According to this year's MetLife study on benefits trends, retention has eclipsed health costs as the leading concern for HR/benefits managers. Phased retirement - programs that allow employees who have reached retirement age to continue working a reduced schedule while collecting pensions - is a powerful tool for employers to mitigate this concern. Phased retirement not only addresses problems posed by impending labor shortages as baby boomers retire, but also helps baby boomers who are financially unprepared for retirement. However, implementing such a program can be more complex than employers may expect. Companies looking to adopt a phased retirement program must analyze several benefits issues to avoid traps in the benefit plan rules.

Qualified retirement plans

Several sets of rules affect phased retirement by regulating qualified retirement plan payments to employees who have not terminated employment.

Regarding defined contribution plans, 401(k) plans may be drafted to allow employees to receive in-service withdrawals at age 59 1/2, but not at younger ages at which employees are often eligible for early retirement. Profit-sharing or stock bonus plans may also permit in-service distributions at earlier ages.

Defined benefit plans, however, are bit trickier. In 2004, however, the Internal Revenue Service proposed rules for defined benefit plans that extended phased retirement to employees younger than normal retirement age. These regulations - the current status of which is unclear - require employees in phased retirement programs to be at least 59 1/2, receive pensions (including early retirement subsidies) prorated consistent with their reduced work schedules and continue to earn prorated benefits.

Yet, before the regulations could be finalized, the Pension Protection Act of 2006 allowed qualified pension plans to make distributions beginning at age 62, even to an employee who has not terminated employment. Beginning Jan. 1, PPA authorizes qualified pension plans to pay pensions to employees age 62 and older who are still actively employed, even if 62 is not the plan's normal retirement age. The statute sets out no technical conditions, though the IRS issued regulations effective May 22 stating employers seeking to set a normal retirement age earlier than age 62 must set an age that is representative of the typical retirement age for their industry. Although it is not clear how employers must determine this age, it is presumed an employer that sets the age lower than 55 will have to justify that determination.

The disconnect creates a legal issue for employers, and plan sponsors will want to tread carefully as they create a phased retirement program. In addition, many other technical issues need to be resolved in implementing any phased retirement program, such as minimum reductions in work schedule, defining eligible employees, how to adjust payments and future benefits, and anti-discrimination issues.

Medical benefits, deferred compensation plans

Employees not yet eligible for Medicare will not want to lose their medical coverage during phased retirement. Many employers have medical plans that exclude part-time employees working fewer than 20 to 25 hours per week. Retiree medical coverage, where it exists, is typically only offered to full retirees. As such, health benefit plans may need to be modified to provide adequate coverage to employees in phased retirement.

New Section 409A regulations may punitively tax employees who receive payments from deferred compensation plans - including supplemental pension plans - before terminating employment or, in the case of certain key employees, before six months following termination of employment.

For the purposes of Section 409A, an employee is presumed to be still employed if the expected services will exceed 50% of average services over the preceding 36 months. Employers must take care to avoid paying deferred compensation to employees in phased retirement if the requirements of Section 409A are not satisfied.

In light of the legal uncertainties, employers considering a phased retirement program should consult actuaries and legal counsel. Benefit programs, particularly defined benefit plans, should be reviewed to determine what actions employers will take to comply with legal requirements and make their phased retirement program successful.

Carol I. Buckmann is counsel in the New York office of Osler, Hoskin & Harcourt LLP, specializing in employee benefits.