Earnings-and-Length-of-Service FormulaThe most common formulas used for defined-benefit plans are those that base benefits on both earnings and length of service. That type of formula determines the benefits for 56 percent of workers in the private sector who are covered by defined-benefit plans. As with the length-of-service formula, that fraction varies more by occupation than by a firm's size, with white-collar and service employees most likely to have their benefits calculated under an earnings-and-length-of-service formula. Furthermore, those two factors are used to calculate the benefits of virtually all government workers. Under that kind of formula, retirement plans pay a benefit that is a fraction of an employee's average annual salary, and the fraction rises with the length of service. In calculating average salaries, private plans most commonly average salaries over a five-year period, but the period may be defined in different ways. Many plans simply take the average of the five consecutive highest years of earnings out of the last 10 years worked. Some plans, however, do not require the five years to be consecutive; others allow the five years to be drawn from the entire career; and some simply use the last five years worked. State and local government plans typically average salaries over the last three years of service, whereas federal government plans use the three years of highest earnings. The fraction of a worker's average salary that the plans pay is generally 1 percent to 2 percent multiplied by the number of years of service. The average percentage paid in 2002 by medium-sized and large private-sector establishments was 1.54 percent--slightly below the average of 1.71 percent reported by small private-sector establishments. Thus, a worker retiring after 30 years of employment would receive 30 times 1.54 percent, or 46.2 percent of his or her average salary in the final years. If the participant's salary in the final years averaged $40,000, the pension would be $18,480 per year. More than any other type, the earnings-and-length-of-service formula impedes the mobility of the labor force. A worker who switches employers midway through his or her career retires with lower pension benefits than if he or she had not switched, even if the new employer offers an identical pension plan. For example, if a person switched employers after 15 years, at which time his or her average salary was $20,000, half of the pension benefits would be based on that salary rather than on the average salary of $40,000 attained under the second employer. Instead of a pension of $18,480, the pension would be only $13,860. More-frequent job changes would reduce that value even further.
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