Integration with Social Security

Both employment-based retirement plans and Social Security are designed to help replace preretirement earnings. Integrating employment-based plans with Social Security allows employers to partially offset the progressive nature of Social Security's benefit formulas. The percentage of earnings that is replaced by Social Security falls as income rises, dropping from 90 percent for workers with the lowest lifetime earnings to approximately 25 percent for those with earnings that are always at the maximum taxable amount ($94,200 in 2006). Social Security replaces none of a worker's earnings that exceed the maximum taxable amount. When an employer's plan is integrated, the tilt toward lower-wage workers under Social Security causes an offsetting tilt in the employer's plan so that the plan replaces more of the earnings of higher-wage workers than of lower-wage employees. About one-third of full-time employees in the private sector who are covered by defined-benefit pensions were subject to such an offset in 2002.

Without integration, some low-wage workers who had long service with an employer could receive combined Social Security and pension benefits that would come close to or exceed their earnings before retirement. That situation could discourage someone from continuing to work. With integration, however, more of the benefits of employment-based plans go to higher-wage workers. In fact, because integration could effectively negate the nondiscrimination and top-heavy rules, plans are limited in the extent to which they can integrate and the methods they may use.

Most commonly, retirement plans integrate through the "step-rate" method--by reducing the plan's replacement rate for earnings that are subject to Social Security taxes relative to the rate for earnings above the Social Security maximum wage base. For example, plans might replace terminal wages of up to $94,200 at the rate of 1.54 percent per year of service but then replace wages in excess of $94,200 at a rate of 2.04 percent. For an employee with 30 years of service, that method of integration would effectively extend Social Security's replacement rate bracket of 15 percent to earnings above the maximum taxable wage base--for which the statutory replacement rate is zero.

Another common method--the "offset" method--subtracts a percentage of the primary Social Security benefit (usually 50 percent) from the pension benefit. If an employee with 30 years of service and $40,000 of terminal wages was covered under a typical defined-benefit plan and had a primary Social Security benefit of $10,000, the pension in the integrated plan would fall from $18,480 to $13,480.

Before 1984, the federal government and many states and localities chose not to participate in Social Security so there was no need to integrate their pension plans with that program. Participation in Social Security at the state and local level is now common. Even so, most state and local pensions are not integrated: in 1998, only 7 percent of state and local employees were in integrated plans. Most federal employees hired before 1984 are not covered by Social Security.⁽¹⁾ Employees hired later (and some hired earlier who voluntarily switched) are covered by Social Security and a different pension system, but that system is not explicitly integrated with Social Security.⁽²⁾