Hybrid Retirement Plans

1. Hybrid Retirement Plans University of Illinois September 14, 2005

2. Introductions • Julie Durkinjulie.durkin@watsonwyatt.com • Michelle Rorvickmichelle.rorvick@watsonwyatt.com • Watson Wyatt Worldwide • 6,000 associates • 90 offices in 32 countries lf:\J:\act\00022\recruiting\UofI-Champaign\2004-2005\Finance Class\finance360Pres.ppt

3. What does Watson Wyatt do? • Consult with employers to design, finance and administer benefit plans to attract and retain employees • We balance these needs with the employer’s financial constraints

4. What does Watson Wyatt do? • Benefits consulting • Retirement • Investment consulting • Group & health care • International • Workforce planning • Communication • Technology solutions • Human capital consulting

5. Agenda • Hybrid Plans • Cash balance plans • Case Studies • Future of Retirement Plans • Questions

6. Hybrid Plans • What are they? • Why were hybrid plans created? • Why would an employer be interested in a hybrid plan?

7. Hybrid Plans • Defined contribution features • Defined benefit features

8. Hybrid Plans • Characteristics • Defined benefit plans that are made to look and act like defined contribution plans, or • Defined contribution plans that mimic accrual patterns similar to defined benefit plans

9. Hybrid Plans • Examples • Cash balance plan • Defined benefit plan that expresses a participant’s benefit with a hypothetical account balance • Defined lump sum/Pension equity plan • Lump sum at retirement based on pay credits (age and/or service) • Age/Service based profit sharing plans • Annual employer contributions (% of pay) • Contribution % based on age and/or service

10. Cash Balance Plans – What is a Cash Balance Plan?

11. What is a Cash Balance Plan? • Pension plans that define a participant’s benefit as a hypothetical account balance • Combines strengths of Defined Benefit and Defined Contribution Plans • Account grows with annual pay-related credits and interest credits • Employees receive lump sum or annuity at retirement/termination

12. What is a Cash Balance Plan? Example • Account is established for each employee (hypothetically, no actual asset allocated in the trust) • Each year the account is credited with a deposit equal to 6% of the employee’s pay • Each year the account is credited with interestequal to a public index (5.5%)

13. What is a Cash Balance Plan? Example Contribution is based on 6% of pay; Salary increases are 4% per year;Interest credits are based on the published rate of 5.5% per year

14. Comparison of Benefit Accruals

15. Transition from 1% Final Avg Pay to 6% Cash Balance – Winners and Losers

16. Cash Balance Plans – Why Do CompaniesImplement Them?

17. Why Do Companies Implement Cash Balance Plans? • Improve employee understanding and appreciation • Easier to communicate • Complement 401(k) plans • Attract and retain talent • Provide portable retirement benefits • Meets the company’s business strategy • Potential Savings • More stable costs

18. Cash Balance Plans –Why Do CompaniesAvoid Them?

19. Why Do Companies Avoid Cash Balance Plans? • Does not meet the company’s business strategy • Uncertainty regarding the future of these plans • Negative press • Transition issues • IBM • Legal issues • IBM (Cooper vs. IBM – age discrimination) • Xerox (Berger vs. Xerox – whipsaw issue)

20. Legal Issues Cash Balance Plans • Two employees, one age 25, the other age 55 • Each receives a contribution credit equal to $1,000 • Plan provides interest credits at the rate of 6% per year • Age Discrimination claim because 55-year oldreceives a smaller retirement benefit at age 65 • Whipsaw issue if the age 65 account balance is discounted back to current age at a lower rate than 6%

21. Proposed Pension Reform Legislation • Change the funding of pension plans • Hybrid Pension Plan legislation would: • Retroactively clarify the legal status of hybrid plans for plans that are not currently subject to litigation; • Establish retroactive conversion requirements; and • Establish additional requirements for future conversions.

22. Case Studies

23. Six Views • Workforce View • What: Demographic analysis & forecasting to customize recommendations to the unique make-up of your workforce • Why: Averages are misleading; we need to dig into details to know where risks are hidden - where you may have challenges recruiting and retaining over time • Employer View • What: Assess “alignment” by clearly defining “desired state” • Why: Ensure benefits programs meet business and HR goals • Employee View • What: Consider employee expectations and perceptions by distinct segments of your workforce • Why: Perception is stronger than reality…how your programs are perceived is how they ARE • Financial View • What: Assess financial impact and return on investment of current and alternative designs • Why: Understand costs and cost drivers before recommending changes • Environmental View • What: Determine which non-design factors may affect program acceptance • Why: Changes to environmental factors may be more powerful - • and less costly - than changes in design • Competitive View • What: Review position in the relevant marketplace • Why: Ensure that market positioning reflects strategic intent

24. Sample Conversion Questions Given: • An employer is considering a pension plan redesign. • The plan currently provides a benefit equal to 1.5% of a participant’s final average compensation multiplied by years of service. • The employer is considering a cash balance plan that provides a benefit with pay credits equal to 3% of pay.

25. Why would an employer consider this change? • Reduced volatility • Less expensive plan on an ongoing basis • Enhanced employee understanding

26. How will employees view this change? • Reaction will depend on management’s relationship with employees • Employees will want to understand the reason for the change • Reactions will vary dramatically depending on employees’: • Individual situation • Understanding of the current plan and the difference in these types of plans

27. Other Issues • How will the costs of these programs compare? • Does the proposed plan provide competitive benefits?

28. Case Study A Current Business Situation • Large manufacturer wants to review current benefit programs • Mature population in decentralized locations • Employer has maintained an extremely paternalistic culture to date

29. Case Study A (cont.) Current Business Situation • Mostly rural locations where company is major employer in town • Publicly traded company with mandate to reduce costs • Company has grown through acquisitions

30. Objectives for Retirement Program – Case Study A • Facilitate integration of acquired companies • Share responsibility between employer and employee • Provide minimum floor of protection • Improve perceived value of program • Provide competitive program

31. Objectives for Retirement Program – Case Study A (cont.) • Improve employee understanding • Provide a program that does not encourage retirement at a certain date • Maintain a cost neutral program

32. Case Study A – Current Program • Pension Plan: • 2% of Career Average Pay payable at age 65 • Unreduced benefits payable at age 60 • Subsidized early retirement provided at age 55 with ten years of service. • Eligibility is after 1 year of service • Vesting is 100% after 5 years.

33. Case Study A – Current Program (cont.) • 401(k) Plan: • pre-tax deferrals • 50% match on deferrals up to 3% of pay

34. Case Study A – Current Costs • Present value of pension benefits for active participants • $1,200 M • Matching contribution • $10 M • Total - $1,210 M

35. Case Study A • Given this situation, what would your proposed plan design be? • How would your proposed design satisfy the objectives? • How do you think the employer/employees will respond to your proposal?

36. Employer Proposal • Discussion

37. Employee Proposal • Discussion

38. Case Study B Current Business Situation • Two liked size companies merge and a year later merged company acquires three smaller businesses • Logistics company • Company is re-branded • IPO likely in near future • Low margin business • Paternalistic culture at the two original companies

39. Case Study B – Background • Company A Program • 1.5% final average pay pension plan • 401(k) pre-tax contributions with discretionary matching contribution • a retiree medical and life program • Company B Program • No pension plan • 100% match up to 3% of pay • Smaller acquired businesses • No pension plan • 50% match up to 6% of pay

40. Case Study B – Objectives • Integration of companies • Build retirement program consistent with business goals • Reduce costs of programs • Create a program which will attract and retain employees • Promote joint responsibility for retirement

41. Case Study B • Given this situation, what would your proposed plan design be? • How would your proposed design satisfy the objectives? • How do you think the employer/employees will respond to your proposal?

42. Case Study B – Employer Proposal • Discussion

43. Case Study B – Employee Proposal • Discussion

44. Future of Retirement Plans

45. Future of Retirement Plans • Baby boomers are retiring • Uncertainty regarding social security system • Employer sponsored plans • Phased retirement • Retirement age • Health • Life expectancy • Pension reform

46. Retirement Consulting • Design retirement programs based on changing objectives • Determine cash flow for plans • Contributions satisfying ERISA requirements • Benefit Payments • Calculate pension expense under FASB # 87 and 132 and IAS #19 accounting standards

47. Retirement Consulting (cont.) • Calculate benefits • Perform budget planning calculations • Asset liability modeling • Non-discrimination testing

48. Questions