My Organization Already Has A Defined Benefit Plan In Place, But We Want to Restructure It, What Should We Keep In Mind?
It is important to note that in restructuring a defined benefit plan and substituting a basic retirement benefit provision for a more liberal benefit provision, the actual benefit accrued prior to the amendment date will be determined by the more liberal provision with the exception of changes made to the active service death and disability benefits.
WHICH PLAN DESIGN FEATURE HAS THE GREATEST IMPACT ON PLAN COSTS?
The plan’s benefit formula is key in defined benefit plan design. The benefit formula is the foundation of a pension program affecting both the level of retirement income that the plan will provide, as well as accounting for the major portion of plan costs.
WHAT KIND OF BENEFIT FORMULAS ARE THERE?
Benefit formulas under a defined benefit program can be grouped into two categories, Unit Accrual Formulas, and Fixed Percentage Formulas. Both types can be integrated with Social Security.
HOW DOES A UNIT ACCRUAL FORMULA WORK?
A unit accrual formula provides a percentage of salary for each year of service. Benefits at retirement are equal to:
Accrual Rate X Salary X Service = Annual Benefit
HOW CAN A UNIT ACCRUAL FORMULA BE INTEGRATED WITH SOCIAL SECURITY?
An integrated unit accrual formula provides a percentage of salary for each year of service, integrating benefits with Social Security. An integrated benefit formula serves to provide proportionally higher benefits to highly compensated employees who would expect to receive a lower retirement income, expressed as a percentage of pay from Social Security, than lower paid employees. Integrated formulas also reduce program costs, as a lower accrual rate is used to determine benefits based on salary up to the covered compensation level, while a higher accrual rate is used to determine benefits based on salary in excess of the covered compensation level.
A benefit formula which is integrated with Social Security provides benefits at retirement equal to:
Accrual Rate X Salary X Service + Excess Accrual Rate X Excess Salary X Service = Annual Benefit
COVERED COMPENSATION LEVEL
The average of the Social Security taxable wage base for the 35 year period prior to retirement. It may be used in one or two ways:
INDIVIDUAL COVERED COMPENSATION LEVEL
The average of maximum taxable wages for the 35 years prior to Social Security normal retirement age. This amount varies by employee based on year of birth. It is currently between $48,816 (for those born in 1940) and $110,100 (for those born after 1974).
FLAT COVERED COMPENSATION LEVEL
A flat dollar amount equal to one-half the Individual Covered Compensation Level (above) for someone of Social Security normal retirement age for the current year. This amount is the same for all employees terminating in a particular plan year. Currently, the amount is $33,600 for someone age 65.
HOW DOES A FIXED PERCENTAGE BENEFIT FORMULA WORK?
Fixed Percentage benefit formula provides a target percentage of salary after a specified amount of service – either 25 or 30 years.
Target % X Salary X Service Prorate = Annual Benefit
Target percentage is between 10% and 80%.
Salary is High-5 or High-3 Year Average.
Service prorate is a factor used if an employee will not have met the target service by age 65:
Factor = Service at 65 Target Service
Otherwise the service prorate factor = 1.
The accrued benefit for those who terminate employment prior to age 65 will be the target percentage of salary multiplied by:
Completed Service to Termination
Expected Service to Age 65
HOW DOES A FIXED PERCENTAGE BENEFIT FORMULA WORK?
The following is an example of a fixed percentage benefit formula:
Formula: 70% High-5 Year Average Fixed Percentage Formula, 30 Years Target Service
Employee Age: 65
High-5 Average Salary: $52,400
Final Salary: $58,000
Years of Service: 20
Target Service: 30 years
70% Target Percentage X High-5 Year Average Salary $52,400 X 20 Years Actual Service ÷ 30 Years Target Service (.66) = Annual Benefit $24,453
Benefit Expressed as a Percentage of Final Salary: 42%
HOW CAN A FIXED PERCENTAGE FORMULA BE INTEGRATED WITH SOCIAL SECURITY?
A fixed percentage integrated benefit formula provides a target percentage of salary after a specified amount of service, integrating the benefit with Social Security.
Target Percentage X Salary X Service Prorate + Excess Target Percentage X Excess Salary X Service Prorate = Annual Retirement Benefit
These terms are defined as follows:
A specified percentage up to the Covered Compensation Level, and a specified percentage in excess of the Covered Compensation Level. The target percentage will vary under an integrated benefit formula based on the target service elected.
High-5 or High-3 Year Average Salary.
An amount of salary in excess of the Covered Compensation Level.
25, 30 or 35 years
A factor used if an employee will not have met the target
HOW DO ANCILLARY FEATURES AFFECT DEFINED BENEFIT PLAN COSTS?
A defined benefit plan’s ancillary features play a key role in determining program costs. These features affect the level of benefits provided by the plan, and can have a substantial impact on program costs.
In evaluating these features, it is important to consider how effectively they are utilized and whether they make sense, given the composition (i.e., age, length of service, retirement patterns) of the employee group. You may also want to consider whether benefits are being duplicated in the company’s other benefit programs (i.e., life insurance or long-term disability policy).
Ancillary features include:
- Early Retirement Features
- Disability Benefit
- Active Service Death Benefit
- Post Retirement Benefit
- Normal Form of Payment
It is important to note that when restructuring a defined benefit plan and substituting a basic retirement benefit provision for a more liberal benefit provision, the actual benefit accrued prior to the amendment date will be determined by the more liberal provision except for changes to the active service death and disability benefits.
About the Author