By Frank Thoen and Mahrukh Mavalvala

Instead of employers bemoaning the loss of skilled baby boomers from the workforce or employees resenting mandated retirements and rules, a small but growing number of companies are offering phased retirement plans to employees who are seeking more flexibility for their retirement.

Such innovative plans, only recently addressed by pension legislation, allow employees to stage their retirement benefits and dates along with work responsibilities. Employees get flexibility, and employers extend workforce numbers and boost knowledge transfer- the valuable sharing of knowledge and experience from senior employees to junior employees.

Potential issues include complying with tax and legal requirements that may change as companies experiment with the phased option over the next several years.

Opportunity now

In 2005, AARP surveyed 2,167 workers ages 50 and older; 38% said they were interested in phased retirement.

Perhaps they knew someone who retired gradually from the public sector, where phased retirement has long been a popular option. Many states offer such flexibility in deferred retirement option plans (DROPs) and partial lump-sum option plans (PLOPs).

In working with the public sector, Milliman has observed that 60% of South Carolina state employees opt for the deferred retirement choice, and 50% of teachers in Arkansas do so as well. The catch is that phased retirement doesn't always benefit the employer financially. Phased retirement has only shown cost-neutrality in the case of certain public-safety careers.

Understandably, to many HR executives, phased retirement seems counterintuitive. In fact, many companies recently have encouraged long-service employees to retire earlier, rather than to continue working.

Federal law permits individuals to receive distributions from their retirement nest eggs before age 59 1/2 only if they are separated from service. In a defined contribution plan, in-service distributions prior to age 59 1/2 are subject to a 10% tax. It is only recently that Social Security recipients have been able to earn more than their benefit payment amounts after attaining their Social Security normal retirement age without having those federal benefits reduced.

Workforce reality

From the employer's perspective, interest in phased retirement is all about the 21st century's changing workforce. Consider the challenges:

• A shrinking number of potential workers.

• A growing gap between the skills new workers bring to the job and the skills the job actually requires.

• An aging population overall.

• Companies competing for the top talent, especially in certain industries.

For long-service employees, the interest in phased retirement is all about their financial security, desired active lifestyles, and physical and emotional health.

Not only do these older workers see themselves staying active and involved longer, but also they want to remain productive and useful as they age. They're concerned about paying for health care when medical costs are high and uncertain going forward.

Phased challenges

Because the phased retirement option is so new for the private sector, it poses substantial challenges, including plan design and costs, legal restrictions and health benefits with associated costs.

Some of the less tangible questions center on how the phased retirement approach would mesh with the company culture and whether employees physically can continue working in the same capacity.

The IRS has noted that normal retirement age could be between the ages 55 and 62, based on facts and circumstances. Other legal issues center on how a subsidized early retirement will be treated by the IRS, along with the importance of nondiscrimination testing. Phased retirement plans need to ensure that the effective availability of the program does not discriminate in favor of highly compensated employees.

For defined benefit plan sponsors considering the phased retirement option, other plan design concerns include:

• Determining the group that will be offered phased retirement. If an employer doesn't offer phased retirement to all plan participants, nondiscrimination issues will need to be reviewed.

• Determining whether phased employees would or would not receive a subsidized benefit while they are still working. Will the in-service benefit include a subsidy for early retirement?

• Determining precise benefits during in-service distribution. Questions must be answered regarding payment of death benefits, disability benefits and added benefit accruals.

• Determining the benefit at ultimate retirement. This is probably the most technically complicated issue because it must factor in so many new variables, including benefits paid and benefits earned during the phased retirement period.

• Juggling administrative complexity. Foremost here would be the need for effective communication with employees, as well as actually making the new calculations.

• Balancing intended results versus unintended consequences.

The intent of phased retirement should be to retain valued employees who would have otherwise retired, while adding value to the workforce without affecting retirement costs. The danger, however, is that employees who hadn't planned on early retirement will switch to the phased option, potentially creating greater costs and bringing no value to the overall workforce.

Is it right for your company?

How do you evaluate whether phased retirement is good for your organization?

• Assess the need for phased retirement by evaluating questions such as: Is your company losing employees in key positions? Do you find it difficult to hire replacements? Have you realized that current employees are a considerable resource?

• Understand your company's current barriers to phased retirement, such as corporate culture and other options for a reduced workweek.

• Consider changes to existing retirement plans. Are there ways to enhance employees' flexibility without affecting costs? Can existing plans offer some of the same benefits and/or choices as phased retirement? These might include an in-service distribution option for defined contribution plans, elimination or suspension of benefit provisions for defined benefit plans or an in-service retirement option for defined benefit plans both after and before normal retirement age.

Organizations may welcome the newfound flexibility that phased retirement offers. Admittedly, the many details and uncertainties may scare some plan sponsors away from offering the phased option.

As the IRS provides more guidance, phased retirement could become viable for many employers and employees.

After all, baby boomers aren't going to disappear tomorrow.

The first boomers are turning age 62, and some started to collect the early-option, smaller Social Security checks in January of this year.

Frank Thoen is a principal and consulting actuary in the Seattle office of Milliman.

Mahrukh Mavalvala is a consulting actuary in the Seattle office of Milliman and assists a wide range of corporate clients on defined benefit plans, including actuarial valuations, plan administration and plan design.