ERISA financial incentives and economic damages: A question from a plaintiff's attorney
Question ask by a plaintiff's attorney concerning ERISA plans:
One thing that frequently comes up in the ERISA cases that I handle, is that the retirement plan structure provides company's with a strong financial incentive to terminate employees who are closer to retirement. I understand this in principle, but I need to know more about the details of how this works.
Specifically, it has been often stated to me that in defined benefit retirement plans (i.e. fixed pension benefits ) that calculate costs and contributions using the "projected unit credit" method are back loaded by design. That is, these plans, which are large majority of plans, because of the concepts of discounting and the time value of money, create a situation where a participants later years of pension contribution are more valuable to the employee (and more costly to the company) than the earlier years with the company.
Question: Is this correct, do defined benefit pension plans create this type of 'back loading' situation?
Answer:
Yes, many defined benefit plans do create a back loading situation where the later years of an employees participation in the plan is more cost to the company (and more valuable to the employee). This is because under many plans, the participant's projected future retirement benefit is allocated among each of his or hers years of participation in the plan.
Think of the following simplified example. In this example, the company will pay 1% of the person's salary upon retirement. That is for a person earning $30,000 they will pay $300 per year starting when the person retires at age 65. So a person who works 20 years and earns $30,000 a year will have retirement benefits of $6,000 a year. (Low numbers but the concepts are really close to many retirement plan formulas)
In this plan, the retirement promises made in later years are worth more than the promises made in the earlier years. Why is this? This is because the discounted value of the amount promised in the first year of the persons retirement is worth LESS than the retirement promises made in the later years. For example, since in the first year the person will not retire for many years, the company will have many years (say 20) before they have to actually pay the plan participant. As a result the company could earn many more years of interest before they have to pay out.
The bottom line is that the present value of the $300 retirement promise made in the first year of participation is about $$80 while the present value of the same retirement promise made in year 19 is about $270.
One thing that frequently comes up in the ERISA cases that I handle, is that the retirement plan structure provides company's with a strong financial incentive to terminate employees who are closer to retirement. I understand this in principle, but I need to know more about the details of how this works.
Specifically, it has been often stated to me that in defined benefit retirement plans (i.e. fixed pension benefits ) that calculate costs and contributions using the "projected unit credit" method are back loaded by design. That is, these plans, which are large majority of plans, because of the concepts of discounting and the time value of money, create a situation where a participants later years of pension contribution are more valuable to the employee (and more costly to the company) than the earlier years with the company.
Question: Is this correct, do defined benefit pension plans create this type of 'back loading' situation?
Answer:
Yes, many defined benefit plans do create a back loading situation where the later years of an employees participation in the plan is more cost to the company (and more valuable to the employee). This is because under many plans, the participant's projected future retirement benefit is allocated among each of his or hers years of participation in the plan.
Think of the following simplified example. In this example, the company will pay 1% of the person's salary upon retirement. That is for a person earning $30,000 they will pay $300 per year starting when the person retires at age 65. So a person who works 20 years and earns $30,000 a year will have retirement benefits of $6,000 a year. (Low numbers but the concepts are really close to many retirement plan formulas)
In this plan, the retirement promises made in later years are worth more than the promises made in the earlier years. Why is this? This is because the discounted value of the amount promised in the first year of the persons retirement is worth LESS than the retirement promises made in the later years. For example, since in the first year the person will not retire for many years, the company will have many years (say 20) before they have to actually pay the plan participant. As a result the company could earn many more years of interest before they have to pay out.
The bottom line is that the present value of the $300 retirement promise made in the first year of participation is about $$80 while the present value of the same retirement promise made in year 19 is about $270.
posted by The Experts @ 5:42 PM
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