DB vs. DC - A False Choice in Retirement Plans
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 2 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 3 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 4 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 6 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 7 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 8 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 9 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 10 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 11 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 12 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 13 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.” 14 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 15 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 16 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 17 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 18 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 19 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 20 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 21 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 22 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. 23 Questions and Answers ? 24
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