Tuesday, August 7, 2012

Have DC Plans Delivered in States that Try Them? No One Knows

In a previous blog featuring responses to questions from Ron Snell, senior fellow at the National Conference of State Legislatures, we learned that Alaska’s switch from a defined benefit to defined contribution plan for public employees was caused by concerns that actuarial projections were wrong, and healthcare benefit costs exploded.

We weren’t satisfied with our question though because it left too much wiggle room for the true-believers of DC plans. So we asked Mr. Snell the following: “…the question [we have now] is whether the DB plan was the core problem or a poor actuary and exploding health care costs. If those were extracted from the equation, would the DB plan have needed to be closed to future participants?” Our reason for asking this is fairly simple: was the performance of the DB plan to blame? Sure, a plan can have bad assumptions. Sure, the people can overpromise benefits – in this case healthcare benefits. But when it comes down to it, is the performance of the DB plan to blame? Here’s what Mr. Snell said:

I understand your question, but I don’t know what the answer is. The situation at the time was that the funding ratio of the plan, which was well above 100 percent in FY 2000, and had been there for several years preceding FY 2000, fell to less than 66 percent in FY 2005 because of investment losses in the recession of 2000 and growing liabilities. A broadly-shared sense by the middle of the decade was that the plan was too expensive for the state. Many other states in that situation have chosen alternatives short of fundamental plan redesign, so one answer to your question would be that there might have alternatives to the one the Legislature adopted. I’m not in a position to critique the Legislature’s decision. Opinion in Alaska remains sharply divided as to the wisdom of the change, and most sessions since the change was adopted have seen proposals to reverse it.

So I don’t know.

It’s very refreshing to see someone so honest in public policy debates. Unlike many others who blindly advocate for DC plans, Mr. Snell realizes, like us, that there are many considerations about developments around public employee pensions and the options to remedy them. As we responded to Mr. Snell, it seems that the Alaska legislature threw the baby out with the bathwater in response to what was going on.

Which led us to our final question to Mr. Snell: “Is there any analysis available as to how the employees have done on their own using the DC plans?” Here was his response:

…there’s not a lot of evidence because most of the public DC plans are too new.

Indiana has a DC component in its hybrid plan (which goes back to the 1960’s) but I am told (having asked several times) that the state has never studied the question of the adequacy of returns from the DC plans.

When around 2000 Nebraska looked at the issue of the adequacy of benefits from its long-term DC plan for state employees (which also was begun in the 1960’s), the conclusion was that benefits were not comparable to those that Nebraska teachers received from their DB plan or that similarly-situated state employees received in DB plans in the surrounding states. That was attributed in large part to members’ tendency to invest very conservatively, relying on money market funds and fixed-income securities in the hope of avoiding investment losses. Nebraska therefore closed that plan to new members, and enrolls them in a cash-balance plan with a guaranteed rate of return.

Much is made of the low earnings of the now-closed West Virginia DC plan for teachers, but my own feeling is that there were so many complicating factors in the West Virginia situation, no generalizations should be based on it.

Michigan of course began a DC plan for state employees in the mid-1990s, but so far appears not to have studied the adequacy of retirement benefits.

A study that attempts to provide a general answer is a paper Roderick Crane and others of TIAA-CREF published a few years ago, “Designing Public-Sector Pensions for the 21st Century,” that discusses that issue among many others.

Crane makes the point that wealth-accumulation instruments and pension plans are different, and that defined contribution and cash-balance plans may be constructed to be one or the other, but not both. Key elements of a design intended to provide adequate salary replacement are mandatory participation (not true of all public DC plans, when they are a component of a hybrid plan), adequate contribution levels, and conversion to annuities at retirement.

Crane looks at the long-term record of DC plans in higher education, and concludes that when combined employer and employee contributions are at least 10%, and have a substantial investment in equities, from 40% to 60% over a lifetime, such plans can produce income replacement ratios of 43% to 49%. The addition of Social Security benefits would result in replacement ratios of 70% or more. He also indicates that a combined contribution rate of 15% can produce a replacement ratio of 70% before Social Security benefits are taken into consideration.

Crane notes (p. 48) that contribution levels should be substantially more than 10% to provide salary replacement for plans whose members do not participate in Social Security.

Below is a link to Crane’s paper. I have taken the salary-replacement figures above from page 50.

Again, we appreciate Mr. Snell’s candor. We will dig into the Crane study and let you know our thoughts. – Max Patterson

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