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, the employee contributes a portion of salary to the fund while the company makes a single annual payment. That payment may be a fixed dollar amount or a percentage of salary.

Understanding the Benefit Allocation Method

Both the employee's contribution and the company's matching payment go into a fund that is invested in long-term assets. Over time, this grows into a pension fund that will be paid out to the employee in the form of regular annuity payments.

In virtually any pension plan, the benefit each retiree receives is based on the person's salary over time. The best-paying pensions are due to those at the top compensation levels and those who put in the most years' 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 an annuity. 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 may 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, more junior, 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 of 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 view the total costs of the benefits, however 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. Among others, aggregate cost methods take into account the whole group, and the cost of the plan is usually calculated as a percentage of yearly payroll. In addition, the percent is adjusted yearly if there are any actuarial gains or losses.