Lecture 22: Pension Benefit
Formulas
• Approaches to retirement plans
• Defined benefit plans
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Elements of defined benefit formulas
Non-pay-related formulas
Pay-related formulas
Social Security integration
Accrual rules
Benefit forms
Miscellaneous benefits
• Defined contribution formulas
Approaches to Retirement Plans
• Defined benefit
– Plan formula defines the
benefit that will be paid to
the employee
– Employer bears investment
risk
– Generally favors older,
longer service employees
– Benefits may or may not be
portable
– More complicated to
communicate
– Complicated administration
• Defined contribution
– Plan specifies the amount
the employer will contribute
to the plan
– Employee bears investment
risk
– Provides portable benefits
– Better for younger
workforce
– Easier to communicate
– Relatively easier
administrative and
government regulations
Elements of Defined Benefit
Formulas
• Benefit service
– Elapsed time
• Date of hire
• Date of participation
– Hours
• Earnings
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Base pay only
W-2 pay
Bonuses
Commissions
• Averaging of pay
– Final average earnings (FAE)
– Career average
• Benefit approach
– Annuity
– Lump sum
Non-Pay Related Defined Benefit
Formulas
• Flat-amount
– $500 per month
• Unit-benefit
– $50 per month times years of service
Pay-Related Defined Benefit
Annuity Formulas
• Career average pay plans
– Benefit is a function of earnings over entire
career with the employer
• 2% of career earnings
• Final average pay
– Flat-percentage
• 50% of compensation at retirement
– Unit-benefit
• 1.5% of final five year average earnings (FAE(5))
times years of service
Pay-Related Account Balance
Defined Benefit Formulas
• Cash balance
– Pay credit = % of each
year’s pay placed into
an “account”
• 8% of pay paid into an
“account” each year
– Interest credit
• Rate equal to one-year
Treasuries credited to
the account each year
– Account balance paid
at termination or
retirement
• Pension equity
– % are accumulated
each year
– Accumulated credits
are multiplied by final
average earnings and
amount is paid as a
lump sum
• 10% given per year of
service
Social Security Offset Method
• Offset limitations
– No more than .65% of pay up to covered
compensation (CC) may be offset
• Limit service to 35 years
• Further reduced for subsidized early retirement
– Cannot reduce more than 50% of gross benefit
• Example:
– 1% of FAE(5) times service - .65% of FAE(5)
up to (CC) times service up to 35 years
Social Security Excess Method
• Excess Limitations
– Maximum difference between the base % and
the excess % is .65%
– Limit service to 35 years
– Further reduced for subsidized early retirement
• Examples
– 2% * FAE * SVC + .65% * FAE > CC * SVC
– 2% * FAE <= CC * SVC + 2.65% * FAE>CC *
SVC
Defined Benefit Accrual Rules
• Must pass one of the following
– 3% rule
• Accrual must be at least 3% of total benefit
– 133 1/3% rule
• Rate of accrual must be < 4/3 of earlier accrual
– Fractional rule
• Use a service prorate to determine the benefit
• 1% of pay for 10 yrs + 1.5% for next 10 yrs
– Projected benefit = 25% of pay, AB > 3%*25% = .75%
--> passes 3% rule
– 1.50%/1.0% = 1.5 --> fails 133 1/3% rule
Forms of Payment for Defined
Benefit Plans
• Life annuity
• Lump sums
• Joint and survivor
– 50% joint and survivor required by law
• Social Security leveling option
• Certain and life options
Miscellaneous Benefits Paid
Under Defined Benefit Plans
• Preretirement survivor annuity
• Incidental death benefits
• Disability benefits
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Reduced accrued benefit
Continued accrual
Definition of disability
Age/service requirements
• Early retirement supplements
Defined Contribution Formulas
• Money purchase plans
– Amount contributed to an individual account
– Account grows with interest
• Target plans
– Amount contributed is based on the amount
necessary to accumulate to a target benefit
• Social Security integration -- excess only
– Usually integrate on wage base
– Maximum difference = 5.7%