1. W W W. W A T S O N W Y A T T. C O M Hybrid Retirement Plans University of Illinois September 14, 2005

2. 1 Introductions Julie Durkin julie.durkin@watsonwyatt.com julie.durkin@watsonwyatt.com Michelle Rorvick michelle.rorvick@watsonwyatt.com michelle.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. 2 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. 3 What does Watson Wyatt do? Benefits consulting – Retirement – Investment consulting – Group & health care – International – Workforce planning – Communication Technology solutions Human capital consulting

5. 4 Agenda Hybrid Plans Cash balance plans Case Studies Future of Retirement Plans Questions

6. 5 Hybrid Plans What are they? Why were hybrid plans created? Why would an employer be interested in a hybrid plan?

7. 6 Hybrid Plans Defined contribution features Defined benefit features

8. 7 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. 8 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. 9 Cash Balance Plans – What is a Cash Balance Plan?

11. 10 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. 11 What is a Cash Balance Plan? 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 interest equal to a public index (5.5%) Example

13. 12 What is a Cash Balance Plan? 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 Example YearPayPay CreditInterest CreditBalance #1$50,000$3,000$0$3,000 #2$52,000$3,120$165$6,285 #10$71,166$4,270$2,154$45,580 #20$105,342$6,321$7,247$145,327 #30$155,933$9,356$17,660$348,111

14. 13 Comparison of Benefit Accruals

15. 14 Transition from 1% Final Avg Pay to 6% Cash Balance – Winners and Losers

16. 15 Cash Balance Plans – Why Do Companies Implement Them?

17. 16 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. 17 Cash Balance Plans – Why Do Companies Avoid Them?

19. 18 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. 19 Legal Issues 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 old receives 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% Cash Balance Plans 25-year-old55-year-old A. Pay Credit1,000 B. Interest credits to age 6510,2861,791 C. Account balance at age 6511,2862,791

21. 20 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. 21 Case Studies

23. 22 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 Competitive View What: Review position in the relevant marketplace Why: Ensure that market positioning reflects strategic intent 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 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

24. 23 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. 24 Why would an employer consider this change? Reduced volatility Less expensive plan on an ongoing basis Enhanced employee understanding

26. 25 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. 26 Other Issues How will the costs of these programs compare? Does the proposed plan provide competitive benefits?

28. 27 Case Study A Large manufacturer wants to review current benefit programs Mature population in decentralized locations Employer has maintained an extremely paternalistic culture to date Current Business Situation

29. 28 Case Study A (cont.) Mostly rural locations where company is major employer in town Publicly traded company with mandate to reduce costs Company has grown through acquisitions Current Business Situation

30. 29 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. 30 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. 31 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. 32 Case Study A – Current Program (cont.) 401(k) Plan: – pre-tax deferrals – 50% match on deferrals up to 3% of pay

34. 33 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. 34 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. 35 Employer Proposal Discussion

37. 36 Employee Proposal Discussion

38. 37 Case Study B 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 Current Business Situation

39. 38 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. 39 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. 40 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. 41 Case Study B – Employer Proposal Discussion

43. 42 Case Study B – Employee Proposal Discussion

44. 43 Future of Retirement Plans

45. 44 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. 45 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. 46 Retirement Consulting (cont.) Calculate benefits Perform budget planning calculations Asset liability modeling Non-discrimination testing

48. 47 Questions