DONALD BELL AND DIANE HILL

Many workers look forward to receiving benefits from private pension plans as well as from social security. Half of all full-time wage and salary workers in private industry in May 1979 were covered by pension plans;' nearly all of them were also under the social security system. This dual retirement income has fostered interest in coordinating public and private plans. Often, social security payments are considered when setting the terms of private pension plans. There are two types of private pensions plans: defined contribution plans, which require an employer to contribute a specified amount of money into a pension fund; and defined benefit plans, which provide specified benefits according to a formula taking into account an employee's years of service, or earnings, or both. A defined contribution plan does not promise a predetermined level of benefits-the benefits paid at retirement depend on the amount credited to an employee. In a defined benefit plan, pension benefits are predetermined and the employer must make contributions adequate to finance those benefits. Both types of plans may reflect the existence of social security (Old-Age, Survivors, and Disability Insurance) either implicitly, by informally providing lower annuities than would be the case if social security benefits were not available; or explicitly, by formally recognizing the existence of social security.2

Plans which explicitly acknowledge social security benefits are called integrated plans. Their formulas generally recognize not only the level but also the underlying structure of social security benefits. For example, social security benefits as a percent of preretirement earnings (replacement rates) are greater for low-wage earners than for high-wage earners. Some employers counter this difference by using a

Donald Bell and Diane Hill are labor economists in the Office of Wages and Industrial Relations, Bureau of Labor Statistics.

benefit formula which results in greater replacement rates under the private plan for high-wage earners. Internal Revenue Service regulations, discussed later, govern the extent to which this is permissible.

Proponents of integrated private plans maintain that coordinating private pensions and social security benefits yields equitable retirement income for all workers, regardless of earnings, while keeping employer costs within reasonable bounds. (Employers often contend that their payment of social security taxes should be considered when determining outlays for private benefits.3) On the other hand, critics stress that integrated private plans may provide low benefits—or none at all—to low-wage earners.4

Information on integrated private pension plans was obtained from the Bureau of Labor Statistics' annual survey on the incidence and characteristics of employee benefit plans in medium and large firms. Of the 914 defined benefit pension plans studied in 1981, 521, or nearly three-fifths, were integrated. Most of the integrated plans (60 percent) reduced private pensions by a portion of the social security payment. The remainder (40 percent) were coordinated with social security through percent-of-earnings benefit formulas that applied different percentages to earnings above and below specified dollar levels.

Defined benefit plans which integrate by deducting a portion of the social security payments are called offset plans. Those which establish higher pension formulas for earnings above a specified level than for those below are called excess plans; the earnings level is related to the maximum wage subject to social security taxation (the "taxable wage base"), which was $29,700 in 1981. (Integrated defined contribution plans, excluded from this study, follow the excess approach; contribution rates, expressed as a percent of earnings, are higher on earnings above a specified level than below.)

Offset plans

Sixty percent of all the integrated plans included in the study were offset plans. The formula in an offset plan and its effect on replacement rates (annuity as a percent of earnings in the final year of work) are illustrated in the following:

Two employees retired at the beginning of 1981 after 30 years of service; one earned $20,000 in 1980 and the other, $30,000. Both employees were covered by a private pension plan with a typical offset provision which provides pensions equal to 1.5 percent of average earnings in the five highest

earnings years ("high-five" average earnings) multiplied by years of service, less 50 percent of primary social security benefits (excluding benefits for spouses or other dependents). The workers' earnings were not constant over the years. Therefore, it is necessary to estimate their earnings in each of the years affecting the private pension and social security benefit calculations. The estimated "high-five" average earnings used here were calculated from assumed earnings histories developed by the Social Security Administration, which also provided the social security benefits. Replacement rates were calculated by dividing each benefit by the workers' earnings in the last year of work."

Analysis of pension plan provisions is complicated by technical terms which permeate the pension literature. The use of these terms cannot be avoided. However, each of the technical terms used in this article is defined below.

Career earnings formula. A formula which bases pension benefits on average earnings in all years of credited service.

Defined benefit plan. A pension plan which includes a formula for calculating retirement benefits (such as a specified percent of earnings or flat dollar amount per year of service) and obligates the employer to provide the benefits so determined. Therefore, employer contributions are not fixed, but are whatever is needed, together with earnings of pension fund investments, to finance the required benefits.

Defined contribution plan. A pension plan that obligates the employer to contribute money to a pension fund according to a formula (such as a specified percent of earnings). Benefits are not fixed, but depend on the amount of employer contributions and the earnings of pension fund investments.

Early retirement. Retirement before the normal retirement age. Early retirement pensions depend on earnings and service, but are reduced for each year prior to the normal retirement age.

Excess plan. An integrated pension plan which provides relatively higher pensions on earnings above a specified level than on earnings below that level. A pure excess plan calculates pensions only on earnings above the specified level, while a step-rate excess plan has separate calculation formulas for earnings above and below the specified level.

Flat-benefit plan. An excess plan that expresses pensions as flat percentages of earnings, independent of length of service.

Integrated pension plan. A private pension plan that is explicitly coordinated with social security, either through the offset or excess approach. A common objective is to recognize employer costs for social security in setting private pension benefits. In addition, integrated private pension plans often provide greater benefits relative to preretirement earnings for the higher-paid workers. Integration level (breakpoint). The level above and below which excess plans apply different percent-of-earnings formulas. The integration level may be the "social security taxable wage base" or a specified dollar amount, usually the taxable wage base at the time the excess formula was developed.

Normal retirement. Retirement at the earliest age specified in a pension plan for retirement with all accrued pension benefits by virtue of earnings and service, without reduction due to age.

Offset plan. An integrated pension plan that reduces private benefits by a portion of an employee's social security benefit.

Old-Age. Survivors, and Disability Insurance (OASDI). The old-age insurance program established by the Social Security Act, referred to as "social security" in text.

Replacement rate. Retirement annuity as a percent of earnings in the final year of work.

Taxable wage base. The maximum wage or salary subject to payroll taxation for social security purposes. The wage base was $29,700 in 1981, the year covered by this study.

Terminal (final) earnings formula. A formula that bases pension benefits on average earnings in the final years of credited service-often the last 3 or 5 years.

Unit benefit plan. An excess plan that expresses pensions as percentages of earnings per year of service.

11,646 58.2

15,619 52.1

(5) Offset pension plus social security
(4) + (3)
Replacement rate

Prior to calculation of the social security offset, private pensions replace 38.5 percent of preretirement earnings for both the $20,000 and the $30,000 worker (2). However, after deducting half the social security benefit paid to these workers, the $30,000 worker receives a greater private pension proportionate to preretirement earnings than does the $20,000 worker (4). But the replacement rate for combined social security and offset private benefits is higher for the $20,000 worker; this stems from the social security benefit formula, which yields a higher replacement rate for the $20,000 worker, (3) and (5).

Offset plans use a variety of approaches to determine the social security deduction. (See table 1.) One-fourth of the offset plans in the 1981 study specified deductions independent of an employee's length of service: they generally

called for flat percentage deductions, averaging 60 percent of primary social security benefits. However, a majority of the offset plans (three-fourths) specified a percentage deduction which varied with length of service. These percentage offsets ranged from 0.75 percent to 5 percent per year of service, but the effect of this formula was usually limited by either a ceiling on the size of the offset (usually 50 percent) or a curb on the years of service included in the calculation (typically 25 to 40 years). In cases where deductions varied by length of service, offsets for retirements after 30 years of service averaged 49 percent of the primary social security benefit in capped plans; this was higher than the 33-percent average found in plans without a ceiling on the maximum offset. (It is possible that uncapped formulas include lower percent-per-year offsets in recognition of their potential impact on long-service employees retiring after 35 years or more on the job.) In all cases, the amount of the offset is fixed at the time of retirement and subsequent changes in social security benefits, either legislated or costof-living adjustments, do not affect private pension pay

ments.

Excess plans

Two-fifths of the integrated pension plans were excess plans. These plans contained percent-of-earnings benefit formulas which applied a higher percentage rate to earnings above a specified level (the breakpoint or integration level) than to those below. Excess plans achieve patterns of replacement rates relative to preretirement earnings similar to those under offset plans. This is illustrated in the following: Two employees retired at the beginning of 1981 after 30 years of service, with earnings in 1980 of $20,000 and $30,000. Their pension plan provided benefits per year of service equal to 1 percent of career average annual earnings up to $7,800, and 1.5 percent of earnings above this level. (The estimates of social security benefits were provided by the Social Security Administration; estimates of career average earnings are based on the Social Security Administration's assumed earnings histories.)

All

Terminal

Integration status

plans

earnings

Defined benefit plans:

Number

914

510

151

253

Percent

100

100

100

100

Percent with integrated formula2

Offset3

Because the two workers had career average earnings exceeding the breakpoint, each obtained the same pension benefits at the 1-percent accrual rate (2). However, the $30,000 worker, with greater earnings above $7,800 received more benefits from the 1.5-percent rate (3) and, as a result, a higher overall private pension replacement rate (4). Nevertheless, as in the offset plan example, the replacement rate for combined social security and private benefits is higher for the $20,000 worker than for the $30,000 worker (6).

Excess plan formulas differ considerably in such areas as the integration level and the formula components. Some plans specify the "social security taxable wage base" as the integration level; others specify a dollar amount, typically the taxable wage base in effect at the time the pension formula was adopted. Excess plans commonly calculate benefits as a percentage of average annual earnings multiplied by years of service (unit-benefit plans); some, following Internal Revenue Service guidelines, calculate benefits as a flat percent of earnings of retirees with 15 years or more of service (flat-benefit plans).

A limited number of excess plans-1 percent of all the pension plans studied-calculated pension benefits only on earnings above specified dollar breakpoints (pure excess plans). The remainder contained separate pension calculation percentages for different earnings levels (step-rate plans).

Slightly more than half of the step-rate excess plans designated the social security taxable wage base" as the integration level. Accordingly, they adjust automatically to changes in this base. Most of these plans specified either a career average of social security tax bases (68 plans) or the social security tax base in each year worked (28 plans). The remainder used the average social security tax base during the final 3 or 5 years of service. On average, step-rate excess plans integrating at the social security tax base provided benefits per year of service equal to 1.05 percent of earnings up to the tax base, and 1.64 percent of higher earnings-a spread of 0.59 percentage points.

The remaining half of the step-rate excess plans integrated at a specific dollar figure. For the most part, these plans did not regularly adjust the integration level to match changes in the social security tax base. For example, one plan specified a $6,600 breakpoint; it provided benefits equal to 1 percent of the first $6,600 of career average annual earnings and 2 percent of higher earnings, multiplied by years of service. The breakpoint in this instance was the 1966 social security taxable wage base ($6,600).

Among the step-rate excess plans citing dollar amounts as breakpoints, the specified earnings level ranged from $3,000 to $24,000 per year and averaged $7,282. Benefits averaged 0.99 percent of earnings below the breakpoint and 1.65 percent above, a spread of 0.66 percentage points. This was slightly more than the 0.59 points under plans using a social security tax base integration level.

Alternative formulas and minimum benefits

Integrated pension formulas may result in nominal private annuities for low-paid or short-service employees. Many of the pension plans studied contained provisions to counter this possibility. Two approaches were used. In the first, an integrated plan specified a minimum level of private benefits; in the second, a pension plan with an integrated formula also contained an alternative formula which was not integrated with social security. The retiree's private annuity is based on the formula which yields the higher benefit.

The following tabulation of the 521 integrated pension plans in the 1981 survey indicates the relative importance of plans with minimum benefit provisions and alternative, nonintegrated formulas. (Sums of individual items may not equal totals because some plans contained both minimum benefits and alternative formulas.)

Relation of formulas and integration

Table 1 shows the overall extent to which private pension plans were integrated with social security. It also indicates a strong relationship between the benefit formula of a private pension plan and the incidence and form of integration. For example, integration was largely confined to private pension plans which calculated benefits as percentages of preretirement earnings. Integration provisions were found in threefifths of the plans calculating pensions as a percentage of career earnings and in four-fifths of those using terminalearnings formulas which base pensions on earnings in the last years of service.

Furthermore, terminal and career earnings plans use different approaches to integration. Career earnings plans typically used step-rate excess formulas, whereas the terminal earnings plans applied the offset approach in a majority of the cases.

The incidence of integration declined substantially among plans without career or terminal earnings formulas. Benefits were coordinated with social security in 6 percent of the 253 plans which did not have a percentage-of-earnings benefit formula; these plans mainly stipulated dollar benefits per year of service or dollar schedules of benefits varying by length of service.

Influence of collective bargaining. Collectively bargained pension plans tend to exclude integration provisions. Inte

The proportion of union-management plans in 1981 with integration formulas is markedly below that recorded in two earlier BLS analyses. 10 A study of 300 pension plans under collective bargaining in late 1952 found offset provisions in 140 of the plans. A second study, of 300 bargained plans in effect in the fall of 1959, found integration provisions in 120 of the plans-79 integrated by the offset method and 43 by excess formulas (2 plans used both offset and excess formulas). Although differences in survey scope and method preclude precise comparison among the three studies, the data clearly indicate that integration is less common in unionmanagement pension plans today than 30 years ago.

Integration provisions in early bargained plans-mainly offset formulas-partly mirrored union efforts to encourage employer support for expanded social security benefits." More recently, union-management plans have tended to drop integration provisions as social security benefits improved. Impact of Internal Revenue Service rules. Income tax considerations greatly affect the way private pension plans integrate with social security. Since passage of the Revenue Act of 1942, Federal tax breaks have been denied to pension plans which discriminate in favor of officers, shareholders, supervisory, or other highly paid employees with respect to coverage, benefits, or contributions. Integrated private plans can qualify for tax advantages as long as combined pension and social security replacement rates are no higher for employees earning more than the social security taxable wage

base than for lower earning individuals.

Internal Revenue Service rules take account of the variations in pension plan integration. Under current rules, an offset plan can reduce benefits up to 833 percent of primary social security benefits payable at the time of retirement (the amount of the retiree's offset cannot be changed because of subsequent social security benefit adjustments). IRS rules with respect to step-rate excess plans prescribe maximum spreads between percentages applicable to earnings above and to those below the integration level. 12

Integration formulas and replacement rates

The wide variety of integration formulas in pension plans makes it difficult to summarize their effects on retirement income. A common approach focuses on a limited number of hypothetical offset and excess plans drawn up to illustrate typical integration formulas; pensions are calculated for workers at different earnings levels retiring under each of these plans.

An alternative approach is to calculate benefits for a representative sample of actual pension plans. This alternative approach is possible here because of the availability of the detailed provisions of individual pension plans. Subsamples were taken of the integrated pension plans found in the 1981 BLS study of employee benefit plans-to obtain reasonable balance, every fifth offset plan and every third step-rate excess plan was selected. For each of these plans, pension benefits were calculated for two workers retiring at the beginning of 1981 after 30 years of service, and with final earnings of $20,000 and $30,000.

Considering the small samples (54 offset and 66 step-rate excess plans), it is not possible to present useful information on levels of pension benefits. However, the pattern of replacement rates by earnings level is instructive. (See table 3.) Both under the offset and excess plans analyzed, the higher paid employee, on average, received a greater private