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Redesigning Public Sector DC Plans after the Crash

Against this economic backdrop, state and local governments are scrutinizing all areas of operations and expenditures. Retirement benefits for employees are no exception given the magnitude of the expenditures involved¹ and the year-to-year volatility of necessary contributions with traditional pensions. Reform options on the table include a tier of lower defined benefit (DB) pension benefits for new hires and higher employer and employee contributions. In some cases, there are calls to give a fresh look at the potential use of defined contribution (DC) plans as the primary retirement income vehicle for public employees. Given the current dismal experience of 401(k) participants in the private sector, any proposal to adopt the standard 401(k) model should be greeted as one of dubious merit – simply put, the typical 401(k) is poorly designed to function as a vehicle for generating an adequate and secure retirement income. The arguments against the 401(k) model are many, and NAGDCA’s policy that DB approaches best serve the interest of participants recognizes these flaws. There are DC designs without the flaws of the typical 401(k) model, however, and to the extent that governments are considering this step, it is important that public policy makers do so in a way that considers DC designs focused on generating retirement income.

The remainder of this article discusses best practice designs for DC plans that function as primary retirement plans for public sector employees.

Guiding Principles for Plan Design
To establish best practice benchmarks for the design of public sector DC plans that are intended to be the primary source of retirement income, it is useful to set out principles for their design, funding and administration:

• Principle #1:  The primary principle being that retirement plans focus on providing adequate and secure income throughout retirement for all employees – not wealth accumulation.
• Principle #2:  Adequate funding of a sponsored plan is a shared employer/employee responsibility.
• Principle #3:  Effective retirement programs require an appropriate investment offering.
• Principle #4:  Effective retirement programs require a broad range of integrated participant services.
• Principle #5:  Retirement programs are more effective with competent fiduciary mechanisms.

The resulting implications for best practice plan design are:

• Provide participation and vesting requirements that maximize retirement savings.
• Provide for a total contribution level and an investment structure that together are expected to accumulate sufficient savings to fund an adequate retirement income for each participant.
• Include a payout design that provides an adequate and secure income level throughout retirement.
• Manage the various risks that threaten retirement objectives, including investment volatility, longevity, and inflation.
• Provide access to independent, expert and personalized education, planning and investment advice services during both the accumulation phase and through retirement.
• Active management of the plan by the sponsoring employer with an emphasis on administrative simplicity to control costs.

Resulting Best Practices for Plan Design
The following is an outline of DC plan design best practices proposed by the authors in a recent paper published by the Pension Research Council.² These practices, if adopted, would increase the likelihood of the plan fulfilling the principles outlined above. Best practices are compared with current practices in the public plan market. Two sets of plans, chosen to be illustrative of common practice, were examined; eleven covering general public sector employees plans and seven covering public higher education employees.³

Eligibility and Participation
Mandatory participation is the best practice for a core DC plan, along with low or no age restrictions on participation and waiting periods for participation of no more than one year. Employers may also consider expanding the eligibility for plan participation to less than full-time employees.
In the public sector plans examined (both state and higher education), participation by the employee is mandatory in all cases. The only caveat is in the case of an optional retirement plan, where participation in a retirement plan is mandatory, but the individual chooses whether to participate in the primary DB plan or the primary DC plan. In two other plans, all new hires are automatically enrolled in the DB plan, but then have a limited period of time to switch to the DC plan if they so choose.
Not only is plan participation mandatory, but it is also typically immediate. There are several instances of service requirements.

Contribution Levels
Best practice calls for non-elective contributions by both the employer and employee that will result in an adequate retirement income assuming typical investment returns. This implies mandated contribution levels totaling at least 12 percent of pay if covered by Social Security and 18-20 percent of pay if not.⁴

All of the public plans examined specify both non-elective employer and employee contribution levels as a fixed percentage of pay. In the state plans examined, non-elective employer contribution rates range from 4 percent of salary to 10.15 percent. In some plans, the employer contribution rates vary for different types of positions. The non-elective employee contribution rate ranges from 0 percent to 9.4 percent. Combining the non-elective employer and employee contribution rates results in total non-elective contribution levels ranging from 4 percent to over 18 percent.

In the public higher education plans examined here, employer non-elective contribution rates range from 5 percent to 15 percent of salary. In addition, employer non-elective contribution rates can vary within the plan based on salary, years of participation or age. The employee non-elective contribution rate ranges from 0 percent to 10 percent. As with employer contribution rates, required employee contributions sometimes vary within a given plan based on years of participation, age or salary. Across the public higher education plans examined, combined employer and employee non-elective contribution rates were a minimum of 10 percent, typically in the range of 15 percent, and as high as 20 percent.

Vesting
Best practice calls for participants to be immediately vested in employer contributions after no more than one year of service. If immediate participation is adopted by a plan sponsor, then best practice allows for the imposition of a vesting period of up to one year. If participation is delayed, then best practice implies a vesting period of less than one year and possibly immediately (given the best practice of participation beginning no later than one year after the hire date.)

In the state plans examined, only one had immediate vesting in employer contributions. The typical vesting schedule is graded vesting over a period of 5 years, though the period of service required ranged from 1 to 12 years. Immediate vesting is the near universal norm in the public higher education plans examined, with the exception of 100 percent cliff vesting after 1 year of service in one plan.

Investments
Best practice calls for mandatory investment or default into an option that automatically manages the participant’s asset allocation. Vehicles for this purpose include lifecycle target-date funds, and simplified low-cost advice or qualified managed accounts to address investment risk.⁵ When participants are given choice, best practice calls for a limited non-overlapping array of investment options (about 15-20) covering the major asset classes and allowing participants a reasonable opportunity to manage their own risk and return needs.

The number of options offered in the state plans examined ranges from 9 to 70. The number of investment options offered in public higher education is typically greater than the number offered elsewhere in the public sector. With one exception, which offers 10 options, all other higher education plans examined offer anywhere from 31 to over 150 options. The larger number of funds offered by these public universities is usually related to the existence of multiple service providers offering stand alone bundled arrangements.
All plans reviewed specify a default option for when a participant does not specify investment elections. In some cases, the default is a managed account or a target-date fund; in other cases, it is a relatively conservative investment, such as a short term bond fund or a balanced investment fund.

Pre-Retirement Distributions
Best practice plan design eliminates or minimizes leakage from participant accounts prior to retirement. Best practice would not allow lump sums at job change, hardship withdrawals or loans.⁶  All public plans examined provide full lump sum distributions at job change. With a couple exceptions, hardship withdrawals and plan loans are not available.

Retirement Distributions
Best practice plan design regarding retirement distributions is to limit participant ability to withdraw funds as a lump sum combined with the requirement that a minimum amount (e.g., 40%) of the account be annuitized, ideally through a vehicle providing some degree of inflation protection.⁷  This addresses both longevity and inflation risks in retirement.

In the state plans examined here, full lump sums are always a distribution option. On the other hand, most of the state plans have annuitization as a distribution option, but none require any degree of annuitization by the participant. Three of the state plans also provide an inflation hedged annuitization option. All other state plans examined provide no inflation hedge other than the ability to invest in equities after retirement.
Among the DC plans in higher education examined, all have an annuitization option providing features that at least partially address inflation risk, including the use of variable life annuities and fixed life annuities with a feature for annual benefit increases. These plans, however, also offer full lump sums as a distribution option and do not require any degree of annuitization at retirement.

Administrative Structure
Best practice is a single recordkeeper structure. High administration and investment fees reduce the ultimate level of retirement savings available to DC plan participants. Multiple vendor structures and agent-broker delivery models are generally more expensive than single recordkeeper administrative platforms. Larger plans should be able to take advantage of available economies of scale to deliver plan services at lower cost. Total costs (administrative and investment fees) for a quality, state-of-the-art core DC plan should be available for 100 basis points or less for larger plans.
Among the state plans examined here, all but one use a single recordkeeper structure. Among public university plans, however, multiple recordkeeper structures are the norm.

Education and Advice
Best practice design provides broad-based retirement and investment education services to participants. A higher best practice hurdle is the provision of individual-specific investment advice. The mode for delivering personalized retirement services will need to reflect the evolving ways that individuals access information, e.g., by phone, through the internet and in person. While technology can enable more effective communication, it will not replace the need for one-on-one consultation, particularly as individuals approach retirement.

All of the plans reviewed provide their participants with basic information regarding the plan, as well as basic education about saving for retirement. Eight of ten state plans examined provide investment advice.⁸ Participant investment advice is provided by all but one of the public university plans examined here.

Conclusion
Defined benefit plans will likely remain as the primary vehicle for delivering secure retirement benefits to state and local government employees. However, the current financial stresses are causing some governments to consider alternative defined contribution plans. DC plans will not be a panacea to solve these financial problems. However, in the consideration of DC plans, it is important not to follow the path of the flawed private sector 401(k) model. Through appropriate plan design, DC plans can provide an adequate and secure retirement income for participants.

[1] In 2007, state government contributions to employee retirement systems totaled $30.1 billion and local government contributions totaled $42.3 billion. (Source: 2007 Census of Governments, Survey of Public Employee-Retirement Systems, U.S. Census Bureau).

[2] “Defined Contribution Pension Plans in the Public Sector: A Benchmark Analysis,” in The Future of Public Employee Retirement Systems, edited by Olivia S. Mitchell and Gary Anderson, Oxford University Press (2009).   A copy of the full paper can be obtained at http://www.tiaa-crefinstitute.org/articles/042408.html.

[3] DC plans reviewed include those sponsored by the states of Alaska, Colorado, Florida, Michigan, Montana, Nebraska, North Dakota, Ohio, South Carolina, West Virginia, the District of Columbia, and those sponsored by Indiana University, Michigan State University, Purdue, State University of New York, University of Iowa, University of Michigan, and University of Washington.

[4] Assumes a 77 to 94 percent wage replacement target as derived in the 2008 Georgia State University/Aon RETIRE Project. This target reflects, in part, the higher costs of retiree health care that current and future retirees are likely to experience. Public safety employees would need to have significantly higher contribution rates in order support earlier retirement ages common to those job classifications.

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NAGDCA would like to recognize and congratulate the 2009-2010 Industry Committee: