WHAT IS 'Benefit Allocation Method'

The benefit allocation method is a way for companies to fund an employee pension plan. Only one premium payment is made per year and it is used to purchase a single benefit. Typically, the plan specifies that for each unit of service an employee will receive a certain amount, either a dollar amount or a specified percentage of salary, towards an employee pension. 

BREAKING DOWN 'Benefit Allocation Method'

The specifics for each company's benefit allocation method are likely included in the company's employee benefits plan. The benefits are based on an average of an employee’s salary over time. Those employees at higher compensation levels receive more benefits because they have paid more into the system. Usually, the transaction involves the purchase of an annuity. Higher paid employees with longer service typically receive a greater benefit. Payments are made for each year of service to the employer.

Benefit Allocation Method Considerations

Notable for companies is that their benefit allocation method must consider that the costs associated with future years may be in line to increase steadily for certain segments of their employee population. For example, those that are nearing retirement age as they prepare to leave the company. Increases are due to the ever-shortening period during which interest has the ability to compound. It can also be magnified by the benefit allocation methodology used by the company, and by the decreased likelihood of employee termination before retirement. 

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 kept stable as new members join, and younger members balance out the advancing ages of older employees nearing retirement, contribution rates can remain relatively consistent. 

All things being equal, benefit allocation methods typically result in lower levels of funding than corresponding cost allocation methods. Cost allocation methods differ from benefit allocation methods in that they 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.

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