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Switching from DB to DC plan no panacea for state or retirees

Posted by Tom Mellish, Executive Director, IRTA on Nov 17, 2015 3:23:00 PM

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A General Assembly Interim Education Committee has recommended a review of the effect of a defined contribution plan - hoping it would help improve teacher retention. The Indiana State Teachers Associations sees problems of switching to a Defined Contribution Plan.

The IRTA does not believe a DC Plan will help Indiana entice more teachers into the profession and actually hurt recruitment and retention of teachers.

It is interesting to note that the Public Employees of Indiana have had this option for a few years and yet only ten percent of the employees have signed-up for the Defined Contribution Plan.

To more clearly define the issue, here are the definitions of Defined Benefit and Contribution Plans:

 

Defined Benefit Plan – This is a “traditional" pension plan under which an employee receives a set monthly amount upon retirement, guaranteed for life or the joint lives of the member and his or her spouse. The monthly benefit is based upon wages and length of service at time of retirement.

Defined Contribution Plan - This is a retirement savings program under which an employer promises contributions to a participant’s account during employment but with no guaranteed retirement benefit. The retirement benefit is based exclusively on the contributions and the investment earnings of the plan. The benefit ceases when the account is depleted regardless of the participants age or circumstances. Examples include 401(k), 403(b) and 457 plans.

Here are our thoughts about the proposed switch:

Immediate Costs of Switch

Introducing a DC-Only Plan will not eliminate the necessity of continued maintenance of the DB Plan. The DB Plan will need to be administered for current retirees and those who have vested service for approximately the next 75 years. Additionally, there will be added costs for administering two separate programs.

The cost of the DB Plan would climb if the plan is closed. Actuarially, a closed plan is more expensive because there is a smaller population over which the costs can be spread. Also, Governmental Accounting Standards Board Statement  No. 25 requires a shorter period for amortizing costs and unfunded liability for closed plans which in turn increases the cost.

It costs more to administer DC plans. The median cost to administer a DC Plan is approximately 1.4 percent compared to .3 percent for a DB Plan. The higher DC Plan expenses reduce the assets available for benefits (based on information published by the National Association of State Retirement Administrators).

Long Term Costs of Switch

Higher public sector wages. Historically, wages for government and education have been lower than private industry in exchange for a guaranteed and livable retirement benefit. Switching to a DC Plan will require wages to increase to become more competitive, thus offsetting any potential savings an employer hopes to realize. Additionally, wages will have to be higher to provide enough disposable income for employees to contribute to their retirement savings plan and still provide essential services to their families.

Higher employee turnover. Highly trained employees who no longer have the incentive of a guaranteed retirement income will be willing to leave their positions for opportunities in the private sector. The result will be less loyalty from senior employees, fewer experienced employees and a more transitory workforce lacking “institutional memory.”

Lower return on investment. If a DB Plan is closed to new hires, the assumption then becomes the DB Plan is not set up in perpetuity and thus the time horizon of the investments will require a change to more liquid assets. The allocation of top performing investment classes such as real estate and private equity would need to be reduced or eliminated, resulting in a decrease in potential return on investment.

Social Costs of Switch

Welfare is a real possibility. If retirees do not have enough income at retirement or outlive their resources, state welfare resources could be called upon to provide support.

DC plans are unreliable vehicles for ensuring retirement income security. There is often a loss or diminishing return on assets before retirement due to loans or cashing out retirement savings during a job change.

As a group, employees are generally poor investors. Too many investors engage in practices such as market timing, taking too little or too much risk or not allocating assets among different asset classes. A DB Plan assets are managed by professional managers that on average, earn higher returns than DC plans through the pooling of resources.

DB plans promote orderly employee turnover. DC plans determine retirement eligibility on the basis of adequacy of assets which provides no assurance that employees can retire at the current normal retirement age. The result is many employees remain on the job long after productivity has declined which blocks advancement opportunities for younger employees.  

Market cycle may determine retirement despite age or health. Employees may not be able to retire in a down cycle or if they do, be forced to live on a lower monthly income or a shorter period of retirement income.

Approximately one-fourth of all public employees do not participate in Social Security. Switching their DB Plan to a DC Plan will expose many of these workers to the dangers of insufficient retirement savings.

Conclusion

In his presentation to PMOC on August 26, 2015, INPRS Executive Director Steve Russo included the following statement: “Despite short term market under performance and updated mortality experience, INPRS’ managed pension plans remain well funded with no expected increase in 2017 employer contribution rates.”

Most employees prefer a DB Plan because it is a life-time annuity which they cannot outlive. Indiana’s pensions are adequately funded and well managed. Only the Teachers Pre ’96 Fund is not funded to recommended levels but the legislature has taken prudent steps (Pension Stabilization Fund) to ensure its viability. More importantly, the unfunded liability on the Pre ’96 Fund disappears in approximately 20 years.

Switching from a DB Plan to a DC Plan is a major public policy consideration. In Indiana, any proposal to switch from DB plans to DC plans is a “solution in search of a problem”. Additionally, such a switch would create new problems that simply would not justify a public policy change of this magnitude.

(This summary is based on reports published by the Utah Education Association)

 

 

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