Designing the Right Retirement Plan


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Retirement plans represent a large expense that employers incur to attract, retain, and motivate employees. Designing an effective retirement program means not only developing a plan that assists employees in meeting their retirement goals, but also addressing your organization’s business needs. Use this tool to get started!


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Your Benefts Philosophy Retirement plans represent a large expense that employers incur to attract retain and motivate employees. Designing an effective retirement program means not only developing a plan that assists employees in meeting their retirement goals but also addressing your organization’s business needs. The maturity of your business the demographics of your workforce the level of competition you face and your organization’s cost and beneft objectives all infuence the decision as to which retirement plans make the most sense for an organization. Designing an effective retirement program for your organization starts with a review of your management philosophy compensation strategy the different types of plans available an analysis of what your peers offer and considerations such as demographics and the maturity of your business. Designing a retirement program that accomplishes these goals begins with understanding an organization’s business objectives and how those objectives translate into a benefts philosophy. There are two basic approaches that a company should consider in developing a benefts philosophy. 2 Pentegra

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understanding benefts The frst centers on an “Objective” approach—that compensation and benefts are offered in order to fulfll a specifc function i.e. to provide employees with suffcient retirement benefts. The adequacy of the benefts involves an analysis of what level of compensation and benefts allow an employee to maintain a certain standard of living. The other is a “Competitive” approach—that attractive benefts and compensation packages are offered in order to attract and retain employees. Beneft programs should be viewed as an important component of total compensation. Adequacy of total compensation involves an analysis of wages and the level of benefts offered by competitors. It is important to recognize that while these two approaches are different they are not exclusive. The successful benefts program will refect a blend of both philosophies. A successful benefts program will refect a blend of both philosophies.

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4 Pentegra The Objective Approach How Much Do Employees Need The objective approach involves examining the level of income needed in order to retire comfortably. We use replacement ratios as a tool in determining how much income a retirement program should provide when viewing these programs from an objective perspective. A replacement ratio is the percentage of gross pay prior to retirement that one needs after retirement to maintain the pre-retirement standard of living. It takes into consideration the fact that the post-retirement standard of living will refect lower taxes and other fxed costs. Experts recommend that employees retiring in the next few years will need between 70 and 90 of their pre-retirement income to maintain a similar standard of living in retirement. These factors take into consideration the fact that post-retirement standards of living refect lower taxes and other fxed costs. However they do not take into consideration the impact of infation on purchasing power after retirement. The table below illustrates how this percentage varies based on pre-retirement income. Annual Pay Before Retirement 15000 20000 30000 50000 70000 90000 Replacement Ratio 82 76 72 72 75 83

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objective What level of income do employees need to retire comfortably

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Understanding Replacement Ratios Retirement income can come from multiple sources but primarily from Social Security an employer-sponsored retirement plan and personal savings. Social Security’s Role Social Security was never intended to be the total source of retirement income — but rather a safety net. The age to qualify for benefts will increase as younger employees will not be eligible to receive full benefts until age 70. Annual cost-of-living adjustments may be curtailed in the future as Congress struggles with budget defcits and the anticipated Social Security shortfall. While an employee married non-working spouse retiring at age 65 currently earning 20000 can expect nearly 68 of fnal salary from Social Security Primary plus spousal beneft higher salaried employees have a gap of over 60 to meet the study’s recommended replacement goal. Employer-Sponsored Retirement Plans—How Much And From What Source The next level of protection is generally provided by the employer’s plan or plans. The level of income replacement from employer plans is dependent on variables including the employee’s salary length of service retirement age and the employer’s plan type/formula/match etc. Defned beneft plans might be structured to provide from 30 to 40 of the total replacement income needed depending on the employer’s beneft and cost objectives. This type of plan usually provides an annuity at retirement. Defned contribution plans are a potential but less certain source of the replacement ratio mix. Plan structure employee investment savvy and length of time in the plan are all factors which must be taken into consideration in determining how much income the plan will provide. T ypically these plans provide between 10 to 30 of replacement income. Unfortunately studies show that more than 30 of lump sum distributions from these types of plans are spent well before retirement. Employee savings are an unpredictable source of security as savings may be a signifcant source of income for some and non-existent source for others. The rate of personal savings in America is fairly low — currently just below 4. It is unrealistic to expect that lower salaried employees will have signifcant savings outside of any employer-sponsored savings plan to rely on at retirement. 6 Pentegra

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knowledge Retirement income can come from multiple sources.

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8 Pentegra The Competitive Approach In order to remain competitive in today’s business environment an organization must also analyze the level of benefts it provides in relation to its peer group. The basis for providing a competitive beneft program for a business is twofold. In order to attract talented personnel it must offer both adequate and attractive beneft plans in relation to its peers. While some turnover is unavoidable businesses that provide competitive beneft plans will generally experience lower turnover among middle and upper management positions. While the cost of providing such a beneft program can be high the cost associated with turnover or failure to attract and hire the professionals you need to run your business can be substantial. Compensation Strategies Compensation has a direct link to the retirement benefts you offer employees. It is critical to developing an effective retirement program—if your compensation strategies are not competitive your retirement program won’t be competitive. Salary In order to implement an attractive compensation program salary must be competitive with what other institutions of similar size and structure are offering. In determining the appropriate amount of base pay for employees at all levels comparisons of averages are used from peer group comparisons. Usually midpoint salary ranges are used as a starting point and individual performance and experience is used to reach an effective point of compensation. T ypically you would perform an analysis based on institutions comparable in size assets and employees in a specifc geographic area. Increases in salary can have a dramatic effect on retirement program costs depending on the type of programs offered and the demographics of your institutions.

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expertise Analyze benefts in relation to peers.

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10 Pentegra T ypes Of Programs T o Consider There are two broad categories of retirement programs—defned beneft plans and defned contribution plans. Each plan has advantages and disadvantages for both employees and employers. Defned Beneft Plans T raditionally savings institutions have offered defned beneft programs. Defned Beneft pension plans offer a guaranteed lifetime beneft. They provide defnitely determinable benefts based on a formula that takes the employee’s salary and service into consideration. T raditional defned beneft plans are designed to beneft career employees. Benefts accumulated in the early years of an employee’s career are minimal however they accelerate more rapidly as an employee reaches retirement. At retirement benefts can be paid over a lifetime of the retiree and the lifetime of the spouse if elected. The employer assumes the investment risk under a defned beneft plan. The plan’s beneft formula guarantees a certain level of beneft and the employer bears the investment risk if plan assets are inadequate to fund this level of benefts. Conversely pension costs are offset by favorable investment performance among other things. If returns are favorable the employer’s costs are reduced and in some cases even eliminated for a period of time. Cash Balance Plans While traditional defned beneft plans have been favored by many mutual institutions changing employee demographics have seen an increase in the number of fnancial institutions that convert from a traditional defned beneft program to the cash balance plan. Cash balance plans are a type of hybrid defned beneft plan. They provide the beneft protection and security of a traditional defned beneft plan. Benefts are expressed in the form of an account balance. Although cash balance plans can be started as a new plan most are established by amending an existing defned beneft plan. Initial account balances can be derived from the value of an employee’s accrued beneft as of the transition date under the existing defned beneft program. The lump sum beneft at retirement is based on an accumulation of annual allocations expressed as a percentage of pay plus interest credited at a guaranteed rate annually. Benefts at termination are completely portable enabling employees to “rollover” their account to a new employer’s plan or to an IRA. This portability feature is one of the elements that make cash balance plans similar to defned contribution plans.

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choice Defned Contribution Plans Defned contribution plans such as 401k and proft sharing plans are account accumulation plans. Benefts at retirement are based on the size of the individual’s account. Because individual account balances are expressed in dollars and cents rather than beneft formulas employees can at any point in time defnitively determine the value of their account. The complexity arises in determining the level of beneft that the account value will provide at retirement. 401K Plans The most well-known and widely offered defned contribution plans are 401k programs. 401k plans offer two major incentives—a tax shelter and often employer matching contributions. Under a 401k plan the employee usually saves a portion up to 100 of his or her salary on either a pretax or after-tax basis through payroll deduction. T ypically the employer makes a matching contribution to provide an incentive for employees to contribute to the plan. Employee and employer matching contributions and earnings accumulate tax-deferred. The employee has full investment discretion and assumes full responsibility for those investments. The plan provides an easy way for the employer and the employee to share in the responsibility of savings for retirement. Proft Sharing Plans Under a proft sharing plan employer contributions are discretionary. Contributions to a proft sharing plan are usually keyed to the existence of company profts—although actual profts are not required for a company to make a contribution. Contributions are then allocated to participant accounts according to the plan’s allocation formula. At retirement benefts are based on the value of a participant’s account. Each plan has advantages and disadvantages for both employees and employers.

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12 Pentegra Executive Beneft And Director Plans Executive beneft plans reward a select group of employees without impacting costs on an employee-wide basis. Executive beneft plans can be used to replace benefts lost due to IRS limits on qualifed plans provide benefts in addition to those provided under qualifed plans as well as to defer compensation. These plans can also be used to provide enhanced benefts in the event of a change in control. While these plans are designed to cover only your key employees they are an integral part of any compensation program. Beneft Equalization Plans An executive beneft program for key employees designed to replace qualifed plan benefts lost as a result of IRS limitations on salary and benefts. Supplemental Executive Retirement Plans An executive beneft program designed to reward offcers and/or commissioned salespeople. Plans may be entirely discretionary and designed to provide rewards arbitrarily or based on specifc performance factors. Benefts provided through these arrangements are over and above those provided by qualifed plans. Deferred Compensation Arrangements Deferred compensation arrangements permit designated executives to defer additional compensation to avoid current taxation. These plans are typically established in order to provide a vehicle for key employees highly compensated employees and Directors to defer compensation until retirement. 457b Plans Similar to deferred compensation arrangements 457b plans are deferred compensation plans for employees of local and state governments and tax-exempt organizations. These plans are typically established in order to provide a vehicle for key employees highly compensated employees and Directors to defer compensation until retirement when taxes may be lower. 457f Plans A 457f plan is a non-qualifed retirement plan which gives the tax-exempt employer an opportunity to supplement the retirement income of its select management group or highly compensated employees by contributing to a plan that will be paid to the executive at retirement.

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choice An integral part of any compensation program.

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14 Pentegra Demographic Considerations In designing the right retirement program for your organization many factors have to be considered. These issues include appropriate beneft levels beneft limitations deductibility of contributions cost issues employee demographics and competitive issues. Increasingly organizations today sponsor more than one type of retirement program as different types of plans meet different goals and provide varying levels of retirement income. A combination of plans often results in a retirement program that better meets the needs of both the employer and employees. The Demographics Of Your Organization What type is most cost-effective for your group Demographics play a signifcant role in determining the type of program that will be most effective for your organization. Employees come in different ages situations and salary levels. Is your workforce made up of employees that are under 35 or over 40 What kind of turnover do you experience Do you want to reward long-service employees or attract younger employees Different plans provide different types of benefts to different types of employees. And employees have different expectations about retirement security. T o maximize your beneft dollars you need to consider the demographics of your employee group. Younger Employees Vs. Older Employees Defned beneft plans can be more advantageous to older employees if they have established their career at your institution. Defned contribution plans such as 401k plans tend to be more advantageous to younger employees. Y ounger employees have the beneft of time—time over which their savings can grow tax deferred with the added effect of compounding. Generally speaking these plans are less advantageous to older employees because they have fewer years over which to accumulate savings for retirement and fewer years for those savings to grow. But younger employees appreciate the increased control fexibility and access to funds that a 401k plan provides. Cash balance plans may also provide an attractive plan design because they allocate benefts more equitably among younger and older employees. That is because dollars contributed early in an employee’s career have the most signifcant impact as a result of compounding of interest.

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consider Career Employees Vs. Mobile Employees Generally traditional defned beneft plans pay the most generous benefts to long-service employees who spend their career dedicated to working for the organization. Career employees want to be rewarded for their commitment to the organization and sponsoring a traditional defned beneft plan is an effective way to accomplish this goal. For the short-term employee on the other hand defned beneft plans provide minimal benefts. That’s because real benefts start to accrue after a number of years of service with the organization. Defned contribution plans such as 401k and proft sharing plans provide more immediate and visible benefts for this type of employee. These plans also offer portability—employees may take their account with them when they leave the company and place the distribution in an Individual Retirement Account or their new employer’s defned contribution plan. A combination of programs is optimal.

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16 Pentegra Beneft Limitations In order to design the appropriate retirement program however the employer must pay special attention to beneft limitations and tax deductibility limits. When discussing IRS beneft limitations several limitations come into play. Internal Revenue Code IRC Section 401a17 limits the amount of compensation that may be used to determine benefts and contributions under any type of qualifed plan. The current annual compensation limit is 285000. In addition to the maxi- mum compensation limit there are maximum beneft limits which impact both defned beneft plans and defned contribution plans like 401k programs. Section 415 of the Internal Revenue Code specifes that the maximum annual beneft that an employee may receive under a defned beneft plan at age 65 is limited to 230000 at ages 62-65 in 2020. In the case of early retirement this limit may be signifcantly lower. The IRS also limits the annual amount of contributions that can be made to an employee’s account under a defned contribution plan to the lesser of 57000 or 100 of compensation. If more than one defned contribution plan exists such as a 401k and proft sharing plan these plans are generally combined for maximum beneft limitations. Since it is more likely that a highly compensated employee is impacted by these IRS limitations often a nonqualifed plan is developed to supplement the qualifed plan benefts. Tax Deductibility Limits The IRS also has rules governing tax deductibility limits which are detailed in IRC Section 404. These deduction limits may impact employers maintaining more than one retirement program. The IRS has set specifc limits on the maximum amount that may be deducted for each type of plan. Employers maintaining a defned beneft plan may generally deduct the normal cost of the plan plus the amount needed to amortize any unfunded liabilities over 10 years. The plan’s normal cost is defned as the cost to fund the current year’s beneft accruals. However if the plan assets exceed liabilities the employer’s required contribution and the IRS deductible contribution is reduced or even eliminated. Defned contribution plans are also subject to overall combined deductibility limits. 401k and proft sharing plans are subject to a maximum deduction of 25 of total annual W-2 compensation exclusive of elective deferrals to 401k and Section 125 plans for eligible employees.

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attention Where an employer maintains more than one defned contribution plan the IRS limits the tax deductibility of contributions by treating all defned contribution plans as a single plan. Where both a defned beneft and a defned contribution plan are in place the IRS generally limits the tax deductibility of total contributions to these plans to 31 of the total W-2 compen- sation of all eligible employees. One question that may arise in discussing deductibility is “What happens if a non-deductible contribution is made” In the event that a non-deductible contribution is made an employer must pay an annual 10 federal excise tax on the non-deductible portion until the contribution either becomes deductible in a later year or is returned to the employer. In addition to taking maximum beneft limits and deductibility limits into consideration in designing your retirement program cost constraints are also a major consideration. Our experience indicates that an employer’s overall retirement costs exclusive of social security are often in the range of 10-15 of compensation this does vary widely. The average employer contribution to a 401k plan among fnancial institutions was 3 percent of payroll. Defned beneft plans can be structured with a cost as low as 4-5 of payroll and rarely exceed 15 of payroll. 401k plans and proft sharing plans can range from no employer cost other than administrative cost to as high as 25 of payroll. While plan sponsors remain concerned about the cost of maintaining their retirement beneft programs our experience over the last year has focused on reviewing plan design in order to reduce cost and volatility of contributions and expense. In the case of any plan redesign employers must clearly understand the effects a restructured program would have on their employees—particularly long-term employees—on an individual basis yet continue balance the needs of younger employees who typically prefer more portable defned contribution plans. Retirement costs often range from 10 to 15 of compensation.

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Our difference. Your advantage. For more information on plan design considerations contact us at or 800.872.3473. Follow our conversation. Pentegra offers the beneft of over 75 years of expertise in plan design.

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2 Enterprise Drive Suite 408 Shelton CT 06484-4694 800 •872 •3473 tel 203 •925 •0674 fax © 2020 Pentegra Retirement Services All Rights Reserved

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