db vs. dc a false choice in retirement plans
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Florida Government Finance Officers Association Nature Coast Chapter Citrus Hills Golf & Country Club April 16, 2014. DB vs. DC A False Choice in Retirement Plans. Presented By: James J. Rizzo Piotr Krekora Gabriel, Roeder, Smith & Company [email protected] - PowerPoint PPT PresentationTRANSCRIPT
Copyright © 2013 GRS – All rights reserved.
DB vs. DCA False Choice in Retirement
Plans
Presented By:
James J. RizzoPiotr Krekora
Gabriel, Roeder, Smith & [email protected]
Florida Government Finance Officers Association
Nature Coast Chapter
Citrus Hills Golf & Country ClubApril 16, 2014
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There had been a debate swirling around corporate and governmental employers for many decades as to which is better:
► Defined benefit (DB) retirement plans, or
► Defined contribution (DC) retirement plans
Let’s defined the terms first by examining their characteristics
DB Plans and DC Plans
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Traditional Defined benefit (DB) plans► Benefits paid are defined by formulas and rules► Contributions by employer are actuarially determined► Pension plans usually pay monthly pensions for life► Like the pension part of FRS► Like local police and fire pension plans► Like Social Security
Traditional Defined contribution (DC) plans► Employer contributions are defined by a formula► Account balance plans that credit interest equal to the
actual earnings of underlying investment assets► Like the Investment Plan part of FRS► Like 401(k) plans in the private sector► Like so-called 401(a) plans and 457 plans in the
government sector
DB vs. DC Debate
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Individual Account Balances Account Interest Credited Investment Risk* Predictability of Contributions* Unfunded Actuarial Accrued Liability* Retirement Planning* Longevity and Other Risks* Benefit Skew* Form of Benefit* Portability Vesting Funded Status Operational Expenses* Education and Communication * Most important
distinctions
Distinguishing Features
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DB vs. DC Comparison
Core Features(Page 1 of 2)
Individual Account Balances YesNo individual account balances, just a defined
benefit promise; pooled assets and pooled liabilities
Account Interest Credited Actual return of the underlying assets Not applicable
Investment Risk Borne 100% by the employee Borne 100% by the employer
Predictability of Employer Contributions 99% predictable
Much less predictable due to contribution being subject to investment performance and demographic
experience
Unfunded Actuarial Accrued Liability None Yes, if less than 100% funded
Retirement planning Unpredictable due to primary reliance on unpredictable investment earnings
Employees can plan on a predictable stated (or easily calculated) percent of pre-retirement income
Longevity and Other Risks Borne 100% by the employee Borne 100% by the employer
Traditional Defined Contribution (DC) Retirement Plans
Traditional Defined Benefit (DB) Retirement Plans
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DB vs. DC Comparison Core Features(Page 2 of 2)
Benefit Skew Benefits are skewed toward younger shorter service employees
Benefits are skewed toward older, longer service employees
Form of Benefit Almost always paid as a lump sumPaid as a lifetime pension with options for
survivorship
Portability Can be rolled over to an IRA; often not used for retirement income
Retained and paid as a lifetime pension upon retirement eligibility
Vesting Flexible in the design Flexible in the design
Funded Status Always 100% fundedFunding Policy determines funded status; rarely
100% funded
Operational ExpensesHigher investment-related expenses (in bps) than DB plans due to use of mutual funds, often subsidizing
recordkeeping and communications expenses
Lower total operational expenses (in bps) than traditional DC plans
Education and Communications
Employee education meetings and materials required for effective investment elections; often name-brand mutual funds, online information and investment
choices; quarterly account balance statements
Autopilot, little flair and fanfare; often unappreciated (until taken away)
Traditional Defined Contribution (DC) Retirement Plans
Traditional Defined Benefit (DB) Retirement Plans
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A hybrid plan is a single plan that has some features of a DB plan and some features of a DC plan
An arrangement with side-by-side DB and DC plans
► Two separate plans► This arrangement is not really a hybrid plan► Although some people use the term “hybrid” when
describing a side-by-side DB and DC► But consider a Toyota Prius – gasoline and electric in
one car
Two broad types of hybrid plans1. Cash Balance Plans2. Variable Benefit or Variable Annuity
Hybrid Plans
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1. Cash Balance Plans► “Looks” more like a DC plan (each member has an
account balance)► Implementations
• Recently proposed in State Senate for FRS, but more recently amended out
• At OUC and JEA (electric utilities in Orlando and Jacksonville), Cash Balance Plans in the last few years
• In some other states and jurisdictions outside Florida• At many private sector employers
► Employer contributes a fixed amount into each employee’s account; employee contributes as well
► Interest is credited to each account• Different plan designs credit interest differently• Interest credit is not permitted to equal the rate earned by the
actual underlying assets► Benefit is usually paid out in a lump sum at termination
or retirement; sometimes annuitized pension is permitted
Hybrid Plans
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2. Variable Benefit or Variable Annuity► “Looks” a lot like a DB plan (lifetime pensions paid)► Implementations
• State of Wisconsin• City of Ocala GE• Some private sector employers
► Monthly benefit amount varies depending on certain trigger points built into the plan design
• Investment Return Trigger - Some change the multiplier for the current year depending on investment returns for the year - higher multiplier for higher return; lower multiplier or zero for lower returns. Other plan designs pay additional “dividends” on benefits
• Employer Contribution Trigger - Some change the multiplier for the current year (or all years retroactive to transition date) in order to keep the employer contribution predictably within a pre-set corridor – higher multiplier for low employer contribution; lower multiplier for high employer contribution
Hybrids Plans
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Hybrid Features
Core Features(Page 1 of 4)
Cash Balance Variable Benefit
Individual Account Balances Yes YesSome designs have individual annuity
balances; some do not
No individual account balances, just a defined
benefit promise; pooled assets and pooled liabilities
Account Interest Credited Actual return of the underlying assets
Older designs apply a fixed rate or tied to short-term yields. Alternatively, can be partially related to actual return on underlying assets (e.g., with smoothing,
floors and caps)
Designs with annuity balances might index benefits to final average earnings,
while others index to CPI; and still others can be partially related to actual
return on underlying assets
Not applicable
Investment Risk Borne 100% by the employee
Older designs put 100% on employers; recent designs share the risks/rewards between employee and employer (e.g.,
floors and caps)
Some designs share the risks/rewards between employee and employer; while other designs put 100% of the risk on
employees.
Borne 100% by the employer
Predictability of Employer Contributions 99% predictable
Older designs are as unpredictable as traditional DBs; recent designs that
share risk have predictability in between traditional DBs and DCs
Less predictable than DC plans but more predictable than traditional DB
plans
Much less predictable due to contribution being subject to investment performance and
demographic experience
Traditional Defined
Contribution (DC) Retirement
Plans
Hybrid Plan Designs Traditional Defined Benefit (DB)
Retirement Plans
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Hybrid Features
Core Features(Page 2 of 4)
Cash Balance Variable Benefit
Unfunded Actuarial Accrued Liability None Yes, if less than 100% funded Yes, if less than 100% funded Yes, if less than 100% funded
Retirement planning
Unpredictable due to primary reliance on
unpredictable investment earnings
Some designs have ending cash balances that depend only on future
salary and are just as predictable as DB plans; but most designs depend mostly
or partially on unpredictable investment returns or yields
Some designs depend mostly or partially on unpredictable investment
returns, while others have future benefits that fall within a predictable
minimum and maximum
Employees can plan on a predictable stated (or easily calculated) percent of pre-
retirement income
Longevity and Other Risks Borne 100% by the employee
Almost always borne 100% by the employee Borne 100% by the employer Borne 100% by the employer
Benefit SkewBenefits are skewed
toward younger shorter service employees
Skewed toward younger shorter service employees
Skewed toward older, longer service employees
Benefits are skewed toward older, longer service
employees
Traditional Defined
Contribution (DC) Retirement
Plans
Hybrid Plan Designs Traditional Defined Benefit (DB)
Retirement Plans
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Hybrid Features
Core Features(Page 3 of 4)
Cash Balance Variable Benefit
Form of Benefit Almost always paid as a lump sum
Almost always paid as a lump sum, unless prevented from doing so by plan
design
Paid as a lifetime pension with options for survivorship
Paid as a lifetime pension with options for survivorship
PortabilityCan be rolled over to an IRA; often not used for
retirement income
Can be rolled over to an IRA; often not used for retirement income
Retained and paid as a lifetime pension upon retirement eligibility
Retained and paid as a lifetime pension upon retirement eligibility
Vesting Flexible in the design Flexible in the design Flexible in the design Flexible in the design
Funded Status Always 100% fundedFunding Policy determines funded
statusFunding Policy determines funded
status
Funding Policy determines funded status; rarely 100%
funded
Operational Expenses
Higher investment-related expenses (in bps)
than DB plans due to use of mutual funds,
often subsidizing recordkeeping and communications
expenses
Lower total operational expenses (in bps) than traditional DC plans;
approximately same as traditional DB plans
Lower total operational expenses (in bps) than traditional DC plans;
approximately same as traditional DB plans
Lower total operational expenses (in bps) than traditional DC plans
Traditional Defined
Contribution (DC) Retirement
Plans
Hybrid Plan Designs Traditional Defined Benefit (DB)
Retirement Plans
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Hybrid Features
Core Features(Page 4 of 4)
Cash Balance Variable Benefit
Education and Communications
Employee education meetings and materials required for effective investment elections;
often name-brand mutual funds, online
information and investment choices; quarterly account balance statements
Minimal employee communications, but depending on method of crediting
interestinterest; quarterly or annual account balance statements
Employee education is needed for how accrual multipliers might vary
Autopilot, little flair and fanfare; often unappreciated
(until taken away)
Traditional Defined
Contribution (DC) Retirement
Plans
Hybrid Plan Designs Traditional Defined Benefit (DB)
Retirement Plans
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Primary motivations for moving from DB to DC plans1. “The corporate world has moved from DB to DC
plans.”2. “ We got rid of our DB plan where I work(ed).”3. “I never had a DB plan; neither should they.”4. “ The conservative think-tanks and legislatively active
organizations say we should move to a DC plan.”5. “My political party leaders say DB plans are bad.”6. “DB plans are more dangerous than DC plans in the
hands of politicians.”7. “I don’t trust elected officials to stand firm against the
unions by not refusing retroactive benefit improvements for DB members.”
8. “Employer contributions to our DB plans have become unbearably and unreasonably high.”
9. “Employer contributions need to be more predictable.”
10. “Employer (taxpayers) should not bear the investment risk.”
Hybrids Plans
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Driving principles from City Council
► Roll back future benefits to bend the cost curve soon
► Future benefits should resemble FRS
► Share risks between employees and employer
► Make employer contributions more predictable
Case Study: City of Ocala GE
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Bend the expected cost curve
► Changing benefits for new hires alone will take a very long time to bend the expected cost curve
• So putting in a DC plan for new hires alone won’t do much• Putting in a new DB formula for new hires alone won’t do much
► Must change benefits for all employees (current and new) in order to bend the expected cost curve in a reasonably short time
• Either all in a DC or• All in a less generous benefit structure for future service
► Not permitted to roll back benefits for current retirees or for current active employees eligible for normal retirement
► Not permitted to roll back benefits retroactively, i.e., cutting accrued benefits below what active employee have earned now
Case Study
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Bending the expected cost curve
► Freeze the benefits for current actives at what they earned as of the transition date; call it Part A
► Start the new and less generous benefit structure for future service; call it part B
► Final benefit is Part A plus Part B
Case Study
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Make the employer contribution more predictable . . .
By sharing the risk with employees► Moving to a DC plan for new hires alone will take a
very long time to share the risk► Not permitted to share the risk with current retirees or
with current active employees eligible for normal retirement
► Not permitted to share the risk on benefits earned at transition
Part B benefit structure is the hybrid plan design► Part B monthly projected benefit can go up or down,
depending on the trigger mechanism, thereby sharing the risk and reward
► Part A monthly benefit is fixed and frozen at the transition date
Case Study
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Case Study
Without a VBH feature in the legacy DB plan -- It will take over 40 years to reach a 50-50 risk-sharing with employees; in 20 years City/taxpayers still bear 85% of investment risk
0%
50%
100%
0%
50%
100%
2022 2032 2042 2052 2062 2072
Total Risk-sharing ComparisonClosed DB plus DC for New HiresWith and Without VBH Feature
Closed DB w/ VBH plus DC for New Hires Closed DB w/o VBH plus DC for New Hires
Employees Bear 100% Risk
City/taxpayers Bear 100% Risk
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Part B starts out with a 1.6% multiplier, like FRS Regular Class
► Multiplier can go up, but not above a cap of 2.55%
► Multiplier can go down, but not below a floor of 1.0%
► Depending on the level of the actuarially required contribution
► As long as the actuarially determined contribution (ADC) stays within a pre-set employer contribution budget, the multiplier remains unchanged; improves predictability
► Makes the employer contribution more predictable
Case Study
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If the ADC were to go above the top of the budget corridor:
► The multiplier is reduced in order to keep the ADC inside the corridor
► Employee bears the risk above the corridor.
If the ADC were to go below the bottom of the budget corridor:
► The multiplier is increased in order to keep the ADC inside the corridor
► Employee reaps the reward below the corridor
Makes the employer contribution more predictable by sharing the risk (and reward) with the employee
Case Study
0%
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60%
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Proj
ecte
d C
ity C
ontr
ibut
ions
as a
Per
cent
age
of P
ay
Fiscal Year Ending
Total Projected City ContributionsClosed DB Plan with Future Benefits Rolled Back to 1.6%
With 8% DC Plan for New HiresPositive and Negative Stresses at Year 11 Outside the VBH Corridor
Corridor City Alternative 2
Stress Test on City Alternative 2 Better than Expected Asset Returns on City Alternative 222
Case Study
Witha VBHFeature:
BudgetCorridor
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Circular 230 Notice: Pursuant to regulations issued by the IRS, to the extent this presentation concerns tax matters, it is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) marketing or recommending to another party any tax-related matter addressed within. Each taxpayer should seek advice based on the individual’s circumstances from an independent tax advisor.
This presentation shall not be construed to provide tax advice, legal advice or investment advice.
Readers are cautioned to examine original source materials and to consult with subject matter experts before making decisions related to the subject matter of this presentation.
This presentation does not necessarily express the views of conference sponsor, nor Gabriel, Roeder, Smith & Company, and may not even express the views of the speaker.
Disclaimers
Questions
and
Answers ?
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