Employees Deserve Choice In Retirement Plan Design

Employees Deserve Choice In Retirement Plan Design Employer-sponsored retirement plans are designed to help employees replace a portion of their pre-retirement income and maintain their standard of living. From a business perspective, the program needs to be affordable to the employer and serve as a means of attracting and retaining employees.

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

Also, in light of the recent uncertainty and volatility in the stock market, some employees who direct their retirement plan investments may no longer wish to have their benefits entirely dependent on their limited investment management skills.

The underlying company objective of such a retirement design could be to spend approximately the same amount of dollars while increasing overall employee satisfaction.

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

For defined benefit plans, benefits are determined by a formula and the company makes any contributions necessary to provide the promised benefits. If a DB plans investments perform extremely well, there may be times when the employer is not required to contribute.

If investment performance is sub-par, the plan participants will generally still receive promised benefits, but higher employer contributions will be necessary. The amount of contributions needed is also dependent on year-to-year changes in the participant data.

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

The final average pay design automatically adjusts for inflation by applying the employees most recent and presumably highest earnings to the entire service historyas opposed to the career average pay design, which takes into account a workers entire earnings history.

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

A traditional DB plan formula produces a monthly pension benefit payable at an employees retirement. Payment amounts may be limited by regulations, and minimum benefits may be required in certain circumstances.

The amount may be reduced for commencing monthly benefits at earlier ages or if monthly benefits continue to a surviving spouse.

In some cases, an employer subsidizes the reductions. The amount also may be increased after payments commence for cost-of-living adjustments.

Some DB plans allow monthly pension benefits that would otherwise be payable (based on interest rates applicable at the time of distribution) to be converted into a one-time lump sum payment that can be directly rolled over to an individual retirement arrangement or possibly another tax-qualified pension plan.

Under a defined contribution plan, contributions by the employer may be required or discretionary. DC plans have the option of allowing employee contributions. Benefits are determined by the value of an individual employees account balance, which is derived from contributions and earnings on the investments.

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

Instead, limitations and minimums may apply only to the contributions made to the participant accounts. After making a contribution, an employer has no further obligation regarding the benefits, although it retains fiduciary responsibilities relating to the plan.

Traditional types of DC plan designs are:

401(k) plans, which give an employee the option to contribute a portion of pay on a pre-tax basis subject to various possible regulatory restrictions. To encourage employee participation, a company typically will match a portion of employee contributions. Certain tax-exempt and governmental plan sponsors offer 403(b) or 457 planswhich are similar to 401(k) plans.
Profit-sharing plans, which allow a company to decide on an annual basis the total amount to contribute to the plan and provide a formula to determine the amount allocated to each employee.
Money purchase plans, which require the employer to make a contribution each year to an account for the employee.

Most DC plans today offer the opportunity for the employee to be responsible for making investment decisions. As a result, an employer usually provides a wide variety of investment choices and investment education.

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

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

Hybrid DB plan designs include:

A “cash balance” design, which might credit 5 % of pay to an employees account each year, with a guaranteed interest rate of 6 % per year. The cash balance design, like the career average pay design, does not automatically adjust for wage growth that might occur late in a workers career.
A “pension equity” design, which might resemble a traditional DB plans final average pay formula but provides a relatively higher accrual percentage during earlier years of service and pays out the benefit in a lump sum. The pension equity design, like the final average pay design, automatically takes into account wage growth as an employee nears retirement.

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

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

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

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

Following the plan's redesign, the company could in theory contribute approximately the same amount of money into the participants plan of choice and increase overall employee satisfaction.

A company that currently contributes to both a DB and a DC plan for the same employees could conduct a comprehensive review of coordinated plan design. This would consider possible areas where employee choice could improve the delivery of the retirement benefits at the most efficient employer cost.

When contemplating the offering of retirement plan design choices, employers have numerous types of plans, features and options from which to choose. These include two entirely different benefit accrual patternsone may be better suited to younger workers and the other better for older employees.

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

One of the first steps a company should take is to determine its current 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 to select a DC plan, while older employees will likely opt for a DB plan.

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

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

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

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

To help employees decide on an appropriate retirement plan design, the employer could use a model that shows which option offers the best benefits, given various assumptions, such as future salary increases, date of termination and DC plan investment return.

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

One additional step may be required if a company offers employees a choice of retirement plan design: nondiscrimination testing. Testing might be necessary because all employees will not be covered under the same plan. But testing rules are flexible and might only be required once every three years, depending on the margin by which the nondiscrimination tests are passed.

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

Giving employees a choice can directly respond to individual workers needs and desires. Offering such an option also can serve as an important means for an employer to make the transition from one type of plan design to another.

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

Characteristics of DB and DC Plans

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

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