Pensions
Social Security Reform: Pension Plan Integration with Social Security
Fact Sheet
Jules Lichtenstein, AARP Public Policy Institute
October 1998
Table of Contents:
- What Is Integration with Social Security?
- How Does Integration Work?
- Are There Other Limits to Integration?
- Examples
- Footnote
What Is Integration with Social Security?
Employer-provided pension plans often explicitly take account of projected/anticipated Social Security benefits in determining plan benefits. This "integrated" pension plan approach takes into consideration an employer's contributions to Social Security (FICA taxes) and allows employers who sponsor their own pension plan to take credit for the fact that their FICA contributions on behalf of lower-income workers--although the same payroll tax rate as for higher-income workers--buy proportionately more generous benefits than their contributions for higher-income workers. Pension benefits are thereby lowered for all workers, and total retirement benefits (pensions plus Social Security) replace a more uniform percentage of final pay for all employees. However, pension benefit reductions due to integration make it more difficult for lower-income workers to attain retirement income security. The majority of these workers are women and minorities.
How Does Integration Work?
Pension plans use different approaches to integration. One approach, known as "offset," directly takes Social Security benefits into account by reducing pension benefits for each dollar in Social Security benefits received. The maximum permitted pension reduction is one-half of the annual Social Security benefit--reflecting the employer's matched Social Security contribution on the worker's behalf.
In another approach, known as "step-rate," an integrated pension plan can offer more generous benefits to individuals whose earnings are higher than a prescribed wage level--the "integration level." The "integration level" is set by law and cannot be higher than the maximum taxable earnings base (MTEB), i.e., the earnings subject to Social Security tax in a given year. The MTEB is $68,400 in 1998.
In addition, the approach to integration depends on whether a plan is a defined benefit plan, which commits a firm to pay a specified benefit at a future date, or a defined contribution plan, which bases benefits on the amount accumulated in a participant's account. Under the tax code, certain defined contribution plans--e.g., 401(k) plans, simplified employee pension (SEP) plans, and Employee Stock Ownership Plans (ESOPs)--may not be integrated. The only permissible method for integrating other defined contribution plans is the "step-rate" approach. Defined benefit plans may use either the "offset" or "step-rate" approach.1
Top of PageAre There Other Limits to Integration?
Qualified pension plans, i.e., those that receive favorable tax treatment, must meet certain "non-discrimination" rules in setting benefits. Integrated plans must also take account of non-discrimination requirements specified in the tax code. These requirements are designed to ensure that pension plans do not discriminate (i.e., provide greater proportional benefits) in favor of "highly-compensated employees" (HCEs). The general rule, effective in 1997, is that an HCE is an employee who earned at least $80,000 during the preceding year or was a 5% owner. A qualified plan is permitted to offset some, but not all, of Social Security's tilt in benefits toward lower-paid employees. The term used in the tax code to limit this offset is "permitted disparity." Permitted disparity limits both the percent reduction in Social Security benefits when using the offset method, and the percent of benefits permitted above the integration level when using the step-rate approach. The extent of regulatory restrictions placed on an approach affects its selection by an employer.
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| 1) Final Earnings | Final 5 year average |
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| 2) Annual Social Security Benefit | Primary Insurance Amount x 12 |
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| 3) Annual Pension Benefit Before Integration | 30 years x $50,000 (line 1) x 1.5% |
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4) Integration Adjustment Offset Approach: ½ of annual Social Security benefit Step-Rate Approach: Integration level of $40,000--maximum integration level is $68,400 1% of earnings up to $40,000 1.5% of earnings of $40,000 and over |
½ of $12,000 (line 2) (30 years x $40,000 x 1%) (30 years x $40,000 x 1.5%) |
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| 5) Annual Pension After Integration |
Offset: $22,500 (line 3) minus $6,000 (line 4) Step-Rate: $16,500 (line 4) |
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| 6) Total Annual Benefits After Integration | $12,000 (line 2) plus $16,500 (line 5) |
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*Note: These are hypothetical examples--actual results are not necessarily the same for a worker under both approaches.
Examples
Benefits for Workers with Integrated Defined Benefit Plans Under the Offset Approach
A worker has a pension plan that specifies benefits equal to 1.5% of average earnings in the five years prior to retirement, multiplied by years of service, reduced by 50% of the worker's Social Security benefit. Under this plan, a worker with final five-year average earnings of $50,000 and expected annual Social Security benefits of $12,000 would receive an annual pension of $16,500. The integrated pension would be calculated as follows for a 30-year employee:
- The worker's annual pension benefit prior to integration with Social Security is $22,500 (computed by multiplying $50,000 by 30 years, and multiplying this product by 1.5%).
- The worker's pension benefit after integration with Social Security is $16,500 (difference between the prior pension amount ($22,500) and one-half of the annual Social Security payment (maximum permitted) of $12,000).
- The total annual benefits (pension and Social Security) is $28,500. This is $6,000 less than the total benefit would have been if the pension plan had not been integrated and the two benefits had simply been added together.
Benefits for Workers with Integrated Defined Benefit Plans Under the Step-Rate Approach
A step-rate approach involves two benefit percentages: the first, or "base" rate, is a percentage that applies to earnings up to the integration level; the second, or "excess" rate, is the percentage applied to earnings at and above the integration level. A pension plan may set the integration level at a value at or below the MTEB. For example, the integrated plan may have a base rate of 1% up to an integration level of $40,000, and an excess rate of 1.5% above $40,000. In this case, the worker with final average annual earnings of $50,000 and expected annual Social Security benefits of $12,000 would receive an annual pension benefit of $16,500. The annual pension benefit before integration is $22,500.
- The pension benefit is the sum of the two benefit percentage calculations. The first is $40,000 multiplied by 30 years, which is then multiplied by 1%, which is $12,000. The second--$10,000 multiplied by 30 years, which is then multiplied by 1.5%--is $4,500. The sum--$16,500, is the annual pension.
- The total annual benefit after integration is $28,500--$6,000 less than the total benefit of $34,500 if the plan had not been integrated.
1 In 1995, half of all participants in defined benefit plans were in integrated plans (36% in step-rate and 13% in offset).
Written by Jules Lichtenstein, Senior Policy Advisor, AARP Public
Policy Institute
October 1998
©1998 AARP
May be copied only for noncommercial purposes and with
attribution; permission required for all other purposes.
Public Policy Institute, AARP, 601 E Street, NW, Washington, DC
20049
Pub ID: FS70