Guest Article

(From The 401(k) Handbook, Thompson Publishing Group)

Phased Retirement and 401(k) Plans

by Martha Priddy Patterson

---

Summary: Recent Social Security reform related to retirement earnings has opened the door for phased retirement, a method to keep valuable employees in the workforce.

(May 29, 2000) - As the U.S. workforce ages and the strong economy continues, employees who want to retire may not be able to live on retirement income yet, and employers need to keep these employees working for them. Phased retirement may be the answer for both employees and employers. Recent changes in the law and available plan design changes in the employer's 401(k) plan may help promote phased retirement.

The recent elimination of the Social Security retirement earnings test for those aged 65 and over has provided a gigantic boost to the concept of phased retirement. With this change, employees over 65 may begin receiving full Social Security benefits without having their Social Security payments reduced if their annual earnings exceed $17,000. Employers facing tight labor markets have a chance of convincing employees who reach age 65 to continue working full-time or at least part-time. (An employee between age 62 and 64 who wants to retire partially and begin receiving Social Security benefits is still subject to Social Security benefits reductions if he or she earns more than $10,080 in 2000. The Social Security benefit is reduced by one dollar for each two dollars earned above the $10,080 cap.)

Employers recognize that keeping experienced employees who are near retirement age is an inexpensive and efficient method to cope with the worker shortage. The offer of part-time employment, job sharing or project assignments could be an incentive for retiring employees to phase out of full-time employment and gradually move into retirement. This transition period can also be a financial and psychological benefit for the employee, avoiding an abrupt change from a full, regular paycheck and a structured life planned around work to total retirement. A few plan design changes in the employer's 401(k) plan may provide some incentive for those employees to continue working either full-time or part-time. Those changes need not increase the cost of the plan to the employer.

Current Preretirement Employee Landscape

Data from the Employee Benefit Research Institute show that many older employees who retire in fact go to another "bridge" job before they leave the workforce entirely, thus taking their skills and training to a competing employer in return for part-time employment and fewer responsibilities. According to the Council on Economic Development, most older employees would prefer to have a "gradual retirement" rather than a "cliff retirement." With unemployment now at historically low rates - 3.1 percent - employers should make it a priority to help those older workers who wish to continue working without losing retirement benefits. Offering these workers fewer hours and more freedom without losing their experience and willingness to work is important for employers, as well as for the national economy.

401(k) Plans and Phased Retirement

Part of the reason many employees take bridge jobs with a different employer may be that their current employers' retirement plans make it difficult to access retirement benefits while they are employed by the plan sponsor. Ideally, an employee entering phased retirement would be able to live on his or her earnings without drawing on existing retirement plans for day-to-day expenses. However, for those employees who would like to continue working but at greatly reduced hours, and hence reduced income, being able to draw on their retirement plans may be the security blanket they need to enter into a phased retirement arrangement and also may prevent them from "retiring" to a new job with a competing employer.

Compared with other retirement plans, 401(k) plans can be easier to use and are more attractive to phased retirement participants. For example, unlike defined benefit plans, which must suspend benefits if a recipient of any age returns to work, 401(k) plans may permit in-service distributions to those over age 591/2 without penalty to the recipient. Of course, the plan document must also permit such distributions. Currently, relatively few documents are drafted to permit such distributions.

Additionally, many employees may want to begin a phased retirement at age 55 or even earlier. But the law does not permit in-service distributions prior to age 591/2. The employee could go through a "retirement" that permits a 401(k) plan distribution and then be rehired by the employer, but this is cumbersome at best. A better answer to this dilemma may be to offer 401(k) plan loans. A phased retirement employee could borrow from the 401(k) account. Because that employee is in effect borrowing the money from his or her own account and paying the interest on the loan to that account, there is no income lost to interest payments, although the interest payments may be lower than earnings from other of the plan's investments. The loan feature offers the employee flexibility to finance major expenses that may come up in connection with retirement, such as purchasing a different home for retirement without having to sell the existing home or meeting medical expenses of a family member not covered by the employer or by Medicare.

The effect of phased retirees on 401(k) nondiscrimination testing will be unique to each plan, based on plan demographics. Some plan sponsors assume that including phased retirees would make it more difficult to satisfy the actual deferral percentage and actual contribution percentage tests. Certainly, if the employer made phased retirement available primarily to management, even with reduced salaries, those individuals might fall into the highly compensated employee (HCE) category, and their continued participation in the plan could raise the HCE participant percentages. Because the law permits discrimination against HCEs, one answer is to bar phased retirees who are HCEs from participation in the plan. Additionally, because nondiscrimination tests can be based on the nonhighly compensated employees' deferrals, matches, and contributions in the prior plan year, the plan sponsor will know the permissible percentage for HCEs near the beginning of the plan year. The plan sponsor can then limit the highly compensated employees' deferrals and contributions to the appropriate nondiscriminatory percentage.

For some plans, the phased retiree pool might consist of only lower-paid workers who could not contribute to the 401(k) plan on their reduced salary and thus would drop out of the plan. Of course, employers could amend the plan to exclude participation by employees with fewer than 1,000 hours annually and then restrict the phased retirement programs to 1,000 hours or less. That approach has some distinct disadvantages, including the potential to raise issues of age discrimination and to exclude other part-time employees who need and want to participate in the retirement plan.

Current Phased Retirement Programs

Hard data on employers' phased retirement programs are difficult to obtain. The National Institute on Aging's Health and Retirement Study found that nearly 75 percent of respondents would prefer to phase from full-time to part-time work at retirement, yet almost none of those respondents thought their employer would permit phased retirement. When the American Association of Retired Persons (AARP) attempted to survey companies with formal phased retirement programs, the organization could not find enough programs to study. In fact, one reporter for a human resources publication abandoned a planned story on phased retirement because no individuals would talk about their arrangements. As the reporter explained, one of the few individuals she contacted refused to tell her about his arrangement because he thought it was so good, he didn't want to publicize it!

Phased retirement "programs" do exist, but they go by other names and are often focused on goals other than phased retirement. For example, more than half of all employers currently offer employees flextime, and nearly one-quarter of employers offer telecommuting, compressed work weeks and job sharing, according to the Society for Human Resource Management's 1999 Benefits Survey. The fact that these programs are not targeted toward older workers does not prevent the programs from serving as important means for phased retirement, even though the programs are offered to all employees.

The elimination of the Social Security retirement earnings limitation, coupled with the continued labor shortage and the prospect of the baby boomers' retirements, should encourage employers both to include phased retirement as part of existing alternative work arrangements and to adopt new phased retirement programs. Employers that adapt their 401(k) plans and other benefits now to encourage and support phased retirement will have a significant head start in retaining experienced workers.

Martha Priddy Patterson is director of employee benefits policy analysis with Deloitte & Touche LLP's Human Capital Advisory Services in Washington, D.C. Patterson is the contributing editor of The 401(k) Handbook.

Excerpted from the June 2000 supplement to The 401(k) Handbook, (c) Thompson Publishing Group, 2000. All rights reserved.

---

BenefitsLink is an independent national employee benefits information provider, not formally affiliated with the firms and companies who kindly provide much of the content and advertisements published on this Web site, including the article shown above.