Updated: Oct. 1, 2017
Issue: An on-going debate in Illinois state government revolves around the question of whether Defined Contribution retirement plans (DC plans) are more efficient and cost effective for governments to operate as opposed to Defined Benefit retirement plans (DB Plans). Most government-sponsored retirement plans are DB plans.
In the past few years, legislation has been introduced in the General Assembly that would close the state’s five DB plans for all active members and immediately place those members in a DC plan operated by state government. All active members, upon retirement, would receive a DB pension benefit based on the service and funds accumulated up to the date that the DB plans were closed, in addition to distributions from the DC plan. Retired members would continue to receive only the current DB benefit.
A government Defined Benefit plan requires contributions from each active member and public employer to a co-mingled trust fund. That fund provides each member with a guaranteed lifetime annuity in retirement, regardless of how much the member and employer contributed to the trust fund for that member. Active members and the employer supplement the benefit payments of retired employees. Members cannot outlive their benefits. The calculation of the annuity is proportionally equal for all participants.
A government Defined Contribution plan, such as a 401(k) plan, 403(b) plan or a 457(b) plan, requires contributions from each active member and each public employer to individual accounts held by each member. Upon retirement, the member receives a regular disbursement from his or her account until the funds in the account are exhausted. The rate of distribution is determined by the member. Members can outlive their benefits.
Discussion: In general, multiple studies over the last decade show that government-run DC plans are not more efficient or cost effective than government-run DB plans.
Closing a DB Plan and replacing it with a DC Plan provides a smaller benefit to retirees than a DB Plan, costs more than a DB Plan, does not save the government money and results in weaker investment returns for members and could result in active members being enrolled in Social Security and paying FICA taxes. Here is a look at the various issues in the DB vs. DC debate:
Existing Public DC Plans in the 50 States
At the end of 2017, teachers in 49 states were covered by a retirement plan with some element of a DB plan. Alaska, since 2006 has required all new hires to participate in a DC plan. In all, 26 states have public retirement systems that consist solely of DB plans. Twenty-three states (and the District of Columbia) have systems that administer separate DB and DC plans, DB-DC hybrid plans or “cash balance” plans.
Between 1947 and 2013, 21 states created 33 retirement plans with a DC plan component for at least one segment of public employees. Twelve of these plans are optional for members, 21 are mandatory. Twenty-two of these plans contain a guaranteed lifetime pension found in a DB Plan and 11 do not contain a DB plan element. (CSLGE – 2014)
“…none of the sponsors has followed the earlier Alaska-Michigan model of forcing employees to rely solely on a defined contribution plan where the employee bears all the risks. Rather…plans consist of either a hybrid plan or a cash balance plan, which is a defined benefit plan that maintains notional individual accounts but provides some guaranteed base return.” (CSLGE – 2014)
Nine states created mandatory “hybrid” plans that include a DB-style pension component: California, Georgia, Indiana, Michigan, Oregon, Rhode Island, Tennessee, Utah and Virginia.
Seven created optional DC plans that do not include a DB-style pension component: Colorado, Florida, Montana North Dakota, Ohio, South Carolina and Utah.
Five created mandatory cash balance plans that include a DB-style pension component: Kansas, Kentucky, Louisiana, Nebraska and Texas.
Two created optional hybrid plans that include a DB-style pension component: Ohio and Washington.
Two created mandatory DC plans with no DB-Style pension component: Alaska and Michigan.
“The motivation for introducing a defined contribution type plan seems to differ before and after the financial crisis. Before 2008, the motivation appears to have been offering employees an opportunity to manage their own money and participate directly in a rapidly rising stock market. After the financial crisis, the motivation appears to be more defensive – to avoid the high costs associated with large unfunded liabilities; to unload some of the investment and mortality risk associated with traditional defined benefit plans; and to have a less back-loaded benefit structure to increase the amount that short-term employees can take with them when they leave.” (CSLGE – 2014)
Two states switched back from a DC Plan to a DB Plan
West Virginia’s Teacher Retirement System was a DB Plan from 1941 to 1991, when the plan was closed to new members and new hires were placed in a DC Plan. In 2005, the DC Plan was closed and all members were switched to a DB Plan. Under the DC Plan in 2005 the average total member account balance was $23,193, while the average annual retirement benefit under the old DB Plan was $29,777. In addition, higher investment returns under a DB Plan are projected to save the state $1.4 billion in annual contributions between 2005 and 2034. (Pension Review Board – 2012)
Nebraska created a DC Plan for state and county workers in 1967 because the existing DB Plans for educators and judges were underfunded. In 2002, the state closed the DC Plan and transferred all members to a “Cash Balance Plan” that, like a DB Plan, provides a guaranteed annuity in retirement. The switch was the result of a state report which said the DC Plan had higher administrative costs, lower benefits and lower investment earnings than the state’s DB Plan. (Pension Review Board – 2012)
DC plans do not provide the same level of retirement security for members as DB plans.
The 401(k) plan was never designed to be the primary retirement plan for an American worker. It was always intended to be a secondary retirement account that supplemented a pension. Private companies that ended their pension plans in the last 15 years created the notion that a person could – and should – retire on a 401(k) alone.
“401(k)s are an accident of history…Though 401(k)s took off in the early 1980s, Congress did not intend for them to replace traditional pensions as a primary retirement vehicle, and 401(k)s are poorly designed for this role.” (Economic Policy Institute – 2013)
“Unlike in DB plans, where workers receive regular monthly pension payments, in DC plans it is typically left to the retiree to decide how to spend down their retirement savings. Research suggests that many individuals struggle with this task, either drawing down funds too quickly and running out of money, or holding on to funds too tightly and enjoying a lower standard of living as a result.” (NIRS – 2014)
“Under the traditional defined benefit plan, participants are promised a return of about 8 percent. Under any defined contribution arrangement, workers will receive whatever returns the market offers, which could well be less than 8 percent…So benefits have been reduced with the introduction of defined contribution arrangements…
“…moreover, most of the recent efforts have been a move to either hybrid plans, with a mandatory defined contribution and defined benefit component, or to cash balance plans, where participants are guaranteed a return of 4 or 5 percent.” (CSLGE – 2014)
An individual earning $60,000 annually with a 401(k) would need to save $343,847 by the time he or she retired in order to secure a yearly retirement income equal to $48,000, or 80 percent of $60,000. (Journal of Financial Planning in Pension Review Board -- 2012)
At the end of 2013, the average 401(k) balance across the nation was $72,383. That’s not much to live on if a person lives 15 years in retirement. The median account balance was $16,649, which means half of the people with 401(k)s had less than that in their accounts. (ICI Research Perspective -- 2014) 401(k) account balances vary by age with higher balances held by people closer to retirement. The average balance for a working person in his or her 50s with 10-to-20 years of contributions to the account was $123,777 at the end of 2013. For someone in their 50s with 20-to-30 years of contributions, the average balance was $211,424. (ICI Research Perspective – 2014)
“The typical working household close to retirement age had only $111,000 at the end of 2013 in their 401(k) savings plan at work and individual retirement accounts outside of work…That $111,000 would provide only $500 a month for living expenses if converted to an annuity.” (Chicago Tribune – 2014)
In Nebraska, the average annual benefit for a member of the state’s DB Plan was $16,797, while the average annual benefit for a similar member of the state’s old DC Plan was $11,230. (Center for Tax and Budget Accountability – 2007)
In Michigan, 15 years after the closing of a DB Plan and a switch to a DC Plan for new hires, the older DB Plan members received an annual benefit of $30,000. The DC Plan members approaching retirement had accumulated an average of $123,000 in their accounts, creating an annual retirement income of $9,000. (Pension Review Board – 2012)
A couple earning $75,000 before retirement has a 90 percent chance of outliving their assets in retirement if they don’t have a DB Plan. (Ernst and Young – 2008; Pension Review Board – 2012)
Closing a DB Plan and converting the retirement system to a DC Plan raises costs for the sponsoring government
Closing all five state public DB Plans in Illinois and transferring members to DC Plans would not eliminate the $207.9 billion in obligations to teachers and public employees that have accumulated through fiscal year 2016. Those obligations include an unfunded liability of $129.8 billion. Those obligations have to be paid. (COGFA – 2017)
Closing all five state public DB plans and transferring members to DC plans would, for several years, greatly increase annual state contributions beyond current projections. Government accounting standards require a sponsoring government to fully fund a closed DB plan by the time the last current member retires; which would be approximately 30 years. (TRS Study – 2010)
Under current circumstances in Illinois, that means eliminating the $129.8 billion unfunded liability and achieving 100 percent funding by 2045, a more aggressive funding schedule than currently exists. Current state law requires the state to reach 90 percent funding by 2045.
Closing a DB Plan and transferring members to a DC plan undercuts historic revenue streams to the DB plan needed to pay the obligations of the DB plan, forcing state government contributions to increase. Only two revenue streams would exist, the annual state contribution and investment income. The state’s pension investment income varies from year to year, depending on the strength of the world economy.
Contributions from active members end and no replacement funds are added. However, at the same time, more and more DB Plan obligations must be paid as members retire. (Keystone Research Center – 2013)
A perpetual state-run DB plan like TRS continually enrolls new members, which mitigates the probabilities that some members will live longer than expected and receive more in retirement than members that die earlier than expected or live only to the average life expectancy. In a closed DB plan, the expectation that all members will live beyond the average life expectancy must be factored into the funding calculation, which raises costs.
“…DB plans not only provide all participants in the plan with enough money to last a lifetime, but also accomplish this goal with less money than would be required in a DC plan. Because DB plans need to fund only the average life expectancy of the group, rather than the maximum life expectancy for all individuals in the plan, less money needs to be accumulated in the pension fund.” (NIRS – 2014)
In 2010, TRS estimated that if the system’s DB plan was closed that year, the fiscal year 2011 state contribution would climb 123 percent, from $2.3 billion to $5.2 billion. (TRS Study – 2010)
In Michigan, the state’s public DB Plan was closed to new members in 1997 and DB Plan members were given two chances between 1997 and 2012 to switch to the new DC Plan. DB Plan revenue from active member contributions has gradually declined over time as these members retire and no new members are added. As a result, the state’s annual contribution to the DB Plan increased from $229.5 million in 1997 to $447.9 million in 2011. The funded ratio of the DB plan decreased from 109 percent in 1997 to 72.6 percent in 2010. (Pension Review Board – 2012)
After the switch, the unfunded liability of the state employee retirement system grew from $697 million in 1997 to $4.078 billion in 2010. (Keystone Research Center – 2013)
Alaska closed its DB Plans for new teachers and public employees in 2006. The state’s annual contribution to the two plans was $1.05 billion in 2012 and is expected to grow to $2.46 billion in 2029. (Pension Review Board – 2012)
After the switch, the unfunded liability of the two state retirement systems grew from $3.8 billion in 2006 to $7 billion in 2011. (Keystone Research Center – 2013)
In San Diego, the voter-mandated switch from a DB Plan for employees to a DC plan increased the city’s annual pension contribution in 2013 by $27 million. The city owes $7.3 billion to employees from the old plan. The city’s total annual pension contribution in 2013 was $275 million and will gradually increase to $323 million in 2025 and then decline to $82 million in 2029. (San Diego Union-Tribune – 2013)
In New Hampshire, a 2012 study said closing its public employee DB Plan would increase the retirement system’s unfunded liability by $1.2 billion. (Keystone Research Center – 2013)
In Texas, a 2012 study said closing its DB Plan for teachers would increase the retirement system’s unfunded liability by $11.7 billion. (Keystone Research Center – 2013)
Studies consistently show that DB plans cost less to administer than DC plans and are more efficient
“For a given level of retirement income, a typical individually directed DC plan costs 91 percent more – almost twice as much – as a typical DB plan.” (NIRS – 2014)
It was estimated in 2007 that if all five Illinois retirement systems switched from a DB Plan to a DC Plan, administrative costs would rise anywhere from $275 million to $610 million per year. (Center for Tax and Budget Accountability – 2007)
The cost of administration and investing for a DB plan are 0.43 percent of total assets in a retirement plan, while the same costs for a DC plan equal 0.95 percent of total plan assets. (Center for Retirement Research – 2006, in Pension Review Board -- 2012)
In Nevada, a 2010 study found that ending the state’s DB Plan for public employees and replacing it with a DC Plan would cost the state an additional $1.2 billion over two years. (Las Vegas Review-Journal – 2010)
In Minnesota, a 2011 study of transferring public employees from a DB Plan to a DC plan found that transition costs would total an additional $3.5 billion over 15 years. (National Institute on Retirement Security – 2012)
Plan investment returns are stronger than DC Plan investment returns
“Researchers find a large and persistent gap when comparing investment returns in DB and DC plans, although the gap has narrowed somewhat over time. A 2013 report from CEM Benchmarking finds that DB pensions outperformed DC plans in average by 99 basis points, net of fees, over the 17 years ending in 2013 – largely due to differences in asset mix. Watson Wyatt found that DB plans outperformed DC plans by an annual average of 76 basis points, net of investment expenses, from 1995 to 2011.” (NIRS – 2014)
“Of course, moving away from defined benefit plans means that individuals must face the risk of poor investment returns…and the risk that inflation will erode the value of their income in retirement – on at least a portion of their retirement savings in hybrid plans.” (CSLGE – 2014)
DB Plans that continue to take in new members can diversify their investment portfolios over a longer period of time, which increases investment return. A closed DB Plan must conserve funds in order to meet all of its obligations in a shorter period of time, so only short-term investments are used and as a result return is reduced. (Keystone Research Center – 2013)
“…a DB pension fund endures across generations; thus a DB plan, unlike the individuals in it, can maintain a well-diversified portfolio over time. This well-diversified portfolio will include investments which are expected to earn higher returns than a less diversified portfolio, which focuses on more secure but lower-returning asset classes.” (NIRS – 2014)
Between 1995 and 2011, the average rate of return for DB plans was 8.01 percent, while the average return rate for DC plans was 7.25 percent; a difference of 76 basis points. (Towers Watson Insider – 2013)
Between 1988 and 2004, DB plans had a weighted median return rate of 10.7 percent, while the return rate for DC plans was 9.7 percent. (Center for Retirement Research – 2006, in Pension Review Board -- 2012)
In Nebraska, public employees in a DC Plan saw an investment return of 6 percent between 1983 and 1999, compared to 11 percent for public employees in the state’s DB Plan. (Center for Tax and Budget Accountability – 2007)
DC Plans have higher administrative and investment fees
“By pooling assets, large DB plans are able to drive down asset management and other fees. For example, researchers at Boston College find that asset management fees average just 25 basis points (e.g., 0.25 percent) for public sector DB plans. By comparison, asset management fees for private sector 401(k) plans range from 60 to 170 basis points…We find that a DB plan can provide the same level of retirement income at almost half the cost of an individually directed DC plan.” (NIRS – 2014)
In New York, a 2011 study found that the administrative costs of DB Plans are 36 percent to 38 percent lower than a DC Plan providing equivalent benefits. (Keystone Research Center – 2013)
“A DC plan involves costs that do not exist in a DB plan, such as the costs of individual record keeping, individual transactions, and investment education to help employees make good decisions.” (NIRS – 2014)
DC Plan investment decisions are made by the member; DB Plan decisions are made for a pooled fund by professional investment managers. Professional managers in most cases diversify the portfolios of DB Plans across several asset classes to moderate risk and return; similar portfolio diversification is less prevalent in DC Plans.
“Research has found that DB plans have broadly diversified portfolios and managers who follow a long-term investment strategy. We also know that the average individual in DC plans, despite their best efforts, often falls short when it comes to making sound investment decisions…Furthermore, studies show that over the long term, individual investor level returns significantly lag behind the returns of any individual asset class or benchmark – largely due to inappropriate investment decisions.” (NIRS – 2014)
As DC Plan members approach retirement, they choose safer investments and return is reduced. Co-mingled DB Plan portfolios maintain consistent risk and return parameters because there is no “end” to the plan. (Pension Review Board – 2012)
Enrollment in a DC Plan Could Lead to Enrollment in Social Security
TRS members currently are not enrolled in Social Security and do not pay the federal FICA tax because TRS retirement benefits equal or exceed the minimum “safe harbor” benefit floor set by the Social Security Administration. (TRS Study – 2010)
TRS members automatically would be enrolled in Social Security if the minimum TRS benefit fails to meet the “safe harbor” limit. TRS members would then have to pay half of the 12.4 percent FICA payroll tax, or 6.2 percent. School districts would have to pay the other half.
Because the size and distribution of retirement benefits from DC plans are dependent on decisions made by each member, there is no standard retirement benefit to measure against the “safe harbor” limit, so it is likely that the Social Security Administration would enroll all DC plan members and require teachers and school districts to pay the FICA tax.
The reportable earnings of TRS members in fiscal year 2014 were $9.3 billion, so total FICA taxes paid would have been approximately $1.25 billion. School districts would have been responsible for $625.5 million of that tax payment.
Sources
Center for Tax and Budget Accountability – “The Illinois Public Pension Funding Crisis: Is Moving from the Current Defined Benefit System to a defined Contribution System an Option that Makes Sense?” – 2007
Teachers’ Retirement System of the State of Illinois – “Costs of Defined Contribution Plans & Social Security” PowerPoint – August 5, 2010.
Las Vegas Review-Journal – “Segal study calculates cost of switching Nevada public workers to a defined contribution plan” – December 15, 2010
Pension Review Board – “A Review of Defined Benefit, Defined Contribution, and Alternative Retirement Plans” – May, 2012
National Institute on Retirement Security – “On the Right Track? Public Pension Reforms in the Wake of the Financial Crisis” – December, 2012
San Diego Union-Tribune – “Annual payment $44 million higher, thanks to Proposition B switchover and lackluster investment returns” – January 12, 2013
Keystone Research Center – “Digging a Deeper Pension Hole” – February 26, 2013
Towers Watson Insider – “DB Versus DC Investment Returns: The 2009- 2011 Update” – May 22, 2013
Economic Policy Institute – “Retirement Inequality Chartbook; How the 401(k) revolution created a few big winners and many losers” – 2013
Center for State & Local Government Excellence – “Issue Brief – Defined Contribution Plans in the Public Sector: An Update” – April 2014
Commission on Government Forecasting and Accountability; Illinois General Assembly – “State of Illinois Budget Summary Fiscal Year 2015” – August 1, 2014
Chicago Tribune – Are you your retirement fund’s worst enemy? – September 24, 2014
National Institute on Retirement Security – “Still a Better Bang for the Buck” – December, 2014
Investment Company Institute – “ICI Research Perspective: 401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2013 – December, 2014