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.
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