This document summarizes key aspects of defined benefit pension plans (DBPs), including typical benefit formulas, risk allocation, and design features. It also discusses the transition from DBPs to defined contribution plans (DCPs) and hybrid plans like cash balance plans. Cash balance plans allocate more risk to employees by basing benefits on current pay rather than final pay. The document poses questions about risk allocation and using the benefits model to evaluate different plan designs.

1. Chapter 4 – Retirement – Evolution and Design
Thomas E. Murphy

2. On the road? Feed the pigeons?
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3. Total Retirement Income
Employer
Plan
Personal
Savings
Social
Security
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4.  Social Security – the
safety net
 Employer
sponsored
retirement
 Personal savings
and investments
 Objective: provide
retirement income
for life.
 Tax favored
treatment
 Who assumes the
three risks?
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5. Who bears the risk? Employer or employee?
 Longevity
 Investment
 Inflation
November 3, 2010
Will I have
enough? How
many years do I
have?
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6.  What are the design features of a Defined
Benefit Plan (DBP)?
 What is a final pay plan?
 What are typical benefit formulae for a DBP?
 What HR strategies does a final pay plan
serve?
November 3, 2010
DBPs R Not
Dead
6Thomas E. Murphy

7. Unit Benefit Flat Benefit
 Modify the definition of
“Final Pay.”
 Unit Benefit – multiply
a set dollar amount
times years of service.
($50 per month X 30
years of service =
$$1500 per month)
 Flat Benefit: Set
amount per month is
paid once employee
has requisite age and
years of service. (Reach
age 60 with 30 years of
service, benefit is
$2500 per month)
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8. DCP Private
(61%)
DBP Public
90%
DBP Private
(21%)
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9.  Demographics of workforce
 Age and sex of workforce
 Financing of benefits
 Use of capital markets to finance
 Allocation of risks (longevity, investment, and
inflation)
 Job tenure – encourage or not relevant?
 Tax qualified status and fund protection
 Legal compliance issues (ERISA, IRC, PPA
November 3, 2010 9Thomas E. Murphy

10.  The Benefits Model?
 Let’s look at DBP
design features and
see how Benefits
Model applies?
November 3, 2010
Encourage retention?
Sufficient retirement income?
Competitive?
Fair?
Cost effective?
10Thomas E. Murphy

11. You Must Know these! Drivers: Fig. 4.2 at 90.
 Coverage
 Eligibility
 Vesting
 Calculating the benefit
 Typical Final Average
Pay Formula
 COLA?
 Separated vested
 Funding and Protection
 Investment strategy
 Beneficiaries
 Calculating
participating service
 Normal and Early
retirement ages
 Distribution options*
 Death before
retirement
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12. The Choices Adverse Selection Risk?
 Annuity
 Named beneficiary
 Lump sum (Discount
rate and Present Value)
 Disability Retirement
(103)
 Deferred Benefit
 Level Income Option
(Table 4.2, at 102)
 10-15 year certain (98)
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13.  What is covered compensation?
 Social security integration and offsets (101)
 Restoration benefit
 Breaks in service (102)
 What You Should Know about Your Retirement
Plan! (U.S. DOL. See site below)
 http://www.dol.gov/ebsa/publications/wyskapr.
html
 Disability retirement (103)
 Non-portability (104)
 §415 limits on income and benefit
 Cap on years of participating service?
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14.  Maximum Pension-
$195,000
 Maximum
Compensation to
be included in
formula- $245,000
 And more . . .
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15.  And, what about
ACTUARIAL
REDUCTIONS?
 How and why do
they apply to a
DBP?
 How are DBPs
administered?
 Let’s do some
calculations!
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16.  How to allocate risks?
 Should employer be
sole source of
financing?
 Aggressive use of
capital markets?
 Funding with other
assets?
 What is a reasonable
income replacement
goal?
 Can we measure the
effectiveness of our
retention and loyalty
objective?
 What are design
levers we can use to
adjust? (See:
Exercises Nos. 3, 4,
6, 7, 8, 13 (pp.129-
131)
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17. 401(k) Profit Sharing
ESOP SIMPLE
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18. Your $
Employer
$
Your
Benefit
$$
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19. November 3, 2010 19Thomas E. Murphy

20. Longevity
Investment
Inflation
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21.  What was driving
force leading to
transition to DCP?
 What is relative
contribution of
employers?
 Simplicity,
portability, and
ownership oriented
employee
 Very favorable tax
treatment!
 Advantage of
compounding
 Portability
 No actuarial
reductions!
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22.  Coverage
 Eligibility
 Portability
 Vesting
 Employer matches
 Why no Actuarial
reductions?
 §415 limits on
contributions
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23.  Elective deferrals -
$16,500
 Catch –ups over 50
years - $5,500
 Maximum total
contribution -
$49,000
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24. Note: fiduciary liability Note: restrictions
 Investment choices-
self directed
 What is employer’s
obligation here?
 What are lifestyle,
target funds?
 What about too much
company stock?
 Loans and withdrawals
 Plan administration
and fees
 How are funds
distributed? Lump sum
or Annuity?
 What about retirement
age?
 Early and Minimum
Distribution Rules (see
infra)
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25. Retiring early? Retiring later?
 Will I have enough?
 What’s my number?
 Impact of recession
 Will I have to get a
part-time job after
retirement?
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26.  Early and minimum
distribution rules of IRS
 Discrimination testing!
What is this?
 What is non-elective
enrollment?
 What is a “safe harbor”
plan? (See chapter 9
and Blog)
 BIG ISSUE: are
employees saving
enough for retirement?
November 3, 2010
Happy
Birthday:
Age 59.5
and 70.5
26Thomas E. Murphy

27. Risks
DBPs
MoreRisks
DCPs
LessRisks
Cash
Balance
Plans
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28.  What would result if the pension formula were
based upon current pay instead of final pay?
 It’s a Cash Balance Plan
 How does this change the risk allocation?
 What impact would this have on length of
service?
 Don’t forget to apply the Benefits Model
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29. No actuarial reductions
Employee receives his
account balance!
 Employer calculates a
benefit annually and
credits to account
 Credited amount is
based upon a
percentage of current
pay
 Account earns
employer established
rate of annual interest
 Account balance can
be viewed by employee
 Account is portable
 Vesting applies (3 year
cliff)
 Benefit paid in lump
sum or annuity
 Favorable tax
treatment
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30.  No employee contributions
 Employer can pool account balances and
invest and obtain higher yields than those
annual investment returns promised to
participants
 Risks – investment risk is on the employer
but is nominal (short term). Longevity and
inflation risks are on the employee.
 Do these plans encourage long term or mid
term service? (See: key design features at
p.120 of the text)
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31.  What happens in a conversion from a DBP to a
Hybrid (cash balance plan)?
 Who goes into new plan and who stays in
DBP?
 What is opening balance?
 Do such conversions violate Age
Discrimination laws?
 What about “wear away” and “whipsawing?”
 (See: text pp 121, 122.)
 How do CBPs comport with Benefits Model?
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32.  Query: how would
you change design
of CBP to
encourage longer
service?
 The Pension
Protection Act
resolves many legal
issues.
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33. November 3, 2010 33Thomas E. Murphy

34.  There are profit sharing cash and profit
sharing retirement plans.
 The retirement plan is essentially a DCP!
 It is a unique concept – results based funding
of a retirement plan.
 If the company does well, so will you.
 Reserves maximum flexibility to employer –
unlike a DBP
 How would you assess the risk allocation?
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35.  Favorable tax treatment
 There are limits on total amount allocated to
plan and to individuals.
 What about Benefits Model?
 The distribution occurs at retirement.
 How is the employee’s amount typically
calculated: (W-2 Earnings of employee ÷ total
earnings) × Annual Profit $$ allocated.
 Or, it may involve % of salary, or age and
service weighted
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36. What about Risks? Benefits Model?
 No monies distributed
until retirement.
 Can use age or service
enhancements
 Early and mandatory
distribution rules apply
 Vesting
 Frequently company
stock is placed into
account.
 Employee is given
diversification option
at age 55.
 Stock price and
dividends increase so
does account balance.
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37. What about Risks? Benefits Model?
 ESOPS
 Company Stock is
allocated to employee
retirement account.
 Expected to create
alignment.
 Vesting
 Minimum and Early
distribution rules apply
 Contributions made
regardless of profits
 Favorable tax
treatment.
 If leveraged ESOP it is
even better for
employer.
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38. Bank loans to ESOP
ESOP buys shares
Employer puts cash
into ESOP
ESOP puts shares in
retirement account
Employer uses cash
to pay off loan
Tax favored
treatment of interest
and principal
Employees have
right to diversify at
age 55
Query: does this
plan produce
alignment?
Issues: vesting, risk,
formula for deposit
of shares
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39. November 3, 2010 39Thomas E. Murphy

40.  Nos. 1-21at
pages130-131.
 Read the Blog and
look especially at
efforts to
ameliorate the risks
in DCPs.
 Should the
government
sponsor a GRA?
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