DONALD G. SCHMITT

Under pension plans of medium and large firms, employees retiring on January 1, 1984, at age 65 after 30 years of service would have received monthly pensions averaging from $385 for those earning $15,000 in 1983 to $886 for those earning $40,000. The corresponding range for employees retiring after 20 years of service was $263 to $623. Social Security benefits, however, would significantly raise these levels of retirement income.

These data were calculated from benefit formulas of 832 pension plans in the 1984 Bureau of Labor Statistics survey of employee benefit plans.1 The annual study covers the United States (excluding Alaska and Hawaii) and private industry establishments employing at least 50, 100, or 250 workers, depending on the industry. The 1984 survey sample consisted of 1,499 establishments, designed to statistically represent 21 million employees in 45,000 establishments.2

BLS field representatives obtained from survey respondents the written descriptions of pension plans that, under the Employee Retirement Income Security Act (ERISA), plan administrators are required to provide to covered employees. These descriptions include the formulas used in calculating employee benefits. Using the benefit formula for current service,3 BLS calculated pensions that would have been paid to employees retiring on January 1, 1984, under each plan

Donald G. Schmitt is an economist in the Office of Wages and Industrial Relations, Bureau of Labor Statistics.

by making alternative assumptions regarding the retirees' length of service and earnings history. (See appendix.)

According to the 1984 survey, 82 percent of the active workers in medium and large firms were covered by private retirement pension plans financed wholly or in part by their employers. The plans include defined benefit plans, money purchase plans, and career contribution plans. The money purchase and career contribution plans, each accounting for only 2 percent of the total pension plan participants, were excluded from this analysis. Approximately 16.5 million workers participated in plans used in the calculation of the basic retirement benefits discussed here. Supplemental pension plans, available to a small number of workers in addition to their basic plan, also were excluded.

Finally, capital accumulation plans are not represented in this analysis. The number of these plans-which include profit-sharing, savings and thrift, and various stock plans— has increased in recent years. Except for profit-sharing, these plans are relatively new, and it is difficult to determine their impact on retirement income. Moreover, many allow employees to obtain some portion of the benefits prior to retirement.

Pension levels

Table 1 shows averages of monthly private pension payments calculated from the benefit formulas of plans surveyed in 1984. Because the formulas take account of length of service and, commonly, preretirement earnings as well, an

nuities under each plan were determined for 42 combinations of service and earnings. In all cases, the data apply to workers retiring on January 1, 1984, at age 65.

Average benefits varied widely among the age-service combinations. The range for all pension plan participants was from $137 monthly for retirees with 10 years of service and earning $15,000 in 1983 to $1,075 for retirees with 40 years of service and final earnings of $40,000.

Nevertheless, patterns did appear in the findings. Average payments increased, for example, with each rise in service and earnings. The amount of increase, however, grew smaller as the length of service increased, particularly for service beyond 30 years. This decreasing return for extra years of service mainly reflects provisions that limit the number of years credited in the payment calculation. One-third of all pension plan participants were covered by such provisions.7 Also contributing to this result are formulas that provide a lower benefit rate after specified years of service, for example, 1.5 percent of earnings per year of service up to 20 years, and 1 percent thereafter.

At each service period examined, benefits increased with the assumptions of higher final earnings. Moreover, at the all-participant level, for a given increase in earnings, the

dollar amount of the pension rise was greater at higher earnings levels. Thus, for employees retiring after 30 years of service, the average pension increased by $71 a month when earnings rose from $15,000 to $20,000 and by $114 when earnings moved from $35,000 to $40,000. In relative terms, when worker earnings increased from $15,000 to $20,000 (33 percent), benefits went up by 18 percent; the considerably smaller percentage growth in earnings from $35,000 to $40,000 (14 percent) was accompanied by a 15percent increase in pensions.

The relationship between benefit levels and earnings reflects the influence of a number of pension plan features. Benefits as a percent of preretirement earnings (replacement rates) are raised for retirees at the lower end of the earnings distribution when pension plans guarantee minimum benefit levels. Benefit replacement rates are also raised for lowwage earners when plans contain dollar-amount benefit formulas that provide annuities independent of prior earnings. Conversely, provision for maximum benefit levels reduces the return to retirement plan participants with relatively high earnings. High-wage earners do have an advantage when so-called step- ate excess formulas are in effect; these formulas calculate benefits as a percent of prior earnings and specify a higher percentage return on that part of earnings above a specified level than below that level."

Levels of private pension benefits also varied by occupational group. At equal levels of pay and years of service, white-collar groups (professional-administrative and technical-clerical) tended to receive higher benefits than bluecollar or production workers. This held true in all cases except at the lowest earnings level ($15,000), where production workers had slightly larger benefits. As earnings increased from $15,000 to $40,000, however, the average gain in benefit amounts was much smaller for production workers. Half of the production workers had pension formulas specifying dollar amounts of benefits, usually independent of prior earnings. Conversely, most of the whitecollar workers had earnings-based pension formulas, which calculate annuities as percentages of preretirement earnings, 10

Assuming equal levels of earnings and service, technicalclerical workers commonly were eligible for greater benefits than professional-administrative workers. The latter employees, however, actually average higher salaries and thus tend to receive larger pension benefits at retirement.

Pension benefits varied widely within, as well as among, service-earnings groupings. Table 2 shows the distribution of participants by amount of benefits at selected service and earnings levels. As can be seen, retirees with 30 years of service and $30,000 in final earnings could receive annuities ranging from less than $100 monthly to $1,200 or more. This spread in benefits reflects the wide variety of benefit formulas in private pension plans. The dispersion widens as earnings increase, because the benefits of workers with earnings-based formulas rise, while benefits remain constant

when formulas provide flat dollar annuities per year of service independent of earnings. Dispersion also widens as service increases, but to a lesser extent. This is because nearly all pension plans incorporate length of service in the benefit formula.

Replacement rates

Pension benefits are frequently evaluated through the use of replacement rates, that is, expressing the annuities as percentages of preretirement earnings. This facilitates examination of the degree to which pensions permit maintenance of preretirement standards of living. Because consumption patterns, tax liabilities, and rates of personal savings change upon retirement, living standards are typically maintained at less than a 100-percent replacement rate. The final report of the President's Commission on Pension Policy includes an estimate that, for single persons retiring in 1980, 79 percent of gross preretirement income was needed to maintain living standards at a $6,500 level of preretirement income; a 51-percent rate was needed at a $50,000 income level. The corresponding ratios for married couples were 86 and 55 percent.11

Estimates of replacement rates required to maintain living standards vary, depending in part on the precise definition given to the replacement rate concept. Are the annuities and preretirement earnings measured before or after taxes? Is the preretirement earnings base the final year's earnings? Is it some average of earnings in years immediately preceding

retirement (such as the 3 years of highest earnings in the last 10)? Or is it an average of earnings over the entire working career?12 In this analysis, pension benefits are measured before taxes and preretirement earnings are defined as gross earnings in the final full year of employment. Consequently, replacement rates reported here are lower than if other definitions of earnings were employed, because earnings typically peak in the final year of work. 13

Table 3 presents the monthly pension payments shown in table 1 (annualized) as percentages of earnings in the final year of work. These replacement rates rise substantially as service increases from 10 to 40 years. At the $30,000 level of earnings, for example, the average replacement rate for all pension plan participants increases from 18.5 percent at 20 years of service to 26.5 percent at 30 years and 32.6 percent at 40 years.

Replacement rates for the overall group, however, tend to decrease as earnings levels increase within each service category. This results primarily from plans for production workers. While white-collar workers experience slight increases in average replacement rates as earnings rise above $20,000, production workers experience a marked decline. As indicated earlier, the explanation for this difference lies in the relatively greater incidence of earnings-based benefit formulas among white-collar workers. 14

As shown in table 4, earnings-based formulas tend to yield higher replacement rates as final earnings rise. Dollaramount formulas (commonly providing benefits independent

$15,000.

$20,000.

$25,000

$30,000

$35,000

$40,000

46952

11.4 16.7 22.0 27.3 32.5 37.1 41.5 9.6 14.0 18.3 22.6 26.9 30.7 34.2 8.9 13.0 16.9 21.0 24.8 28.1 31.2 8.5 12.4 16.2 20.0 23.6 26.6 29.4 8.2 12.1 15.8 19.3 22.8 25.6 28.2 8.1 11.8 15.4 18.9 22.2 24.9 27.4

1Retirement annuity as a percent of earnings in the final year of work. The maximum pension available, not reduced for early retirement or joint-and-survivor annuity, was calculated under each pension plan using the earnings and service assumptions shown. This benefit level was then expressed as a percent of earnings in the last year of employment. Workers are assumed to have retired at age 65 with a total working career of 40 years.

Computations exclude 4 percent of participants in money purchase plans or plans with benefits based on career contributions.

NOTE: Data exclude Social Security payments, which are included in the replacement rates of tables 5 and 6.

ings.

Replacement rates, consequently, become more meaningful when Social Security benefits are added to the computation.

The Office of the Actuary, Social Security Administration, determined the benefit amounts that would be applicable for workers with the earnings histories used in this study. These Social Security benefits were added to the private pension benefits presented in table 1, and new replacement rates were determined using the combination of these two sources of retirement income.

Table 5 shows average replacement rates of combined private pension and Social Security retirement income for a single worker (one who is not receiving spousal benefits under Social Security). The inclusion of Social Security retirement benefits raises the rates significantly from those in table 3. Except at the higher earnings and service levels. Social Security benefits provide the major share of total retirement income.

Inclusion of Social Security benefits also changes the relationship between the size of the replacement rate and the preretirement earnings level. Private pension plans, on average, yield slightly higher replacement rates for whitecollar workers, when earnings rise above $20,000 (table 3). After adding Social Security benefits to the replacement rate calculation, however, the highest replacement rates are at

of earnings) produce the opposite result. In fact, dollaramount formulas produced the highest replacement rates for final earnings of $15,000-the lowest level used in this analysis.

Earnings-based private pensions commonly are integrated with Social Security benefits. This explains the tendency for greater replacement rates at higher earnings levels under these private formulas. The Social Security benefit formula yields pensions that, as a percent of preretirement earnings, are greater for retirees with relatively low earnings histories, and it takes account only of earnings up to the Social Security taxable wage base-$37,800 in 1984. Integrated private pension plans counter this by providing higher replacement rates as earnings rise. Dollar-amount pension formulas, however, are rarely integrated with Social Security benefits. 15

Social Security as a component

Private pension plans do not operate independently. They supply retirement income as part of a "three-legged stool,” which also includes Social Security and individual sav

Final year's earnings

10 15

Years of service 20 25

30

1Retirement annuity as a percent of earnings in the final year of work. The maximum pension available, not reduced for early retirement or joint-and-survivor annuity, was calculated under each pension plan using the earnings and service assumptions shown. This benefit level was then expressed as a percent of earnings in the last year of employment. Workers are assumed to have retired at age 65 with a total working career of 40 years.

Computations exclude 4 percent of participants in money purchase plans or plans with benefits based on career contributions.

2Terminal earnings formulas calculate annuities as percents of earnings in the final years of work-for example, the 5 highest consecutive years of earnings in the last 10. Career earnings formulas are similar, but take account of earnings throughout an employee's career. Under dollar-amount formulas, workers' years of service are multiplied by a dollar amount to calculate benefit payments.

$15,000..

$20,000.

60.8 63.8

$25,000

51.4

54.4 57.2

$30,000

$40,000

1Retirement annuity as a percent of earnings in the final year of work. The maximum pension available. not reduced for early retirement or joint-and-survivor annuity, was calculated under each pension plan using the earnings and service assumptions shown. This benefit level was then expressed as a percent of earnings in the last year of employment. Workers are assumed to have retired at age 65 with a total working career of 40 years.

Computations exclude 4 percent of participants in money purchase plans or plans with benefits based on career contributions.

the lower earnings levels. As already noted, the Social Security benefit formula provides higher replacement rates to lower wage earners.

If the retired worker has a husband or wife age 65 or over who is not eligible for a Social Security benefit on his or her own account, an additional benefit from Social Security equal to 50 percent of the worker's benefit is payable to the spouse. Adding this benefit to the worker's private pension

$35,000 $40,000

75.7 81.0 86.3 91.6 96.8 101.4 105.8
68.3 72.7 77.0 81.3 85.6 89.3 92.9
57.8 61.9 65.9 69.9 73.8
77.1 80.1
50.2 54.1 57.9 61.6 65.2 68.3 71.1
44.4 48.2 51.9 55.4 58.9 61.7 64.4
39.7 43.4 47.0 50.5 53.8 56.5 59.0

1Retirement annuity as a percent of earnings in the final year of work. The maximum pension available, not reduced for early retirement or joint-and-survivor annuity, was calculated under each pension plan using the earnings and service assumptions shown. This benefit level was then expressed as a percent of earnings in the last year of employment. Workers are assumed to have retired at age 65 with a total working career of 40 years.

Computations exclude 4 percent of participants in money purchase plans or plans with benefits based on career contributions.

and Social Security payments results in the average replacement rates presented in table 6. Here, except in the high income and short service examples, the data typically show replacement rates of 60 percent or more. Indeed, workers with relatively low earnings and long service may have all or nearly all of their preretirement income replaced by combined private pension and Social Security benefits when the latter includes an additional amount for the spouse.

'Industrial coverage includes mining; construction; manufacturing; transportation, communications, electric, gas, and sanitary services; wholesale trade; retail trade; finance, insurance, and real estate; and selected services. Major findings of the 1984 survey are reported in Employee Benefits in Medium and Large Firms, 1984, Bulletin 2237 (Bureau of Labor Statistics, 1985). For information on the background and conduct of the survey, see Robert Frumkin and William Wiatrowski, "Bureau of Labor Statistics takes a new look at employee benefits," Monthly Labor Review, August 1982, pp. 41-45.

2Excluded from the survey were executives (those whose decisions have direct and substantial effects on an organization's policymaking), parttime, temporary, and seasonal workers, and operating employees in constant travel status, such as airline flight crews and long-distance truckdrivers.

3 When pension formulas are revised, the new formula may apply only to "current" service, that is, service from the date of the revision. Prior service may still be covered under the previous benefit formula.

*Defined benefit plans contain a formula for calculating retirement benefits (for example, a specified percent of earnings or flat dollar amount for each year of service) and obligate the employer to contribute to a fund whatever amounts are necessary to provide the benefits so determined. Benefits under career contribution plans are directly related to contributions made by the employer or both the employer and employee. Money purchase plans do not specify benefit levels; instead, they obligate the employer to contribute money to a pension fund according to a formula (such as a specified percent of earnings).

"See "The World of Pensions Ten Years After ERISA," EBRI Issue Brief (Employee Benefit Research Institute, September 1984), p. 9.