COMPARISON OF RETIREMENT BENEFIT PLANS IN A CHANGING ECONOMY James Bishop, Bryant University, 1150 Douglas Pike Smithfield RI 02917,

(401) 232-6356, jabishop@bryant.edu Phyllis Schumacher, Bryant University, 1150 Douglas Pike Smithfield RI 02917, (401) 2326319, pschumac@bryant.edu Katie Heeder, Bryant University, 1150 Douglas Pike Smithfield RI 02917, (401) 232-6356, kheeder@bryant.edu

ABSTRACT The focus of this paper is the effect of current market instability on employer sponsored retirement benefits. Todays retirement benefits consist mainly of three types of plans: defined benefit, defined contribution, and hybrid plans. Typical benefits provided to the employee by each plan are analyzed in this paper, based on various ages at retirement and lengths of company service. Recent market instability raises questions about an employees financial security under defined contribution plans and certain hybrid plans. The effect of interest rate and market volatility on each of the different plans is analyzed and recommendations are presented within.

BACKGROUND Up until thirty years ago, defined benefit (DB) plans were the norm in middle and large sized companies. The benefit was typically a percentage (based on years of service) of an employees average pay over some period (usually the final five years) of employment. The concept was to support a retiree over their remaining lifetime with approximately 40% - 70% of their final salary while employed. Combining this with Social Security benefits, it was hoped that this benefit would serve a retired employees economic needs over their remaining lifetime. The cost of providing benefits in DB plans was usually absorbed by the employer, although some plans required participant contributions in order to partially offset the companys expense. Benefits accrued in DB plans are virtually risk-free. These benefits are defined as a guaranteed annuity payable for the life of the retiree beginning at his/her normal retirement age (usually age 65). If, for some reason, the employer is unable to pay out their benefit obligations, the Pension Benefit Guaranty Corporation (PBGC) insures these benefits up to a maximum monthly amount [9]. Over time, defined benefit plans became ill-suited for employers and employees. For employers, DB plans are expensive to maintain because they often require the use of an actuary and several lawyers to ensure proper compliance with the laws governing DB plans [5]. For employees, the nature of the workplace had changed and long careers at a single company became less common. Under this type of plan, a vested employee (an employee that is accruing benefits), who changes employers would continue to be tied to the company until he/she begins collecting the benefit upon retirement. To meet the needs of a new, mobile workforce, it seemed more desirable for these benefits to be portable so that employees could keep some control over their retirement

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income when changing companies. As a result, defined contribution (DC) plans became quite commonplace [8]. The most common DC plans, known as 401(k) plans, are defined as individual account balances in which the employee and/or employer each contribute a percentage of the employees monthly pay into an array of market funds, comprised of mutual funds and bonds, chosen by the employee. At retirement, the accrued account balance is the employees retirement benefit. Thus, unlike DB plans, DC plans are vulnerable to market instability. Another negative aspect of DC plans is that benefits accrue as a lump sum balance instead of a lifetime annuity as is provided by DB plans. Upon retirement, responsibility is placed on the employee to allocate their lump sum balance into income that will last until death. Due to inadequate planning, many retirees have exhausted their funds and outlived the money they had saved. For the purpose of this study, 401(k) plans are the only type of DC plan that will be considered. At the same time that defined benefit plans were giving way to defined contribution plans, hybrid plans were introduced. Hybrid plans are currently classified under the category of a defined benefit plan even though the intent of the plan is to combine the stability of a DB plan with the portability and lower cost of a DC plan. The most common hybrid plan, known as a cash balance plan, differs from a DC plan in that the contributions made into an account often yield an indexed or fixed interest rate (or a narrow range of rates) chosen by the employer, as opposed to the employee chosen, volatile mutual fund yield of a DC plan. Another major difference between a cash balance plan and a DC plan is that the final account balance has to be offered as a life annuity, just as all other DB plans require. Another common hybrid plan, known as a Pension Equity Plan (PEP), is computed similarly to the cash balance plan except that the lump sum balance is not payable until the plans normal retirement age (usually age 65). Whereas cash balance plans provide an employee with a hypothetical investment account payable today, the investment account balance in a PEP plan is a projected value. This value would need to be discounted in order to determine its equivalent value today [2]. Market instability in 2001 and again in 2008 caused employees to lose a significant amount of their retirement savings and has thus raised serious questions about the financial stability of DC plans and certain hybrid plans [1]. The primary objectives of this paper are to compare current retirement plans from an employees perspective and to consider the ramifications of volatile market conditions on accrued benefits. As such, it is important to note that the benefits calculated for this study are exclusive of participant contributions; therefore, only employer funded benefits are calculated.

RETIREMENT PLAN COMPARISON In order to compare a typical defined contribution, defined benefit, and hybrid plan benefit for an employee, adjustments need to be made since these benefits are paid in different forms. All three plans will be compared as lump sum values, as well as, life annuities expressed as a percentage of the final pay while employed (salary replacement ratio). A defined benefit calculation is

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computed as a life annuity and must therefore be converted to a lump sum. Conversely, defined contribution and hybrid calculations are expressed as a lump sum and must be converted to life annuities. The following assumptions are made: Current 55 year old with an annual salary of $100,000 3% annual salary increase in the future and 3% decrease in the past Benefit accrual begins on the date of hire (also called service start age) Service start ages of 25, 35, 45, and 55 Contributory and hybrid plan contributions are made at the end of each year Annual interest compounding Actuarial conversion factors for various forms and timing of benefit payments are based on current Pension Protection Act assumptions (2010 mortality and transitional yield rates) [4]. Consider three retirement ages: age 55 is a typical early retirement age, age 62 is the first age at which a worker may begin social security payments, and age 65 is a typical normal retirement age as defined in most retirement plans. Finally, as a fair basis of comparison, let us only consider employer funded benefits, exclusive of participant contributions. First, we compute a defined contribution plan benefit assuming a 5% of pay employer contribution and a market rate of return of 7.5%. The 5% contribution assumption is based on an approximate average large company DC plan (range is roughly 2% - 8%). A market yield of 7.5% is about average over the past 60 years based on the S&P index. Contributions will be considered to be made at the end of each year into an account earning 7.5% compound interest until retirement. The resulting lump sum retirement values and salary replacement ratios (annual life annuities divided by final salary at retirement) are shown in the table below:
DC Plan - Lump Sum Values Payable at Retirement Age Amounts are converted to an annual life annuity and expressed as a percent of final salary at retirement) Service Start Age Age at Retirement 55 62 65 25 $ 289,658.40 (20%) $ 528,243.66 (33%) $ 676,674.57 (42%) 35 $ 150,214.68 (10%) $ 296,899.68 (19%) $ 389,276.67 (24%) 45 $ 59,289.00 (4%) $ 146,049.51 (9%) $ 201,875.98 (12%) 55 $ (0%) 47,686.14 $ (3%) 79,679.46 $ (5%)

Next, lets consider a typical final five year salary Defined Benefit plan with the following formula for an annual benefit paid starting at retirement age for the life of the employee: Annual benefit = 1.5% FAP5 BS; where FAP5 represents the average of the employees final five full years of pay at the company, and, BS represents the number of years the employee worked for the company (benefit service). The accrual percentage of 1.5% is chosen as the middle of a typical range for DB plans (typically 1% - 2%) [3]. In order to compare the annual annuity payable in the Defined Benefit plan with the lump sum payable in the Defined Contribution plan, we must convert the DB plan annuity to a lump sum

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using actuarial equivalence factors. This conversion is dependent on the interest and mortality assumptions at the time of retirement. Using reasonable current assumptions (year 2010 factors under the Pension Protection Act), the resulting table of lump sum values is below:
DB Plan - Lump Sum Values Payable at Retirement Age (converted to a life annuity and expressed as a percent of final salary at retirement) Service Start Age Age at Retirement 55 62 65 25 $ 280,116.09 (19%) $ 632,680.49 (40%) $ 892,467.11 (55%) 35 $ 186,744.06 (13%) $ 461,685.77 (29%) $ 669,350.34 (41%) 45 $ 93,372.03 (6%) $ 290,691.04 (18%) $ 446,233.56 (27%) 55 $ (0%) $ 119,696.31 (8%) $ 223,116.78 (14%)

Note that long careers favor the defined benefit plans. This is partly due to the fact that DB plans are actuarially reduced for early commencement, so an employee that works up until 62 or 65 does not get a stiff reduction. DC and DB plans give very similar benefits at age 55. It is also noteworthy that many DB plans give an extra incentive for early retirement (a modest reduction rather than an actuarial reduction) and so these plans would compare favorably even at age 55. Finally, lets examine a hybrid plan. Consider a Pension Equity Plan (PEP) with an annual contribution of 9% of pay. Once again, a moderate value has been chosen from a range of approximately 6% - 12% for such plan types [7]. The interest accumulation rate is 3.5% (a typical fixed guaranteed rate, not a market assumption). One oddity inherent in this type of retirement plan is that the balance is always assumed payable at the plans normal retirement age. If the employee quits/retires prior to that time, then the interest stops accumulating AND there is a reduction in benefit for taking the money early. The following lump sum table results:
PEP Plan - Lump Sum Values Payable at Retirement Age (converted to a life annuity and expressed as a percent of final salary at retirement) Service Start Age Age at Retirement 55 62 65 25 $ 162,331.67 (11%) $ 363,803.08 (23%) $ 517,043.17 (32%) 35 $ 105,580.63 (7%) $ 258,965.14 (16%) $ 378,247.04 (23%) 45 $ 51,512.35 (3%) $ 159,083.14 (10%) $ 246,012.13 (15%) 55 $ (0%) $ 63,922.80 (4%) $ 120,028.29 (7%)

The PEP plan does not compare favorably to either DB or DC plans. The impact of these less generous plans will be felt by employees in the years to come.

MULTIPLE RETIREMENT PLANS Finally, it is worthwhile to examine a very common career path in the modern workplace. Within in the past 20 years, many workers either experience at least one change in employers (accruing benefits under multiple retirement plans), or, have a plan change at their lone place of

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employment. Here we examine an example of a switch of plan types ten years after the beginning of an employees career. Below is a table representing a common change from a traditional DB plan to a hybrid plan:
Value of a Life Annuity Expressed as a Percent of Final Salary at Retirement Service Start Age (assumes a change of plan 10 years after Service Start Age) Age at Retirement 55 62 65 25 23% 27% 29% 35 18% 21% 23% 45 14% 16% 18%

It can be seen that all scenarios lead to retirement with less than 30% of the annual income enjoyed by the individual while actively employed.

STOCK MARKET INVESTMENT Now let us consider how market fluctuations affect retirement benefit amounts. Most employees keep their DC balances in the stock market, but for employees over age 55 it makes sense to shift these funds over to bonds (if they are an available alternative). The S&P stock market index is a stable benchmark for tracking investment return on Defined Contribution accounts. We take a look at moving averages over 5, 10, and 20 years for the annual investment returns of the S&P. The following table results: Number of Years Mean Increase Standard Deviation of Increase Probability of loss 5 7.8% 6.9% 10 7.7% 4.7% 20 7.3% 3.2% 1.0%

13.0% 5.3% S&P annual increases from 1950 2008

How does market return impact DC balances? The standard deviation of market increases over longer periods (10 and 20 years) is relatively low. Therefore, DC Plans are reasonably safe unless the employee is close to retirement. If an employee happens to be 60 years old and is looking to retire at age 65, then there is approximately a 13% chance that the market return on their DC account balance will be negative based on past market performance. This figure is based on the normal distribution z-score for the 5 year average mean and SD. CONCLUSION So what does the future hold for retirement plans? Part of the answer for this depends partly on whether there is a sentiment of protecting people against themselves, in that, account money can

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automatically shift to a safer investment when close to retirement. Of course, not everyone is averse to the risk associated with the stock market. Cash balance and hybrid plans are stable and are a good option, they could (and often do) have a floor for the minimum interest earned on the accounts for any given year. In order to make these plan types affordable to the employer, there would have to be a new and simpler set of regulations to match these plan types. Currently the rules for these plans fall under the umbrella of all defined benefit plans. The future of retirement plans should naturally drift towards a cash balance benefit with a required stable conversion to a life annuity upon retirement. The advantage of the cash balance plan is its steady, intuitive balance increase, combined with the security of a life annuity at retirement. This may require new legislative considerations because the rules governing such plans were originally developed for traditional defined benefit plans. There is no recommendation that will help the employer afford to support retirees in all cases (or even many cases), but allowing an employee to plan for their own retirement with some surety of their income is the desired goal. REFERENCES [1] Coombes, A. (2009, October 6). Steady savers gained over 5-year period. Retrieved from http://www.marketwatch.com/story/401ks-took-big-but-not-devastating-hit-in-20082009-10-06. Green, L. (2003, October 29). What is a pension equity plan?. Retrieved from http://www.bls.gov/opub/cwc/cm20031016ar01p1.htm Hamilton, B, & Burns, B. (2001, December 31). Reinventing retirement income in america. Retrieved from http://www.ncpa.org/pub/st248?pg=5 IRS. (2009, September 5). Choosing a retirement plan: defined benefit plan. Retrieved from http://www.irs.gov/retirement/article/0,,id=108950,00.html IRS. (2008). Updated Static Mortality Tables for the Years 2009 Through 2013. Internal Revenue Bulletin 2008-42. Kamenir, J. (2009). How to Make Defined Benefit Pension Plans Attractive to 21st Century Employers. Benefits Quarterly, 25(2), 51-56. http://search.ebscohost.com Lowman, T. (2000, July 7). Actuarial aspects of cash balance plans. Retrieved from http://www.soa.org/files/pdf/actuarial_aspects.pdf McGill, D, Brown, K, Haley, J, & Schieber, S. (2005). Fundamentals of private pensions. Oxford, NY: Oxford University Press. PBGC. (2009, October 27). PBGC Announces Maximum Insurance Benefit for 2010. http://www.pbgc.gov/media/news-archive/news-releases/2009/pr10-02.html

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