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The Actuary The magazine of the Institute & Faculty of Actuaries

Stop, please don’t retire!

As the baby boom generation moves towards retire-
ment, companies are facing the challenge of
replacing a valuable pool of skilled manpower. According to the Employment Policy Foundation (EPF), by 2012, labour shortage in the US is likely to grow to over 6m. A Towers Perrin study indicates that in large companies approximately 50% of the current workforce is aged 45 or over and will be eligible to retire in the next five to ten years. A Cornell University study in 2000 showed that a not all workers want to fully retire when they reach retirement age (see figure 1).
Recognising that there is a growing shortage in the number of people that are able to fill certain key positions, and that employees want more flexibility, companies are coming up with some innovative manpower strategies.
Phased retirement provides a flexible way of meeting employee needs as well as addressing the problem of a shortage in skilled labour. It means a retirement programme that allows older workers to remain in employment with the same employer while allowing the workers the flexibility to reduce their working hours. This allows workers a smooth transition into retirement.
Companies in the US have had informal phased retirement programmes for some time. They have also been encouraging certain key employees to return to work as consultants after retirement.
However, the current regulations in the US (ERISA, Age discrimination rules, and IRS regulations) conflict with each other in the requirements governing the implementation of phased retirement programmes. The IRS prohibits workers from returning full-time to a company that they draw a pension from (section 401(a)(9)). Legal and regulatory limitations make the creation, administration, maintenance, and compliance of a phased retirement plan challenging.
As a step towards streamlining phased retirement arrangements under qualified pension plans, the IRS is proposing a notice of rulemaking (in the form of guidance) that would allow in-service payments from pension plans before normal retirement age.

The proposed legislation what is new
The proposed new regulation aims at allowing plan sponsors to introduce a legal phased retirement programme (under certain conditions). This is defined as a ‘written, employer-adopted programme under which the employees may begin working fewer hours and receiving phased retirement benefits on or after a specified retirement date’.
To satisfy the guidelines, the programme should meet the following conditions:
– Employee participation is voluntary
– Reduction in working hours of at least 20%
– Participants must at least be 59 years of age.
– Single lump-sum or roll-over provisions not allowed
– All early retirement benefits, subsidies, and options as applicable under the qualified pension plan would be applicable for phased retirement
– No key employees allowed to participate
– Final benefit on eventual retirement would consist of the phased retirement benefit plus balance of accrued benefit under the plan

What it means to the stakeholders
Plan sponsors
The primary advantage to the plan sponsor is the incentive it provides to retain trained and qualified personnel for some key positions. It also means reduced training costs, employment/hiring costs, and reduced pension costs (in the short-term) because of the shift from full-time to part-time employment.
However, any changes in the benefit plan design that allows pensions to be paid earlier than expected means more cost for the plan sponsor unless the design is changed so that the plan remains neutral from an actuarial perspective.
The plan sponsor would need to re-examine its policies for the provision of other employee benefits like medical, disability, and life insurance.

Plan participants
The chief advantages to the plan participants lie in the fact that they have the flexibility to reduce their working hours and the opportunity to make a gradual transition into part-time employment and subsequent retirement. In addition, the plan participants have the opportunity to supplement their part-time income with their retirement savings.
According to the Committee for Economic Development, many older Americans would like to continue working but they ‘face various obstacles’. A formal phased retirement programme would be step in the right direction.

Challenges in implementation
Offering phased retirement as an option to the employees would be both expensive and complex to administer. Since retirement programmes typically form just a part of the entire suite of employee benefits, it would mean having to take a fresh look at all the benefits being provided. As well as the retirement and savings plans, other benefits include:
– Life insurance and death benefits.
– Medical and other related benefits, since in the absence of any kind of retiree healthcare, there would be significant reluctance to retire before Medicare eligibility. Employer-sponsored retiree medical plans are typically coordinated with the Medicare benefits that a person is entitled to after the age of 65. The plan design needs to be looked at to make sure that there are no barriers to healthcare for employees participating in the phased retirement programmes. This is particularly significant considering the fact that there have been a number of efforts to reduce/eliminate medical benefits for retirees (the costs towards this are significant).
– Payments for time not worked.

Actuarial neutrality and benefit estimates
The benefit plan may permit one or more phased retirement benefits prospectively to an employee. However, the plan design changes have to bear actuarial neutrality in mind. This can be ensured by having a full actuarial reduction for early retirement and a full actuarial increase for employment continuing after normal retirement.
There are different ways in which actuarial equivalence has to be considered. Some salient ones are discussed below.
– Final average pay benefits The traditional final average pension plan typically considers the final five years of salary. However, in the case of phased retirement, because the individual’s pay drops due to part-time employment, the final salary to be used for calculating the pension would be reduced.
Annualising pay during phased retirement is one way to avoid penalising the employee if he or she opts for phased retirement. Other ways exist.
– Early retirement subsidy Though actuarial neutrality demands that a person should neither benefit nor be at a loss because of early retirement, typical early retirement subsidies are higher than the corresponding fully actuarially equivalent (reduction) factors. So the workers typically have incentives to retire early.
– Method of payout The current legislation requires that any changes/amendments to a qualified pension plan or profit-sharing plan should not reduce the participant’s benefits, including payment options (anti-cutback rule, IRS411(d)(6)). Any actuarial assumptions that seek to achieve actuarial neutrality would also need to consider the fact that for defined benefit plans that allow lump-sum distributions, there may be a conflict between mandated assumptions and actuarially neutral assumptions.

Some aspects that need to be considered from the regulatory perspective are as follows.
– Testing and adjustment of payments Periodic testing is required to ensure that the plan participant’s actual work schedule is not greater than the work schedule used to arrive at the phased retirement benefit.
This requires an annual comparison between the actual and expected number of hours worked and any discrepancy has to translate to a prospective reduction in the phased retirement benefit. This would involve additional reporting.
– Communication requirements The programme should involve detailed and extensive communication to the plan participants to help them understand the full impact of such a programme.
Participation being voluntary, it would be important to inform/alert the participants about the rights they retain compared to the ones that they lose in a phased retirement programme. For example, the impact of in-service payments, annual salary increases accompanied by reduced pay (due to a reduction in working hours).
– Non-discrimination The current non discrimination tests are challenging for the employer wishing to encourage phased retirement. For example IRS401(a)(4) does not allow the employer to make any in-service payments before normal retirement age. If the plan benefits were to be amended to take care of phased retirement by lowering the retirement age, the plan should pass the non discrimination tests using the revised normal retirement age.

Other aspects
– Dual status of the employee Since the proposed regulation would allow the employees to continue in employment with reduced hours of work, the employee would maintain a dual status partially retired and partially ‘in service’.
– Workforce management The employer might be faced with the dilemma of having highly skilled workers opting for phased retirement with the less effective ones opting for continued full-time employment.

Phasing in
The proposed regulations on in-service distributions in defined benefit plans should encourage phased retirement among US companies. There are certain hurdles that need to be crossed before the guidance is in place. It is hoped that the legislation will increase the prevalence of phased retirement, after comments from the industry and other legal bodies, as well as feedback from the public hearing on the debate have been incorporated.