Employees Deserve Choice In Retirement PlanDesign Employer-sponsored retirement plans are designed tohelp employees replace a portion of their pre-retirement income andmaintain their standard of living. From a business perspective, theprogram needs to be affordable to the employer and serve as a meansof attracting and retaining employees.

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Because there is no one retirement plan design that will appealequally to the variety of employees in todays workforce, perhapsthe time has come for employees to have a choice in plans.

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Also, in light of the recent uncertainty and volatility in thestock market, some employees who direct their retirement planinvestments may no longer wish to have their benefits entirelydependent on their limited investment management skills.

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The underlying company objective of such a retirement designcould be to spend approximately the same amount of dollars whileincreasing overall employee satisfaction.

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Under all retirement plan designs, a simple equation applies:Contributions plus investment returns equal benefits.

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For defined benefit plans, benefits are determined by a formulaand the company makes any contributions necessary to provide thepromised benefits. If a DB plans investments perform extremelywell, there may be times when the employer is not required tocontribute.

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If investment performance is sub-par, the plan participants willgenerally still receive promised benefits, but higher employercontributions will be necessary. The amount of contributions neededis also dependent on year-to-year changes in the participantdata.

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Traditional types of DB plan design formulas include “finalaverage pay,” “career average pay,” and “dollar per year ofservice.”

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The final average pay design automatically adjusts for inflationby applying the employees most recent and presumably highestearnings to the entire service historyas opposed to the careeraverage pay design, which takes into account a workers entireearnings history.

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The dollar per year of service design is typically found inplans covering hourly workers whose pay rates do not differ as muchas that paid to salaried employees.

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A traditional DB plan formula produces a monthly pension benefitpayable at an employees retirement. Payment amounts may be limitedby regulations, and minimum benefits may be required in certaincircumstances.

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The amount may be reduced for commencing monthly benefits atearlier ages or if monthly benefits continue to a survivingspouse.

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In some cases, an employer subsidizes the reductions. The amountalso may be increased after payments commence for cost-of-livingadjustments.

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Some DB plans allow monthly pension benefits that wouldotherwise be payable (based on interest rates applicable at thetime of distribution) to be converted into a one-time lump sumpayment that can be directly rolled over to an individualretirement arrangement or possibly another tax-qualified pensionplan.

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Under a defined contribution plan, contributions by the employermay be required or discretionary. DC plans have the option ofallowing employee contributions. Benefits are determined by thevalue of an individual employees account balance, which is derivedfrom contributions and earnings on the investments.

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There are no limits on how much an employee may receive inbenefits, nor are there any required minimum benefit levels.

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Instead, limitations and minimums may apply only to thecontributions made to the participant accounts. After making acontribution, an employer has no further obligation regarding thebenefits, although it retains fiduciary responsibilities relatingto the plan.

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Traditional types of DC plan designs are:

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401(k) plans, which give an employee the option to contribute aportion of pay on a pre-tax basis subject to various possibleregulatory restrictions. To encourage employee participation, acompany typically will match a portion of employee contributions.Certain tax-exempt and governmental plan sponsors offer 403(b) or457 planswhich are similar to 401(k) plans.
Profit-sharing plans, which allow a company to decide on an annualbasis the total amount to contribute to the plan and provide aformula to determine the amount allocated to each employee.
Money purchase plans, which require the employer to make acontribution each year to an account for the employee.

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Most DC plans today offer the opportunity for the employee to beresponsible for making investment decisions. As a result, anemployer usually provides a wide variety of investment choices andinvestment education.

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Plan designs over the past decade have evolved in both the DBand DC arenas. These “hybrid” plans basically are DB plans thathave some DC plan characteristics, or DC plans with some DB plancharacteristics.

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The DB hybrids differ from traditional DB plan designs byproducing a one-time lump-sum amount rather than a monthly lifetimepayment. By so doing, such plans offer the attractiveness of DCplans in that they increase employee understanding of the plan.

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Hybrid DB plan designs include:

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A “cash balance” design, which might credit 5 % of pay to anemployees account each year, with a guaranteed interest rate of 6 %per year. The cash balance design, like the career average paydesign, does not automatically adjust for wage growth that mightoccur late in a workers career.
A “pension equity” design, which might resemble a traditional DBplans final average pay formula but provides a relatively higheraccrual percentage during earlier years of service and pays out thebenefit in a lump sum. The pension equity design, like the finalaverage pay design, automatically takes into account wage growth asan employee nears retirement.

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The DC hybrid designs differ from traditional DC plans byweighting contribution levels in favor of older employees, similarto the benefit accrual pattern of a final average pay DB plan.

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For example, a “target benefit” plan formula looks similar to afinal average pay formula.

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Contributions for each employee are determined based on theamount needed to provide the target benefit amount at retirement. Atarget benefit plan, like a money purchase plan, obligates acompany to make a contribution each year.

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Converting to a retirement plan design with employee choicemakes the most sense for a company that currently makescontributions to either a DB plan only or a DC plan only.

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Following the plan's redesign, the company could in theorycontribute approximately the same amount of money into theparticipants plan of choice and increase overall employeesatisfaction.

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A company that currently contributes to both a DB and a DC planfor the same employees could conduct a comprehensive review ofcoordinated plan design. This would consider possible areas whereemployee choice could improve the delivery of the retirementbenefits at the most efficient employer cost.

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When contemplating the offering of retirement plan designchoices, employers have numerous types of plans, features andoptions from which to choose. These include two entirely differentbenefit accrual patternsone may be better suited to younger workersand the other better for older employees.

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Perhaps an employer wants to consider offering the choice ofwhether or not employees wish to take the investment risk on all oftheir retirement benefits.

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One of the first steps a company should take is to determine itscurrent annual retirement plan contribution requirements. Then,assuming the company wishes to keep costs at about the same level,it should analyze the plan design that will keep costs level,taking into account that younger employees are more likely toselect a DC plan, while older employees will likely opt for a DBplan.

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All current employees would then be given the one-time choice ofremaining in the existing DC plan (or DB plan) or transferring intothe new DB (or DC plan). If the employee elects the new plan, allbenefits earned to date remain in the current plan and all benefitsrelated to future service accrue under the new plan.

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All new employees would be given a one-time choice of which planto go into, the DB plan or the DC plan, after a waiting period ofup to one year.

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To illustrate, an employer might cover all employees under a401(k) plan without matching company contributions. After aone-year waiting period following the date of hire, the employerwould give each employee a one-time choice of participating in afinal average pay DB Plan or receiving 401(k) matchingcontributions and/or profit-sharing plan contributions.

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This approach gives all employees the same opportunity to savemoney on a pre-tax basis in the 401(k) plan and then allows them todecide how they want company contributions to apply.

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To help employees decide on an appropriate retirement plandesign, the employer could use a model that shows which optionoffers the best benefits, given various assumptions, such as futuresalary increases, date of termination and DC plan investmentreturn.

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Offering choice with clear benefit illustrations can help toensure that there are no “losers.”

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One additional step may be required if a company offersemployees a choice of retirement plan design: nondiscriminationtesting. Testing might be necessary because all employees will notbe covered under the same plan. But testing rules are flexible andmight only be required once every three years, depending on themargin by which the nondiscrimination tests are passed.

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At many companies today, an employee has numerous choices tomake regarding benefits. Companies interested in leading the way toappealing to as many employees as possible should consider offeringeach employee a choice of retirement plan design.

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Giving employees a choice can directly respond to individualworkers needs and desires. Offering such an option also can serveas an important means for an employer to make the transition fromone type of plan design to another.

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Jeff Kamenir is a consulting actuary in the Chicago officeof Milliman USA.

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Characteristics of DB and DC Plans

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The characteristics of a particular type of retirement plandesign tend to influence a companys decision on whether to offerthe plan to its employees. The chart below summarizes thecharacteristics of traditional DC and DB designs. Hybrid DB and DCplan designs attempt to combine features from both types oftraditional plan designs.

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Reproduced from National Underwriter Edition, April 7, 2003.Copyright 2003 by The National Underwriter Company in the serialpublication. All rights reserved. Copyright in this article as anindependent work may be held by the author.


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