Florida Government Finance Officers Association
Nature Coast Chapter
Citrus Hills Golf & Country Club
April 16, 2014
DB vs. DC
A False Choice in Retirement Plans
Presented By:
James J. Rizzo
Piotr Krekora
Gabriel, Roeder, Smith & Company
[email protected]
[email protected]
Copyright © 2013 GRS – All rights reserved.
DB Plans and DC Plans
 There had been a debate swirling around corporate and
governmental employers for many decades as to which
is better:
► Defined benefit (DB) retirement plans, or
► Defined contribution (DC) retirement plans
 Let’s defined the terms first by examining their
characteristics
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DB vs. DC Debate
 Traditional Defined benefit (DB) plans
► Benefits paid are defined by formulas and rules
► Contributions by employer are actuarially determined
► Pension plans usually pay monthly pensions for life
► Like the pension part of FRS
► Like local police and fire pension plans
► Like Social Security
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 Traditional Defined contribution (DC) plans
► Employer contributions are defined by a formula
► Account balance plans that credit interest equal to the actual
earnings of underlying investment assets
► Like the Investment Plan part of FRS
► Like 401(k) plans in the private sector
► Like so-called 401(a) plans and 457 plans in the government
sector
Distinguishing Features
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Individual Account Balances
Account Interest Credited
Investment Risk*
Predictability of Contributions*
Unfunded Actuarial Accrued Liability*
Retirement Planning*
Longevity and Other Risks*
Benefit Skew*
Form of Benefit*
Portability
Vesting
Funded Status
Operational Expenses*
Education and Communication * Most important distinctions
DB vs. DC Comparison
Core Features
(Page 1 of 2)
Traditional Defined Contribution (DC)
Retirement Plans
Traditional Defined Benefit (DB)
Retirement Plans
Individual Account Balances
Yes
No individual account balances, just a defined
benefit promise; pooled assets and pooled liabilities
Account Interest Credited
Actual return of the underlying assets
Not applicable
Investment Risk
Borne 100% by the employee
Borne 100% by the employer
99% predictable
Much less predictable due to contribution being
subject to investment performance and demographic
experience
None
Yes, if less than 100% funded
Retirement planning
Unpredictable due to primary reliance on
unpredictable investment earnings
Employees can plan on a predictable stated (or easily
calculated) percent of pre-retirement income
Longevity and Other Risks
Borne 100% by the employee
Borne 100% by the employer
Predictability of Employer
Contributions
Unfunded Actuarial Accrued
Liability
5
DB vs. DC Comparison
Core Features
(Page 2 of 2)
Traditional Defined Contribution (DC)
Retirement Plans
Traditional Defined Benefit (DB)
Retirement Plans
Benefit Skew
Benefits are skewed toward younger shorter service
employees
Benefits are skewed toward older, longer service
employees
Form of Benefit
Almost always paid as a lump sum
Paid as a lifetime pension with options for
survivorship
Portability
Can be rolled over to an IRA; often not used for
retirement income
Retained and paid as a lifetime pension upon
retirement eligibility
Vesting
Flexible in the design
Flexible in the design
Funded Status
Always 100% funded
Funding Policy determines funded status; rarely
100% funded
Operational Expenses
Higher investment-related expenses (in bps) than DB
plans due to use of mutual funds, often subsidizing
recordkeeping and communications expenses
Lower total operational expenses (in bps) than
traditional DC plans
Education and
Communications
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Employee education meetings and materials required
for effective investment elections; often name-brand Autopilot, little flair and fanfare; often unappreciated
mutual funds, online information and investment
(until taken away)
choices; quarterly account balance statements
Hybrid Plans
 A hybrid plan is a single plan that has some features of a
DB plan and some features of a DC plan
 An arrangement with side-by-side DB and DC plans
► Two separate plans
► This arrangement is not really a hybrid plan
► Although some people use the term “hybrid” when describing a
side-by-side DB and DC
► But consider a Toyota Prius – gasoline and electric in one car
 Two broad types of hybrid plans
1. Cash Balance Plans
2. Variable Benefit or Variable Annuity
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Hybrid Plans
1.
Cash Balance Plans
► “Looks” more like a DC plan (each member has an account
balance)
► Implementations
• Recently proposed in State Senate for FRS, but more recently amended out
• At OUC and JEA (electric utilities in Orlando and Jacksonville), Cash
Balance Plans in the last few years
• In some other states and jurisdictions outside Florida
• At many private sector employers
► Employer contributes a fixed amount into each employee’s
account; employee contributes as well
► Interest is credited to each account
• Different plan designs credit interest differently
• Interest credit is not permitted to equal the rate earned by the actual
underlying assets
► Benefit is usually paid out in a lump sum at termination or
retirement; sometimes annuitized pension is permitted
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Hybrids Plans
2.
Variable Benefit or Variable Annuity
► “Looks” a lot like a DB plan (lifetime pensions paid)
► Implementations
• State of Wisconsin
• City of Ocala GE
• Some private sector employers
► Monthly benefit amount varies depending on certain trigger
points built into the plan design
• Investment Return Trigger - Some change the multiplier for the current year
depending on investment returns for the year - higher multiplier for higher
return; lower multiplier or zero for lower returns. Other plan designs pay
additional “dividends” on benefits
• Employer Contribution Trigger - Some change the multiplier for the current
year (or all years retroactive to transition date) in order to keep the employer
contribution predictably within a pre-set corridor – higher multiplier for low
employer contribution; lower multiplier for high employer contribution
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Hybrid Features
Core Features
(Page 1 of 4)
Individual Account Balances
Yes
Hybrid Plan Designs
Cash Balance
Yes
Variable Benefit
Some designs have individual annuity
balances; some do not
Traditional Defined
Benefit (DB)
Retirement Plans
No individual account
balances, just a defined
benefit promise; pooled assets
and pooled liabilities
Account Interest Credited
Actual return of the
underlying assets
Older designs apply a fixed rate or tied Designs with annuity balances might
to short-term yields. Alternatively, can index benefits to final average earnings,
be partially related to actual return on
while others index to CPI; and still
underlying assets (e.g., with smoothing, others can be partially related to actual
floors and caps)
return on underlying assets
Investment Risk
Borne 100% by the
employee
Older designs put 100% on employers; Some designs share the risks/rewards
recent designs share the risks/rewards between employee and employer; while
Borne 100% by the employer
between employee and employer (e.g., other designs put 100% of the risk on
floors and caps)
employees.
Predictability of Employer
Contributions
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Traditional
Defined
Contribution
(DC) Retirement
Plans
99% predictable
Older designs are as unpredictable as
traditional DBs; recent designs that
share risk have predictability in
between traditional DBs and DCs
Less predictable than DC plans but
more predictable than traditional DB
plans
Not applicable
Much less predictable due to
contribution being subject to
investment performance and
demographic experience
Hybrid Features
Core Features
(Page 2 of 4)
Hybrid Plan Designs
Traditional Defined
Benefit (DB)
Retirement Plans
Cash Balance
Variable Benefit
None
Yes, if less than 100% funded
Yes, if less than 100% funded
Yes, if less than 100% funded
Retirement planning
Unpredictable due to
primary reliance on
unpredictable
investment earnings
Some designs have ending cash
balances that depend only on future
salary and are just as predictable as DB
plans; but most designs depend mostly
or partially on unpredictable
investment returns or yields
Some designs depend mostly or
partially on unpredictable investment
returns, while others have future
benefits that fall within a predictable
minimum and maximum
Employees can plan on a
predictable stated (or easily
calculated) percent of preretirement income
Longevity and Other Risks
Borne 100% by the
employee
Almost always borne 100% by the
employee
Borne 100% by the employer
Borne 100% by the employer
Skewed toward older, longer service
employees
Benefits are skewed toward
older, longer service
employees
Unfunded Actuarial Accrued
Liability
Benefit Skew
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Traditional
Defined
Contribution
(DC) Retirement
Plans
Benefits are skewed
Skewed toward younger shorter service
toward younger shorter
employees
service employees
Hybrid Features
Core Features
(Page 3 of 4)
Form of Benefit
Portability
Hybrid Plan Designs
Cash Balance
Variable Benefit
Traditional Defined
Benefit (DB)
Retirement Plans
Almost always paid as a lump sum,
Almost always paid as a
Paid as a lifetime pension with options
Paid as a lifetime pension
unless prevented from doing so by plan
lump sum
for survivorship
with options for survivorship
design
Can be rolled over to an
Can be rolled over to an IRA; often not Retained and paid as a lifetime pension
IRA; often not used for
used for retirement income
upon retirement eligibility
retirement income
Retained and paid as a
lifetime pension upon
retirement eligibility
Vesting
Flexible in the design
Flexible in the design
Flexible in the design
Flexible in the design
Funded Status
Always 100% funded
Funding Policy determines funded
status
Funding Policy determines funded
status
Funding Policy determines
funded status; rarely 100%
funded
Lower total operational expenses (in
bps) than traditional DC plans;
approximately same as traditional DB
plans
Lower total operational
expenses (in bps) than
traditional DC plans
Operational Expenses
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Traditional
Defined
Contribution
(DC) Retirement
Plans
Higher investmentrelated expenses (in bps)
than DB plans due to
Lower total operational expenses (in
use of mutual funds,
bps) than traditional DC plans;
often subsidizing
approximately same as traditional DB
recordkeeping and
plans
communications
expenses
Hybrid Features
Core Features
(Page 4 of 4)
Education and
Communications
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Traditional
Defined
Contribution
(DC) Retirement
Plans
Employee education
meetings and materials
required for effective
investment elections;
often name-brand
mutual funds, online
information and
investment choices;
quarterly account
balance statements
Hybrid Plan Designs
Cash Balance
Variable Benefit
Traditional Defined
Benefit (DB)
Retirement Plans
Minimal employee communications,
Autopilot, little flair and
but depending on method of crediting Employee education is needed for how
fanfare; often unappreciated
interestinterest; quarterly or annual
accrual multipliers might vary
(until taken away)
account balance statements
Hybrids Plans
 Primary motivations for moving from DB to DC plans
1. “The corporate world has moved from DB to DC plans.”
2. “ We got rid of our DB plan where I work(ed).”
3. “I never had a DB plan; neither should they.”
4. “ The conservative think-tanks and legislatively active
organizations say we should move to a DC plan.”
5. “My political party leaders say DB plans are bad.”
6. “DB plans are more dangerous than DC plans in the hands of
politicians.”
7. “I don’t trust elected officials to stand firm against the unions
by not refusing retroactive benefit improvements for DB
members.”
8. “Employer contributions to our DB plans have become
unbearably and unreasonably high.”
9. “Employer contributions need to be more predictable.”
10. “Employer (taxpayers) should not bear the investment risk.”
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Case Study: City of Ocala GE
 Driving principles from City Council
► Roll back future benefits to bend the cost curve soon
► Future benefits should resemble FRS
► Share risks between employees and employer
► Make employer contributions more predictable
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Case Study
 Bend the expected cost curve
► Changing benefits for new hires alone will take a very long time
to bend the expected cost curve
• So putting in a DC plan for new hires alone won’t do much
• Putting in a new DB formula for new hires alone won’t do much
► Must change benefits for all employees (current and new) in
order to bend the expected cost curve in a reasonably short time
• Either all in a DC or
• All in a less generous benefit structure for future service
► Not permitted to roll back benefits for current retirees or for
current active employees eligible for normal retirement
► Not permitted to roll back benefits retroactively, i.e., cutting
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accrued benefits below what active employee have earned now
Case Study
 Bending the expected cost curve
► Freeze the benefits for current actives at what they earned as of
the transition date; call it Part A
► Start the new and less generous benefit structure for future
service; call it part B
► Final benefit is Part A plus Part B
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Case Study
 Make the employer contribution more predictable . . .
 By sharing the risk with employees
► Moving to a DC plan for new hires alone will take a very long
time to share the risk
► Not permitted to share the risk with current retirees or with
current active employees eligible for normal retirement
► Not permitted to share the risk on benefits earned at transition
 Part B benefit structure is the hybrid plan design
► Part B monthly projected benefit can go up or down, depending
on the trigger mechanism, thereby sharing the risk and reward
► Part A monthly benefit is fixed and frozen at the transition date
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Case Study
 Without a VBH feature in the legacy DB plan -- It will take
over 40 years to reach a 50-50 risk-sharing with employees;
in 20 years City/taxpayers still bear 85% of investment risk
Total Risk-sharing Comparison
Closed DB plus DC for New Hires
With and Without VBH Feature
Employees Bear
100%
100% Risk
100%
50%
0%
City/taxpayers
Bear 100% Risk
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50%
0%
2022
2032
Closed DB w/ VBH plus DC for New Hires
2042
2052
2062
Closed DB w/o VBH plus DC for New Hires
2072
Case Study
 Part B starts out with a 1.6% multiplier, like FRS Regular
Class
► Multiplier can go up, but not above a cap of 2.55%
► Multiplier can go down, but not below a floor of 1.0%
► Depending on the level of the actuarially required contribution
► As long as the actuarially determined contribution (ADC) stays
within a pre-set employer contribution budget, the multiplier
remains unchanged; improves predictability
► Makes the employer contribution more predictable
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Case Study
 If the ADC were to go above the top of the budget
corridor:
► The multiplier is reduced in order to keep the ADC inside the
corridor
► Employee bears the risk above the corridor.
 If the ADC were to go below the bottom of the budget
corridor:
► The multiplier is increased in order to keep the ADC inside the
corridor
► Employee reaps the reward below the corridor
 Makes the employer contribution more predictable by
sharing the risk (and reward) with the employee
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Case Study
Total Projected City Contributions
Budget
Corridor
60%
Projected City Contributions as a Percentage of Pay
With
a VBH
Feature:
Closed DB Plan with Future Benefits Rolled Back to 1.6%
With 8% DC Plan for New Hires
Positive and Negative Stresses at Year 11 Outside the VBH Corridor
50%
40%
30%
20%
10%
Fiscal Year Ending
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Corridor
City Alternative 2
Stress Test on City Alternative 2
Better than Expected Asset Returns on City Alternative 2
2043
2042
2041
2040
2039
2038
2037
2036
2035
2034
2033
2032
2031
2030
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
0%
Disclaimers
 Circular 230 Notice: Pursuant to regulations issued by the IRS, to the extent
this presentation concerns tax matters, it is not intended or written to be
used, and cannot be used, for the purpose of (i) avoiding tax-related
penalties under the Internal Revenue Code or (ii) marketing or
recommending to another party any tax-related matter addressed within.
Each taxpayer should seek advice based on the individual’s circumstances
from an independent tax advisor.
 This presentation shall not be construed to provide tax advice, legal advice
or investment advice.
 Readers are cautioned to examine original source materials and to consult
with subject matter experts before making decisions related to the subject
matter of this presentation.
 This presentation does not necessarily express the views of conference
sponsor, nor Gabriel, Roeder, Smith & Company, and may not even express
the views of the speaker.
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Questions
and
Answers ?
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