Defined benefit pension benefits are calculated in a variety of ways, depending on what formula your plan has adopted. ERISA requires defined benefit pension benefits expressed in the normal form of payment at the plan’s normal retirement age. (Often referred to as the accrued benefit.) This is normally a monthly annuity benefit paid out over the lifespan of the employee-participant.
That does not necessarily mean the benefit must pay out either in that payment method or at that time. The benefit pays in the payment options at ages defined in the plan document and summary plan description. Even cash balance plans, typically expressed as a lump sum that accrues interest, also can convert to an annuity. Based upon the plan’s formula, the basic benefit calculates by some combination of years of service and salary. Plans can adopt a wide range of options for how to implement those factors. Over time plans change their formula. A given employee may have a single benefit made up of calculations under several formulas put together.
Calculating payment options in a pension plan
After determining the base amount, the plan uses an actuarial calculation to convert it into optional payment options at different ages. To simplify the explanation, the plan adopts actuarial assumptions of life expectancy. The plan calculates how many of those monthly payments will pay out through life expectancy to create a lump sum amount. It then uses interest rates, defined by the plan, to discount the lump sum amount to the retirement date and recalculate it into optional payment methods. The result of this complicated math is to make sure no matter when or how the benefit is paid, the participant receives the (actuarial) equivalent of the benefit accrued under the plan.
So for example, if the monthly payment for the participant at 65 would pay $100 per month and the plan assumes life continues to 85 then the participant would receive $24,000 in payments over the life expectancy ($100 * 12 months * 20 years).
Valuing payment options in a pension
That means that no matter how or when payment occurs (subject to what the plan allows) the participant should always get very close to $24,000 in value from the plan. Now that’s where it gets tricky. If the plan permits a lump sum payment at 65, the participant does not receive $24,000. Instead, the participant receives the actuarial equivalent, which discounts the lump sum to its present value. The present value is the equivalent of the $24,000 based upon the assumption that if you were given a lesser amount and invested it at an assumed rate of return and take $100 out each month, you would still receive $100 each month from 65 to 85 and end up with nothing at the end of life expectancy. (In this case, you would likely receive around $7,000 given typical plan assumptions.) When plans calculate optional annuity forms of payment, such as joint & survivor payments, they use similar calculations to ensure that an equivalent amount would be paid compared to the normal form of payment.
Adjusting for early payment
If the plan permits payment before 65, an additional calculation occurs to discount the payments for the additional payments. Some plans discount actuarially, some discount by static percentages. It is common for plans to discount payments at age 55 to half of 65 on a static 50% reduction. Others use actuarial formulas that discount and arrive at roughly the same discount.
Here’s why: if payments stretch over 30 years instead of 20, the plan takes that $240,000 and spreads it out over 30 years instead of 20. (So instead of $100 you would get about $66.) But what happens is that the plan will calculate the present value at 55 instead of 65, so it assumes an additional 10 years of earned income so it further reduces the present value and then annuitizes it back out to spread out the payments over 30 years. It can then further calculate appropriate reductions for optional payment methods at the younger age.
Employment attorneys for pension issues
Confusing? Yes. To simply, the plan owes you a benefit at a certain age, based on a certain formula. That’s what the plan says you get. Regardless of what payment method you take or when you take your benefit, you should always get that amount. You can’t take it early to get more than what you earned under the plan. That means the earlier you take it, the less you get. The plan assumes you could invest it.
Retirement plans hire a small army of professionals including actuaries, investment consultants, lawyers, accountants and customer service staff to help administer the plan. Trying to sort out the same level of complexity without help is a good recipe for frustration. Sorting out the legal issues in the plan rules is often easier with the help of an employment lawyer familiar with retirement plan issues. An employment attorney may not be the right professional to help you on every question with a retirement plan; but your employment attorney can answer legal questions and help direct you to the right professional.