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.