After hitting 40-year highs in 2022, inflation rates are trending down. But the decline is expected to be gradual, slowed by continuing inflation for housing, health care, food and energy. In response, many professional services firms are implementing larger-than-average pay increases. On average, industry employees received a 6.8% pay bump in 2022, compared to the 3% average in prior years.
The salary increases are designed to do more than help employees manage rising costs. They are also aimed at helping professional services firms compete for and retain skilled workers. The U.S. job market remains challenging, with hiring rates outpacing quit rates. Faced with high employee turnover and the shift to hybrid work models, firms can use traditional defined benefit pension plans as a differentiator beyond salary to help recruit and retain talent.
While salary is the primary consideration when workers make employment decisions, retirement benefits rank second. Access to a defined benefit pension appeals to many employees, especially in a challenging economy, because market performance does not affect the plan’s benefits. However, salary and pension benefits are interrelated. Today’s pay increases will have long-term implications for the valued pension benefits.
How Wage Increases Impact Pension Plan Costs
Defined benefit plans are designed around a basic formula that typically calculates pension payments based on the employee’s years of service, their final average pay and a predetermined benefit multiplier. In some cases, firms may elect to use a simpler formula by paying a flat amount for each year of service. As decisions are made to increase pay, the impact on future pension payouts needs to be considered.
Based on the plan’s design and experience, actuaries make assumptions about inflation, salary increases, mortality, employee turnover and the rate of investment return on the plan’s assets. These assumptions determine the present value of the total future benefits payable under the plan. When the actual experience of the plan differs from the assumptions, there will be actuarial gains or losses. For example, salary increases that outpace the assumptions are an actuarial loss because they increase the long-term plan obligation. However, earning higher interest rates on investments is an actuarial gain because it can help to offset the increased costs.
Managing costs for both the short and the long term is a balancing act. If the long-term cost implications are projected to be higher than the budget available for funding the plan, adjustments may be made to the plan’s design. Employers such as law firms, architectural and engineering firms or marketing agencies have a few different plan design levers available to help them address future cost concerns.
One of the most common ways firms can reduce future costs is by creating new tiers within the plan or close the plan to new hires by providing retirement benefits to new hires in a defined contribution plan. This tier approach allows employers to adjust components like the multiplier or qualification definitions for new hires going forward without impacting the benefits for existing employees. Closing the plan to new hires and implementing a defined contribution plan provides a more predictable cost for the plan sponsor and shifts the investment risk for retirement benefits to the new hires.
Tiers also enable employers to define the qualifying criteria for different employee groups. For example, firms can use different pension formulas by employee class, such as partners, executives or front-line workers. Similarly, employers can manage cost implications and provide employee retention incentives by determining vesting schedules by employee class. Vesting is a designated time frame between when employees begin to accumulate benefits and when they earn the right to keep them if they leave the employer.
In addition, defined benefit pension plans allow employers to modify plan features to help address rising costs, such as the plan’s salary definition, early retirement provisions or death benefits. This design flexibility enables firms to manage plan costs while continuing to offer the plan as a benefit within its recruiting and retention strategies.
The professional services industry experts at CBIZ can help you evaluate the long-term impact of current wage increases and optimize your pension plan strategy. Connect with a member of our team and gain access to more resources here.This article includes input from Warren Ruppel, Managing Director at CBIZ Marks Paneth and Practice Leader for Government Services, and Bill Karbon, Executive Vice President and Director of Compliance for CBIZ Retirement Insurance Solutions. Together, their teams provide actuarial, compliance and audit services to employers.
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