COLA or indexing benefits prior to benefit date

[Guest Mike Luers]

How can a DB plan address the effect of inflation for an employee if there is a significant period between the time of termination and benefit effectice date? Example: Employee completed 20 years of service at age 45, but can not collect benefits until 55.

[Guest]

ok, I'll bite. There is no prohibition against increasing benefits for terminated vested participants, but it's not very common.

In my experience, benefit increases for terminated vested participants are also very rare in the multi-employer area as well.

Most of these people have quit to take another job, where, in theory, they will earn additional benefits.

[david rigby]

That's correct. In fact, I have seen a COLA for retirees where those in pay status who were originally vested terms are excluded.

Another possiblity, at early retirement age, is to improve the early retirement reduction factors. Likely this will affect other participants, so be prepared for a permanent change.

[Guest Mike Luers]

Thank you for your comments. My original questions were based on the premise that one of the primary problems of DB (government) plans is the failure to facilitate portability and the effect inflation has on this. Espectially for employees who have completed say 20 years but are not yet 55 years old. I have been told that some state plans index their benefits. However I do not know how this is done?

[david rigby]

Indexing can be automatic, such as a 2% increase each year that a benefit is in pay status, or it could be ad hoc, ususally after some approval process by a governing authority, and may be irregular in timing.

However, note that the "effect of inflation" is one of the risks taken by the participant when leaving the job; that is, the DB plan is not required to "protect" against inflation because the plan formula itself (especially in a final average pay plan) is designed to do that. If the EE is not there to earn that benefit, then why should the plan inflate it?

In any case, it is very rare to inflate a benefit prior to commencement date.

[This message has been edited by pax (edited 12-22-1999).]

[Guest Mike Luers]

PAX, Help me out here! If an EE has earned a month benefit of $100/mo.(after 20 years of service, age 45), is it "reasonable" to ask the plan to maintain the "buying power" of the $100 until commencement?

[david rigby]

Reasonable?

Well that is a philosophical issue. I'll comment on actual not theoretical. Very few DB plans (perhaps govt. plans are an exception to this) make any adjustment to an accrued benefit after severance of employment. Some plans do offer COLAs after a benefit is in pay status, but there is no requirement to do so. I have never heard of a plan that adjusts a deferred benefit of the vested terminated employee prior to benefit commencement.

Most DB plans define the benefit by formula, and this is usually a monthly amount that is payable for the retiree's lifetime (i.e. the retiree cannot outlive it) and commences at age 65. Note that the plan is guaranteeing at least 3 things here:

1. the benefit will be payable for life, and

2. the plan bears the entire risk of bad investments, and

3. the monthly amount is guaranteed not to go down.

[This message has been edited by pax (edited 12-22-1999).]

[Guest Steve C]

Let me quickly add that Cash Balance is one type of defined benefit plan that typically provides for pre-retirement indexing (even after termination). Cash Balance is sometimes described as an indexed career average plan.

[richard]

Well, actually the "indexing" in a cash balance plan vs. a traditional DB plan is more apparent than real.

Let me illustrate by way of example.

Let say that Jim, a 45 year old, terminates employment with a traditional DB pension of $100 per month commencing at age 65. That is "worth" approximately approximately $3,740 when he terminates employment. (Based on an age 65 immediate pension of $1 per month being worth $120 and an interest-only discount of 6% for each of the 20 years prior to benefit commencement).

If he waits one year until age 46, he is still entitled to $100 per month commencing at age 65. That pension is now worth approximately $3,965 ($120 factor discounted for 19 years at 6% per year).

Now his friend John terminates employment at age 45 with a cash balance "account" equal to $3,740. The plan continues to credit 6% to account balances of terminated vested employees. (If the plan didn't credit any interest to terminated vested employees, as a practical matter, it would run afoul of IRS rules). So, one year later at age 46, his cash balance "account" is equal to $3,965.

So, it appears that John's cash balance plan is indexing benefits for him after he terminates employment. But, in reality, he is just receiving the same interest that is inherent in Jim's discounted pension.

(By the way, if John were to receive an interest credit of 8%, then I would agree that he would be receiving essentially a 2% COLA. However, current IRS rules make it very difficult to credit high interest rates to employees.)