Retirement Benefits

In order to encourage retirement of aged employees, a pension plan should provide income that will be adequate to maintain the retired worker and his dependents on a standard of living reasonably consistent with that which he enjoyed during the years immediately prior to retirement. (This income will be supplemented, it is assumed, by Social Security benefits and other resources.) Pension planners generally translate this to mean a combined life income of 60% to 75% of the earnings of the five highest pay years for workers with 30 to 35 years of service.

Defined-Contribution Plan

Private pension plans basically use two types of retirement-benefit formulas. The first is the defined-contribution or money-purchase plan in which the contribution rate is fixed but the benefit is variable. Actuarial assumptions are not needed since the employer's contribution rate is based on a percentage of the employee's earnings as long as contributions are made, the plan is considered fully funded. Administration is simple since costs are fixed and ERISA imposes few restraints. The defined-contribution plan presents some problems for employees. Retirement benefits can only be estimated, and benefits may be inadequate if one enters the plan at an advanced age.

Defined-Benefit Plan

The most popular formula is called defined benefit. The retirement benefit may be a flat amount for all retirees or a specified function of earnings and service, or both. The employer's contribution is the actuarially determined amount necessary to provide the benefit. Examples include: a flat dollar amount for all eligible retirees, such as $275 per month; a flat percentage of annual earnings, such as 60 % of the final five-year average pay of $1,200, or $720 per month; or a percentage of earnings for each year of service, such as 2% of the career average for each credit year. Thirty years of service with career average earnings of $l,000 for example, would provide $600 per month.

The defined-benefit provision is attractive to many employees since it clearly spells out the benefits they can expect to receive on retirement. For employers, however, the cost of benefits is not known until the final check is paid. The employer runs a certain risk, moreover in that costs will fluctuate as turnover, investment returns, and mortality rates vary unfavorably from the actuarial assumptions. Under both benefit formulas, ERISA limits either the employer's maximum contribution or minimum benefit.

For most individuals, retirement income will be derived from both Social Security and private pensions. Since the employer bears part of the cost of paying Social Security benefits, it follows that he might wish to allow for these assumed benefits in his pension plan. Pension formulas that consider Social Security payments are called integrated plans. According to federal regulations, however, integration must not discriminate in favor of stockholders, officers, and highly paid employees. The Internal Revenue Service has approved two kinds of integrated plans: the offset and the excess plans. The offset approach is simply to deduct all or part of Social Security benefits from those that would otherwise be payable under the plan. The excess plan covers employees only if their annual earnings exceed a given amount- usually the Social Security' tax base. While this may appear to discriminate in favor of highly paid employees, IRS rules are so developed that the combined Social Security and plan benefits must produce a total retirement income that is a relatively equal percentage of compensation for all employees.