0.70 X $45,000.00 X 1.00 X 1.00) - $13,500.00

The problem with Defined Benefit plans, from the employer’s viewpoint, is that they are costly to maintain, require highly trained professionals to administer, and with the passage of the Employee Retirement Income Security Act (ERISA) in 1974, imposed significant legal and reporting requirements on plan sponsors.

From the employee’s position, by the 1980’s, employees had become very mobile and most had no intention of staying with the same employers for 35 years. Many employees wanted more self-control over plan funding, investments, and a plan that allowed for portability and flexibility. Which leads us to the boom in Defined Contribution plans.