Tuesday, August 30, 2011

Actuary Study Confirms Cost-effectiveness of DB Plans for Three Texas Systems

We released a study last week from the actuarial firm Pension Trustee Advisors that confirms, using actual data from three Texas systems, that the costs to taxpayers for defined benefit programs are less those that would be needed for defined contributions to provide the same level of retirement.

The study is interesting and timely because it substantiates a core reason cities have been using defined benefit plans: they deliver reasonable retirement benefits at a reasonable cost to taxpayers.

Municipal employees, firefighters and police who are asked to forego the opportunity for the greater salary and bonus opportunities in the private sector are deserving of a defined benefit in retirement. In the current system, this benefit is one that takes 20 years or more to grow using contributions from the employee and taxpayers over the course of a person’s career.

In addition to steady contributions, the study found that “longevity risk” or “longevity pooling” is a key reason for the savings that taxpayers achieve through the use of defined benefit plans. Longevity pooling is recognition of the actuarial reality that there are fewer older retirees in a system with each passing year. The city (representing taxpayers) can calculate this mortality rate to reduce the amount of total contributions it must make toward defined benefit plans. The city would not be able to make the same calculation – and reduction in contributions – if it uses defined contribution plans. The taxpayers would have to fund all the employees’ retirement account with the expectation that they will live to some pre-determined age that is not actuarially adjusted for the expected rate of expiration.

Here’s how the study discusses the “longevity pooling” dynamic:

Longevity risk describes the uncertainty an individual faces with respect to their exact lifespan. While actuaries can tell us that, on average, for example, our pool of male police officers who retire at age 57 will live to be 82, they can also predict that some will live only a short time, and some will live to be over 100.  Figure 2 illustrates the longevity patterns among our 1,000 police officers. With each passing year, fewer retirees are still living. Age 82 corresponds to the year when roughly half of retirees are still alive. In a DB plan, the normal form of benefit is a lifetime annuity, that is, a series of monthly payments that lasts until death. A DB plan with a large number of participants can plan for the fact that some individuals will live longer lives and others will live shorter lives. Thus, a DB plan needs only to ensure that it has enough assets set aside to pay for the average life expectancy of all individuals in the plan, or in the police officer’s case, to age 82. Based on our target benefit level, the DB plan needs to have accumulated $921,807 for each police officer in the plan by the time they turn 57. This amount will ensure that every individual in the plan will receive a regular monthly pension payment that lasts as long as they do. The contribution required to fund this benefit, smoothed over a career, comes to 20.1% of payroll.
So longevity pooling gives taxpayers a break they wouldn’t have if their city uses defined contribution plans.

There’s another noteworthy point we should discuss. At first glance, the statement above, that “The contribution required to fund this benefit, smoothed over a career, comes to 20.1% of payroll” seems high and out of line with what private sector employees earn.  The typical private sector employee might rightfully say “I know I don’t get 20% of my salary set aside for retirement. Why should a public sector employee get that much?”

Truly though, most private sector employees do contribute 20% or more – they just don’t know it.

First, consider that a private sector employee’s total “contribution” to Social Security is usually about 12.4% when including their employer’s matching “contributions.” Then consider that many private sector employers match some percentage – anywhere from 3-10% --  of salary that an employee contributes to their own 401(k). Combined contributions into a 401(k) could easily be 6-12% of a private sector employees salary.

So, at the upper limits, a private sector employee and their employer might be contributing as much as 24% of a person’s salary to their retirement, (not counting the set asides for old age medical benefits and even their federal unemployment insurance). At the lower limit, that contribution might be 19%. That’s roughly the same as the 20% contribution of cities for their employees for defined benefit plans that’s cited in the PTA study.

It’s easy now to see the comparability and similarity of amounts. In fact, private sector employees could be viewed as receiving more with their Social Security and defined contribution plans. Oh, have we mentioned lately that, according to the 2010 GAO report, fully 50% of Texas’ public employees don’t contribute to or receive Social Security? (Here’s our blog on that.)

Of course many private sector employees don’t feel that 20% or more of their salaries go toward their retirement. They don’t know that their employer is required to make the matching contributions to Social Security/Medicare. And the 3-10% contribution to their 401(k) feels puny by comparison to the 20% figure that’s bandied about for public sector employees. And their defined contributions plans have proven to be very inefficient over the last 10 years in terms of delivering a consistent return.

In fact, in our view, that perception among many private sector employees, of inefficient defined contribution plans and a lack of knowledge about the 12.4% of salary that’s contributed to Social Security, is probably the root cause of “pension envy.” It is one of the drivers of today’s public policy debates that some are using to push defined contribution plans onto city employees.

Public sector employees have a well defined benefit based on very transparent contributions by them and their employers. Private sector employees don’t have clear defined personal accounts in Social Security. They do know that Social Security benefits are subject to the discretion of the U.S. Government for their payout. There has been much discussion in recent years over cuts to Social Security. Over the last few years, low inflation rates have created circumstances where cost of living adjustments aren’t being granted to Social Security recipients. Retirees have no recourse or control of their Social Security accounts. While many people would like to opt-out of the Social Security system, they can’t.

There’s a lot more information about the study that we will convey in future blogs, but in the meantime please review this very important contribution to the pension debate. – Max Patterson