Whither Wear-Away?

Historically, workforce management has been a key motivator for employers' adoption of retirement plans. The interests of employers in the orderly retirement of superannuated workers - and of the larger society in the social welfare of its older citizens - are the primary forces driving the institutional provision of retirement benefits. Wear-away is a key component of the workforce management process, allowing plan sponsors to transition from one benefit program to another.

What Is Wear-Away?

Wear-away occurs when an employer changes a plan feature that affects participants benefits: the benefit formula, the definition of compensation, the limit on compensation or benefits, or the plan factors for determining any optional form of benefit. Regardless of the change being made, all participant benefits already accrued including optional benefits must be protected. Such plan changes occur routinely, with no disruption in the continued accrual of benefits for participants or in the administration of the plan for the sponsor. For some changes, however, there may be a period of time where benefits payable at certain ages or in certain forms may not increase for some employees. The protected benefit is said to be "worn-away" by the accrual of benefits under the new benefit program.

A Real-Life Example

Suppose that following a corporate acquisition, a company has to merge two disparate plans. The purchaser's plan provides a benefit of 1.25 percent of pay for each year of service. The acquired plan benefit formula is integrated with Social Security, and for each year of service, it provides 1 percent of pay up to $25,000 and 1.5 percent of pay in excess of $25,000.

After merging the two plans, the sponsor naturally wants the newly acquired employees covered by the same benefit formula provided to all other employees. For employees who make less than $25,000, the 1.25 percent of pay formula clearly increases their benefits. But for employees who make more than $50,000, application of the new benefit formula creates a period of wear-away. The length of the wear-away period will vary by participant, depending on the amount of pay over $50,000, length of service and any transition benefits provided by the plan sponsor.

For example, Susan, age 48, earns an annual salary of $80,000 and has been covered by the acquired company's plan for 20 years. At the time of the acquisition, Susan's accrued benefit payable at age 65 was: 1% x pay up to $25,000 x 20 years, plus 1.5% x pay in excess of $25,000 x 20 years = $21,500/year. Under the new plan formula, Susan. s accrued benefit payable at age 65 is: 1.25% x pay x 20 years = $20,000.

ERISA prohibits benefit cutbacks, so Susan's $21,500 benefit under the old formula is grandfathered. But ERISA does not prohibit benefit freezes, and this is exactly what happens to Susan. After working another year, Susan's accrued benefit payable at age 65 has now grown to 1.25% x 21 years x $80,000 = $21,000. Since Susan's grandfathered benefit is $21,500, she has worked another year for the employer without any increase to her pension benefit. Of course, if Susan received a pay increase, her benefit under the new formula would likely exceed the grandfathered benefit.

In this example, prohibiting wear-away would appear to benefit Susan. But it would also impose a significant administrative burden on the plan sponsor. Even if the benefit formulas were identical, there would almost certainly be some aspect of the plans that would be different, such as the plan factors used in determining optional forms of benefit. A prohibition on wear-away would require the new employer to maintain detailed pay and service records for those employees based on their service with the previous employer, along with detailed plan administrative provisions regarding the old plan features. All of this would be in addition to the detailed pay and service records the plan maintains in its normal operation in order to determine participants' benefits under the current formula. For a company that is active in merger and acquisition activity, the administrative burden could become very heavy indeed.

Plan Conversions

Wear-away can also occur when a traditional defined benefit plan is converted to a hybrid plan design, such as cash balance or pension equity. A traditional defined benefit plan determines and communicates its benefit in the form of an annuity. In a conversion to a hybrid plan - which determines and communicates its benefit in the form of a lump sum - an initial lump sum amount has to be established. There is a widespread - but very much mistaken - belief that sponsors converting to a hybrid design commonly establish an initial lump sum worth less than the present value of the participant's normal retirement benefit. If that were the case, affected participants would have to work for quite some time simply to allow the lump sum benefit under the new plan formula to catch up to the benefit already accrued before the conversion.

That may have been true in a few early conversions to hybrid plans, but it just isn't the case today. Before enactment of the 1994 Uruguay Round of the General Agreement on Tariffs and Trade (GATT), lump sum distributions had to be determined using Pension Benefit Guaranty Corporation (PBGC) rates, which were extremely low and resulted in overstated values for participants' benefits, compared to commercial annuity rates. Recognizing that PBGC rates did not reflect the true value of benefits - and in fact encouraged participants to elect lump sum benefits instead of annuity benefits - Congress changed the rates for determining lump sum benefits in the GATT legislation. The new rates are commonly referred to as GATT rates.

In a Watson Wyatt survey of defined benefit plans converted to a hybrid plan design since 1995, 22 out of 24 plans determined the initial lump sum amount using GATT rates - or a rate even more beneficial to participants than GATT rates. In other words, in 92 percent of these plan conversions, participants' initial lump sum amounts were equal to the present value of their normal retirement benefits under the old benefit formula. Wear-away of participants' accrued benefits by establishing a low initial lump sum amount - in those few cases where it occurred - appears to have been essentially fixed by the GATT legislation.

The "Message" in the Benefits

Another aspect of the debate on wear-away has focused on the elimination of early retirement subsidies. Providing early retirement subsidies is one way a company can shape its workforce, by encouraging workers to retire earlier. The message inherent in an early retirement subsidy is simple: "We'll pay you to leave." This message may be appropriate for some employers today, and almost certainly made sense for many employers when younger workers were entering the labor market in record numbers. But the changing demographics of American workers have sharply reduced the number of companies that can afford to show their older workers the door.

During the 1990s, the number of younger workers declined by 14 percent because of the lower birth rate that followed the baby boom. Meanwhile, the U.S. workforce has grown 1.5 to 2 percent per year over the past 20 years - or 15 to 20 percent a decade. These two facts together created a 30 percent shortfall of young workers in the 1990s - a shortfall that will persist as Generation X workers age. Facing both a shrinking supply of younger workers and increasing demand for employees with critical skills, many employers are reconsidering whether they can afford to encourage their most experienced workers to leave.

Eliminating early retirement subsidies or service caps on benefit formulas, or implementing a phased retirement program are among the different ways employers can structure their compensation programs to retain key talent. Phased retirement programs are far more prevalent at firms where the average age of the workforce is 45 or higher. As the aging baby boom drives up the average age at more companies, phased retirement is likely to become more common. Popular with employees, phased retirement appears to present a true "win-win" solution, enabling employers to retain experienced and motivated workers and providing employees with additional flexibility and control over their lives.

There are myriad ways an employer can structure a phased retirement program, and implementation can cause a period of wear-away for some workers. Prohibiting wear-away would restrict plan sponsors' ability to initiate a valued and desirable new benefit program - with the inevitable result that some employers simply won't bother to add the new benefit.

Retirement Plans: Serving Employees and Employers

Retirement plans are designed to serve employers as well as employees. Most employers are sensitive to their employees' retirement planning and provide valuable transition benefits during a conversion. But it's important to remember that employers' need to retain a talented workforce is the basic driver of all benefit design. Given today's shrinking labor pool, designing programs that encourage longer careers is exactly what employers need to do. Wear-away is just one important step in the process.