CE 02 INFRE International Foundation for Retirement Education Retirement Plan Design INFRE CONTINUING EDUCATION Retirement Plan Design 2009 International Foundation for Retirement Education P.O. Box 1860 Lubbock, TX 79408-1860 847.756.7350 fax 806.742.6102 www.infre.org CE02 2009 International Foundation for Retirement Education RETIREMENT PLAN DESIGN Introduction etirement professionals should know everything about pensions, contribution payouts, integration with other retirement plans, health care and estate planning right? We all are retirement professionals but we all may work for R different types of plans or associations. We all are knowledgeable about our specific plan, but our participants do not live in a vacuum. True retirement professionals realize the need for the participant to utilize all of their benefits when planning for retirement. They will have their own pension and they may have a spouse who will also have a pension. They may each have Social Security benefits on top of that, not to mention their 401(k), 403(b), 457 plans and even IRAs. Retirement professionals realize that a participant won’t always know which plan you are discussing or which one you work with. Retirement professionals and Congress realize that portability is an increasingly interesting subject to many young professionals. Retirement professionals realize that they do not know it all; especially in an industry that is trying to make the company pension plan more universal to associates. Retirement professionals realize that the plan structure within your organization may evolve and you will be a player in the changing environment. Retirement issues have become increasingly important in American life. Baby boomers are reaching retirement age in larger numbers than any generation that has come before. Because of this, media attention has made retirement education a sought after benefit. Many baby boomers realize they are reaching retirement age and haven’t saved much for the lifestyle they are planning on living. This so-called “crisis” in Americans’ retirement savings has spawned a Presidential Summit and a Commission to study the situation. National debates have been held to discuss Social Security and its solvency, as well as its ability to protect those currently enjoying benefits and those who would like to enjoy its benefits in the future. Retirement plan models have been developed to better enable retirement plan sponsors to select the best program or combination of programs for its plan members. As with many issues, history plays a large role in shaping our view. The next section will look at the history of retirement plans and bring us up-to-date so we can examine the models available today. CE02 2009 International Foundation for Retirement Education 1 RETIREMENT PLAN DESIGN History Retirement plans are a twentieth century development in the United States. Their development directly coincides with the Industrial Revolution. Before the industrial revolution people were cared for in old age by their family, church and community. There was no need for pension subsidies because old age transfers were voluntary and the majority of intergenerational transfers were agricultural in nature. The industrial revolution brought about change. People moved from villages and farms into the cities, leaving behind their support systems. This move of the early 1800’s was a move to industrial jobs. People moved for the attractive wages but soon found that with greater wages and year round income security came greater risks than they had found in agriculture. They found they were without any support system in the city and therefore began to see the need for pensions and insurance. Individuals who lived long enough were eventually forced to public charities, often with the loss of civil rights that we enjoy today. But the fact was, old age was not a problem of importance to lawmakers. First of all, most people did not live that long, as life expectancy was only 41 years of age! Second, leaders saw these plans as socialist in nature (a term we have heard with the advocacy of national healthcare over the past decade). Finally, the issue was just politically and economically inefficient. The Industrial Revolution had reached its peak years earlier overseas. For instance, the political clout of labor in Europe resulted in the public support of insurance and retirement. In places like England, private insurance “schemes” were becoming common to all classes of people. The movement evolved from private “schemes” to public pension plans, initially aimed at assisting widows and the disabled. In 1871, Chancellor Bismarck of the German Reich considered the working class a danger to the State. If left unchecked, the working class would create social unrest. Bismarck was the father of the modern pension plan. Instead of clamping down on the labor movement, Bismarck took a different approach, which included arranging social insurance to subdue the unrest. Bismarck’s scheme was the first defined benefit pension plan. The plan was mandatory and required that premium contributions be made by workers. Transfers were made to those who were sick, old, or needy. By 1890, health and pension laws spread across Germany and other parts of Europe. People were usually eligible at 70 years of age, if their working capacity was reduced to one third of normal capacity. The age 70 came from the biblical reference to “3 score and 10”. Some of these plans were the first to combine pension and disability. These plans were financially feasible since the chance of people living to age 70 collect was highly unlikely since the life expectancy was age 41! Payments were based on the time worked and wages earned and pensions were not indexed for inflation. Although some changes were made, these existed in this form until WWII. CE02 2009 International Foundation for Retirement Education 2 RETIREMENT PLAN DESIGN The United States lagged Europe in industrializing by some 25 years. Including in this lag was any debate on social insurance and pensions. American Express in 1875 and the Baltimore & Ohio Railroad Company in 1880 offered the first American plans. Proctor and Gamble offered the first profit sharing plan in 1887. By the early 1900’s there were 400 U.S. pension plans being offered. Most were for employees of railroad, banking and utility companies. Even then, manufacturing had no pension concerns. Metropolitan Life and the Equitable Life Assurance society offered the first group annuity contracts in 1921 and 1924 respectively. But during the Roaring Twenties Americans had little concern for the future, so there was little interest in pension plans. The Great Depression brought the Roaring Twenties to a halt. People had no savings and no employment so many sank into poverty. America had lagged behind Europe mostly due to the individualistic culture we had. Americans tended to be migrant and until the great depression there was no need for savings. The first government enacted plan was Social Security in 1935. As was done in Europe, the normal retirement age was set at a prohibitive level, although life expectancy had jumped to age 60 by now. It was immediately reworked from a system based on actuarial assumptions (defined benefit plan) to a “pay as you go” system. Private pensions became widely accepted in the mid-1930 and early 1940’s. During the 1920’s there were only 200 such plans. By 1930, 15% of the entire population was covered by a plan. In 1934, Congress established a pension system for railroad workers. Finally, in 1949 there was a major US steel industry labor dispute. The dispute centered on the belief that American business had a moral obligation to provide for the elderly. As a result of labor disputes, consultants made a case for the increased productivity possible with pension plans. Congress then developed tax incentives for businesses with retirement plans. The social pressure was great under the “New Deal” politics. CE02 2009 International Foundation for Retirement Education 3 RETIREMENT PLAN DESIGN Current Statistics 86% of all state & local government employees participate in some type of pension plan. Approximately 51% of private employees participate in some plan. 67% of employees of medium and large private establishments participate in a plan. 37% of employees of smaller private establishments participate in a plan (with less than 100 employees). 61% of non-government workers have access to a plan.1 There are other factors worth noting: Employees who earn less money are often excluded. Employees with part-time jobs are often excluded. Participation is lower among women. With all this history we can now study the types of plan you may be confronted with, either as an employee or counselor to others. 1 Bureau of Labor Statistics, “Employee Benefits in the United States,” 2008. CE02 2009 International Foundation for Retirement Education 4 RETIREMENT PLAN DESIGN Retirement Plan Types DEFINED BENEFIT PLANS ERISA and the IRS define this type of plan as “any plan that is NOT an individual account plan.” Defined benefit (DB) plans are subject to regulation by the Pension Benefit Guaranty Corporation (PBGC). DB Plan Facts: Provides benefits after retirement from a trust of separately maintained funds, by the purchase of insurance, or from general assets. Amount of benefit is either specifically stated or can be calculated in accordance with a set formula based on factors such as age, length of service, and earnings, but not profits. Annual contributions needed to produce a specific benefit are calculated actuarially. The amount of annual benefit that may be paid to a participant is $195,000 (2009, indexed for inflation). Promises a specific benefit based on a calculated formula at retirement. Flat dollar benefit formula Flat benefit formula Flat percentage of earnings formula Percentage of earnings per year of service formula CE02 2009 International Foundation for Retirement Education 5 RETIREMENT PLAN DESIGN Types of Defined Benefit Formulas Flat dollar benefit formula: A retirement benefit that calls for a specific pension amount without regard to income or service.