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Pension Plan Reform: Recent Activity and Pros/Cons of DB vs. DC Plans

Explore the recent pension plan reform in California, including legislative changes, terminology issues, and the shift from DB to DC plans. Understand the pros and cons of Defined Benefit (DB) and Defined Contribution (DC) plans in terms of investment returns, expenses, benefits, and risks.

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Pension Plan Reform: Recent Activity and Pros/Cons of DB vs. DC Plans

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  1. Pension Plan Reform (Maybe)

  2. Contributions + Investment return = Benefits + ExpensesC + I = B + E

  3. Recent Activity in California Recent Activity – Round One • ACA 5 (Richman), December 6, 2004 • ACAX1 1 (Richman), January 6, 2005 • Jarvis Taxpayers Assn. initiative,January 5, 2005 • Endorsed by Governor Schwarzenegger

  4. Round One: Richman/Jarvis Round One: Richman/Jarvis • NoDB Plan coverage for public employees hired after July 1, 2007 • NewDC Plan instead

  5. Round One: Richman/Jarvis, cont. • Opposition focuses on: • Survivor and disability benefits • Cost of closing DB plans • Employer organizations (counties and cities) develop reform proposals • April 8: Governor withdraws support

  6. Round Two: Legislature • ACAX1 8, April 14, 2005: “Hybrid” Plan • Actually a combination DB plus DC plan • Slightly higher contribution limits • No early retirements! • Normal is 65 general, 55 safety

  7. Round Two: Legislature, cont. • ABX 3, April 14, 2005: Pension Reform • CalPERS, CalSTRS, County systems • Benefit improvements for future service only • Minimum 5 year asset smoothing • No more ‘excess earnings” based benefits

  8. Round Two: Legislature, cont. • ABX 3, April 14, 2005: Disability Reform • No benefit if member takes a similar job • Benefit capped at 50% of pay • Offset in workers’ comp benefits

  9. Round Three: Pension Funds • CalPERS leading discussion • Longer asset smoothing periods • Longer amortization periods for gains/losses • Minimum contribution for plans in surplus • Pension Stabilization Account

  10. Terminology Issues • From ACA 5: But is it true? • DB: “System providing a pension benefit determined by a formula based on age, service credit, and final salary” • DC: “System providing a pension benefit that is equal to the combined employer and employee contributions plusinterest, less administrative expenses” • Tradition - and Webster - define “pension”: • “a fixed sum paid regularly to a person”

  11. Shift in Terminology • “DB vs DC” obscures the issue • The Nature of the Promise • DB: Income Replacement • DC: Capital Accumulation • The Basic Form of Benefit • DB: Income • DC: Account Balance • Fundamentally different, not interchangeable

  12. DB Plans in the USA • Corporate, Multiemployer and Public • Multiemployer generally “Taft-Hartley” • Larger Corporations have not abandoned DB • 346 of the S&P 500, 50% of Fortune 100 • Multiemployer: alive, stable and well • Public: DB still dominant, but under fire

  13. Pros and Cons of DB v. DC • Many Comparisons Available • Volatility of Investment Risk • Longevity Risk • Portability • Benefit Levels • Inflation Protection • Design Flexibility • Return on Investment • Expense of Investment

  14. Pros and Cons: Volatility Risk • DBInvestment volatility risk is on Employer (The “I”) • Diversification, smoothing, amortization • Note: only Diversification available to Members C + I = B + E

  15. Pros and Cons: Longevity Risk • DBLongevity risk is on Employer (The “B”) • Easily manageable at Employer level • Intrinsically unmanageable by Members C + I = B + E

  16. Pros and Cons: Portability • DB plans are not portable, but … • Reciprocity • Service purchases for “other gov’t svc.” • DC plans are portable, but there is “leakage” • Nebraska: 68% of terminating members cash out instead of rolling over

  17. Pros and Cons: Level of Benefits • Younger members need more time in DB plan to be better off than in DC plan, if one . . . • Assumes comparable investment returns • Assumes no “leakage” on termination • Assumes no “leakage” while employed • Hardship and other in-service distributions C + I = B + E

  18. Pros and Cons: Inflation Protection • Pre-retirement: pro DB for career members • Benefits based on “final pay” formulas • Post-retirement: pro DB for retirees • COLA’s • DC – requires purchase of CPI indexed annuities

  19. Pros and Cons: Design Flexibility • Pro: DB • Allows substantial benefits for later hires • Allows substantial benefits for interrupted careers • Survivor benefits • Disability benefits • Service breaks to focus on family

  20. Pros and Cons: Return on Investment • Cost of delivering benefits: Pro DB! C + I = B + E • DC plans have lower investment returns (“I”) • All studies – invest earnings 2% higher in DB plans • Diversified, professional asset management -DB • Overly conservative asset allocations • Inferior asset management

  21. Pros and Cons: Expenses C + I = B + E • DC plans have higher expenses (“E”) • DB investment and administrative costs 50bp • DC investment and administrative costs 150bp

  22. Q U E S T I O N S

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