What Is the Benefit Allocation Method?

Some companies that offer retirement pensions to their employees choose to fund them through the benefit allocation method. In this system, employees contribute a portion of their salaries to the fund while the company makes a single annual payment. That payment may be a fixed dollar amount or a percentage of salary.

Both the employee's contribution and the company's matching payment go into a fund that is invested in long-term assets.

Key Takeaways

  • A company that offers a pension benefit must earmark money to pay them, using any of several accepted methods.
  • The benefit allocation method sets aside the money contributed by employer and employee into a fund that is invested to pay the benefit down the line.
  • By contrast, a cost allocation method estimates the overall cost of benefits that will be owed and sets aside that amount.

Understanding the Benefit Allocation Method

Over time, the joint payments by employer and employee grow into a pension fund that will be paid out to the employee in the form of monthly annuity payments.

In virtually any pension plan, the benefit each retiree receives is based on the employee's salary over time. The best-paying pensions are due to executives at the top compensation levels and those who put in the most years of service, or both. There is typically a vesting period, so employees who stay on the job only a short time may receive no pension.

Usually, the pension is paid as a monthly annuity for life. Using the benefit allocation method, payments are made for each year of service to the employer.

The specifics for each company's benefit allocation method are typically covered in the company's employee benefits plan.

Benefit Allocation Method Considerations

A company that uses the benefit allocation method must consider that the cost of funding the pension plan will increase steadily from year to year, at least for certain segments of their employee population. These costs can be magnified by the benefit allocation methodology. 

However, membership for most plans is open and new members join regularly. The key is to maintain a balance. As long as the average age of the employee population is relatively stable, the low costs of younger members balance out the high costs for older employees, keeping contribution rates relatively consistent. 

All things being equal, benefit allocation methods typically result in lower levels of funding than cost allocation methods.

Cost Allocation Methods

Cost allocation methods view the total costs of the benefits, however they are accrued, as an amount to be allocated equally to all years of service.

For example, the aggregate level cost method typically takes the present value of benefits minus asset value and spreads the excess amount over the future payroll of the participants. 

Aggregate cost methods take into account the whole group, with the cost of the plan calculated as a percentage of yearly payroll. The percent is adjusted yearly if there are any actuarial gains or losses.