Phasing Out

Solving today's unique talent-management problems with phased retirement can be dicey for companies with defined-benefit plans, but there are some ways it can work.

Monday, July 11, 2011
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This June, Oklahoma State University in Stillwater, Okla., expects up to 86 of its most experienced and most tenured professors to retire en masse. And the university couldn't be happier.

Under OSU's new phased-retirement program, the retired teachers, all 65 and older, will return next fall to teach part-time for one to three years. But because they have formally retired, they will also collect their retirement pensions as they work, along with half their former salary and medical coverage, and a continuing, "reduced" contribution to their pension plans.

The program is a win-win for everyone, says Anne Matoy, OSU's assistant vice president of HR. Veteran professors don't have to leave the jobs they love, students have the benefit of seasoned faculty, and department heads know when teachers will retire and will have time to replace them.

"A lot of our employees are very dedicated to academia. They would probably spend their whole lives [teaching]," Matoy says. " ... This allows faculty the opportunity to cut back, perhaps pursue other interests and feel more comfortable when they retire."

Some might call this phased retirement at its best, at a time when employers are trying to hold on to experienced workers and stagger the exodus of boomers from the workforce.

However, formal phased-retirement programs such as OSU's are still rare, especially in the private sector.

There are a few reasons: First, there is no legal definition of phased retirement, and the Internal Revenue Service code has few regulations for how to offer phased retirement with a defined-benefit plan. Second, allowing employees to reduce hours can have a domino effect on a company's pension formula and its part-time benefits program. Third, offering phased retirement can open the door to potential age-discrimination lawsuits from other employees. Private employers also worry about inadequate funding of their pension plans.

In other words, experts agree, it's all very complicated. It is especially complicated if your company has a defined-benefit plan, says Richard Johnson, director of the retirement policy program at the Urban Institute in Washington.

"Defined-contribution plans don't pose a big barrier. The impediment [with pension plans] is [this]: Can people afford to reduce their hours of work if they don't have access to their retirement benefits? ... If you're in a defined-contribution plan, you can start collecting without a tax penalty if [you're] over 59 and a half. If you're in a defined-benefit plan, you're forbidden from receiving in-service distributions before age 62."

Attorney Chantal Sheaks, a principal at Buck Consultants in Washington, calls phased retirement with a pension plan "a very difficult topic."

"Right now there's no clear guidance on phased retirement vis-à-vis defined benefits," she says. " ... I think most people are leery to use a defined-benefit plan as phased retirement, and go other routes to [help employees] retire in a nontraditional manner."

Nevertheless, some HR executives in both the private and public sectors are exploring ways to offer phased retirement within their existing retirement plans. Experts advise them to be aware of IRS and legal requirements, to carefully identify the category of worker they want to retain, to make phased retirement part of a business plan and to document all decisions to avoid potential IRS questions or age-discrimination claims.

Why Phased Retirement Today?

Baby boomers have strapped corporate America into a roller-coaster ride. A decade ago, businesses foresaw a tide of boomers getting ready to retire, and started recruiting their replacements.

When the dot-com bubble burst, there was an effort to get rid of older workers because they earned higher salaries and stood in the way of eager young workers. In 2004, the IRS was pressured to adopt proposed regulations to expedite phased retirement. But that never happened. The only thing the IRS did was change the minimum age at which companies can start in-service distribution of pensions to 62.

With the recession of 2009 and 2010, boomers, scared for their financial futures, held on to their jobs, creating a logjam. And no company wanted to start paying out pensions when DB plans had lost money.

Today, that logjam is easing as the recession wanes and unemployment falls, albeit haphazardly.

But there's another problem: Certain industries can't find trained workers to replace veterans in highly skilled, technical fields, including engineering and laboratory science. So companies in those fields are looking for a way to keep older workers a while longer and stagger their retirements so they don't all go at once.

Phased retirement is one solution, say experts.

"There's clearly increased interest among workers for pursuing phased retirement. The idea of transitioning from full time to full-time retirement is becoming less common. More and more older workers want to phase out," says Johnson.

"Phased retirement is a potential tool to accelerate departures and slow departures, depending how you use it. ... It's a good vehicle for stepping back without leaving the organization altogether," says Allen Steinberg, a principal with Aon Hewitt in Lincolnshire, Ill.

Implementing the Plan

There are several ways to introduce phased retirement, each with advantages and challenges for an employer. One, an employee can formally retire and return as an independent contractor, consultant or part-time worker.

This is a relatively clear-cut way for employers to maintain access to an experienced employee's skills -- and also save on healthcare benefits.

At Stanley Consultants Inc., an engineering, environmental and construction services consulting firm in Muscatine, Iowa, retirees are often brought in for projects.

"The type of work is very heavily project-based. If a project we win needs their background, there is the opportunity to bring them back. In a lot of cases, they've probably been retired six, seven, eight, nine years," says HR Director Dale Sweere. This style of phased retirement is part of the "corporate culture" at Stanley, which has a defined-contribution retirement plan.

However, a company with a DB plan is advised to take certain precautions to ensure it complies with the law:

* Make sure employees are gone long enough to make it clear this is a bona fide retirement before they return to work as a contractor, consultant or part-timer. For example, OSU made certain that their professors retired in June and didn't come back until the fall semester.

"What makes it complicated is there are some legal issues about it if you've officially separated. If you come back too quickly, the IRS could say it's not legal," Johnson says.

* Also, if you hire the retiree as a contractor, make sure he or she meets the rules that define contract work.

Another method for introducing this program is to allow an employee to "phase" into retirement by reducing his or her hours.

Retirement is a huge step that some workers just aren't ready to take. Instead, they might be willing to reduce their hours and ease into retirement at their own pace.

But defined-benefit plans are designed to encourage all employees to retire at the same age. This is good for succession planning, because a company knows when employees will be leaving. But it is not conducive to phased retirement, which involves staggering individual retirements.

"One reason [companies] are dropping defined-benefit plans is because they're not a good way to manage the workforce since [everyone] is encouraged to retire at the same age," says Johnson. "Employers may want to encourage some to leave. Defined-benefit plans encourage everyone to leave."

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If HR wants to be strategic, experts agree, the first step is to identify which category of workers they need to retain, and make that part of a long-term business plan.

"The thing with phased retirement is, you don't want to offer it to everybody," says Jamie Hale, workforce-planning practice leader with Towers Watson in Dallas. "You don't want everybody to stay. It should be targeted. From the cultural aspect, managers need to identify who they want to keep."

Steinberg further suggests employers "figure out who [they] really want to target."

"Figure out who you really care about here," he says, which means assessing potential skills shortages, and assessing the cost-benefit of retaining experienced employees versus recruiting and training new ones.

Continued healthcare coverage can also present a problem. After all, a major reason boomers keep working is for the health benefits, especially before they reach Medicare eligibility. Even employees on Medicare need prescription coverage, and the employer plan might offer better coverage.

However, many companies don't offer health benefits to part-time workers. And if they offered them to some part-timers, they might have to offer them to everyone.

The question might be moot in the year 2014, experts caution. That's when the Patient Protection and Affordable Care Act's state-run health insurance exchanges go into effect. Older employees who just work to keep their health benefits will be able to get coverage through a public health insurance exchange, which offers standardized healthcare plans to individuals who are self-employed, unemployed or retired.

"There will be an exodus in 2014," says Hale. "The folks who maybe wouldn't retire for healthcare [-coverage reasons] ... in 2014, [they] may retire. A lot of companies are concerned how many will retire. It could be a real cliff."

A third method for introducing phased retirement is to allow an employee to reduce his or her hours and receive an "in-service distribution" of pension.

The in-service distribution is the silver bullet for companies with DB plans. Employers can entice workers to reduce their hours and make up the lost salary with an up-front distribution from their pension plan.

In 2006, the IRS opened the door to more phased-retirement programs just by allowing in-service distributions to start at age 62.

"It wouldn't be called phased retirement to allow a distribution at 62," says Sheaks. "The regs make clear that the 62 [provision] is not phased retirement. It's [just] a way of doing it."

But there are two potential pitfalls:

* Impact on the pension formula. Many DB plans use a formula to calculate final pension benefits based on final average pay, usually in the last five or 10 years of service. By cutting one's salary in half in the last years of service, an employee could be hurting his or her final pension.

"It is a challenge for employers with a traditional pension plan. If you ratchet down the hours worked, it can negatively affect the calculations for pension," says Sheaks. She suggests adjusting the formula for "career average" or annualizing the employee's part-time salary to reflect an annual and not hourly wage.

* Potential age-discrimination claims. If a company wants to offer in-service distributions to a select group of individuals at the age of 62, it risks an age-discrimination claim from other employees age 62 and up. That defeats the purpose of a phased retirement plan -- and obviously can get expensive.

Fortunately, a company is allowed to build a business case for select phased retirement -- even from the age of 55 to 62 -- if it can prove to the IRS that that is a typical average age for the particular industry, Sheaks says.

Sheaks advises HR and managers to thoroughly document the company's business objectives. "If you're sued for any decision, [make sure] managers are able to show business reasons for why you do it for some employees and not others."


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