The major defined contribution retirement plan-related changes in SECURE 2.0 include:

Strengthening auto-enrollment and auto-savings in retirement plans

Effective for plan years beginning after 2024, all 401(k) and 403(b) plans must automatically enroll participants with a 3%-10% contribution rate and provide an auto-save increase of 1% per year until it reaches a maximum of 10-15%. The participant must be given the opportunity to opt out of the default rates under current rules governing so-called “eligible automatic contribution arrangements” (EACA). 

This change is significant as it makes retirement plan participation the default position, which was not an option under current law. This will get more individuals into retirement savings plans—something very much needed in the United States. The Bureau of Labor Statistics reported in 2021 that 68% of private industry workers had access to retirement benefits through their employer, but only 51% chose to participate. In contrast, 92% percent of workers in state and local governments had access to retirement benefits, and 82% participated.  

The impact of this change will not be realized immediately because it only applies to new plans established after Dec. 29, 2022. In addition, government plans, church plans, new businesses, and small businesses with 10 or fewer employees are exempt.  

Refundable saver’s match tax credit

The current tax law provides a “non-refundable” tax credit for eligible individuals who contribute to IRAs or employer retirement accounts. Starting in 2027, The SECURE Act 2.0 changes the tax credit to be “refundable” in the form of a federal 50% matching contribution, up to $2,000 per year. The matching amount phases out depending on the employee’s income (e.g., $41,000-$71,000 for married filing jointly; $20,500-$35,000 for single taxpayers.

Using a federal matching contribution to provide the refundable credit will likely improve lower- and middle-income retirement savings.

Increased catch-up contribution limits for older workers

Individuals aged 50 and older under current law can make “catch-up” contributions up to $7,500 to 401(k), 403(b), and governmental 457(b) plans. The SECURE Act 2.0, effective in 2025, increases the catch-up limit for individuals ages 60-63 to $10,000 (indexed beginning in 2024). For higher-income individuals earning over $145,000 in a tax year, the contribution must be made to a Roth Account on an after-tax basis.

Lowered barriers to the use of lifetime income annuities

Beginning in 2023, the SECURE Act 2.0 further reduces tax code barriers for using annuities in defined contribution plans as recommended in Reason’s DC Personal Retirement Optimization Plan (or PRO) plan design in two ways.

Required Minimum Distribution Rules (RMD) Relaxed for Partial Annuitization: Current law requires an individual to determine RMD separately for annuitized and non-annuitized amounts. The result is a higher RMD amount than if the individual had not annuitized anything. The SECURE Act 2.0 removes this disincentive to annuitize by allowing the individual to aggregate both annuitized and non-annuitized distributions for RMD purposes.

Higher Qualified Longevity Annuity Contract (QLAC) Purchase Limits:  A QLAC product allows an individual to buy an annuity with a start date that begins only if they live longer than a stated age (no later than 85) as a way to help protect against the risk of outliving their retirement assets. Under current law, an individual can purchase a QLAC product but cannot spend more than 25% of the account value up to $135,000 (as currently indexed). The SECURE Act 2.0 eliminates the 25% limitation and increases the dollar limit to $200,000 (indexed). 

Other changes help portability, RMD distribution planning, and flexibility

The SECURE Act 2.0 permits retirement plan service providers to offer account portability services that automatically transfer retirement savings to an individual’s new employer’s plan. This helps preserve retirement savings instead of just cashing out of the prior employer’s plan. 

The act also increases the Required Beginning Date for minimum distributions from 72 to 73, depending on the individual’s “applicable age”:

• For those who turned age 72 before 2023, the applicable age is 72 (or age 70 ½ if they were born before July 1, 1949).
• For those who turn 72 after 2022 and reach the age of 73 before 2033, the applicable age is 73. 
• For employees turning 74 after 2032, the applicable age now is 75.

The onerous excise tax for RMD violations is also reduced in 2023 from 50% to 25%. The penalty tax is further reduced to 10% if the failure to take the RMD is corrected within a two-year window period.

Conclusion

The SECURE Act 2.0 takes important and meaningful steps toward increasing retirement plan savings participation. It reduces tax policy disincentives and tax code rules that perversely inhibit lifetime annuity solutions, which would improve retirement income security. It also provides additional flexibility for tax optimization for retirement distributions. 

The post Ways the SECURE Act 2.0 can help people save for retirement appeared first on Reason Foundation.

Beyond the growing pressures of crippling unfunded liabilities, DB plans suffer from a fatal flaw – they are unable to meet the portability needs of today’s highly mobile workforce. Only about one-third of plan participants will ever receive a meaningful benefit from a public DB plan.  

Another significant shortcoming of DB retirement plans is a failure to address specific individual needs. In a traditional DB plan, every person with the same salary and length of service is eligible for the exact same annual benefit. But treating everyone the same ignores the reality that individuals are almost never average. Individuals have different needs based on many factors, such as health or other sources of income.   

A typical DC arrangement suffers many of the same shortcomings. Managing investment risk is often solely on the shoulders of participants. Default investments often use target date funds, so every person with the same birthdate has the same investment mix regardless of circumstances.   

Neither DB nor DC plans are able to meet the needs of broad swaths of individuals. Historically, cost restrictions have made it difficult to design a plan that recognizes individual needs while covering a wide range of participants. Fortunately, that is no longer the case. 

To address these traditional design shortcomings, and in partnership with the Pension Integrity Project at Reason Foundation, we applied decades of retirement plan-related experience to develop a new design approach: The Personalized Retirement Optimization Plan (PRO Plan). This new plan design uses a mix of tested and proven options, making it easy for policymakers to implement. Offering a wide range of individual flexibility in contributions and annuities, the Pro Plan can better fit the unique retirement needs of each individual, making the plan advantageous not only for employees but for employers looking to better serve and retain their workers. 

The PRO Plan starts with the endgame in mind: a lifetime of inflation-protected replacement income. With immediate or very short vesting periods, the plan allows all participants (not just a few) to earn meaningful benefits. It also allows individuals to tailor and structure funding of the target benefit and benefit distribution strategy by first using independent financial advisors and/or advice tools to determine the appropriate investment strategy.  

All other assets available to the individual are considered, including other retirement plans, spousal assets, inheritance, and others. While participant input is critical for success, it is not overly burdensome and only needs periodic updating. This input enables the creation of an appropriately risk-managed and liability-driven portfolio that is adjusted as appropriate throughout the working career. Utilizing a combination of plan-provided annuities and other distribution methods, a default income plan is created that is specifically tailored to the individual.   

Our analysis comparing this new design to existing options finds that the PRO Plan addresses many of the common shortcomings and enables each participant to address their specific retirement needs. Using existing market-based products and modern financial technology, the PRO Plan enables government employers to provide lifetime-guaranteed benefits to their employees, and in a way that is cost-effective. Our research indicates that our new plan design could meet the needs of retirees at 28 to 38 percent lower cost than it would be for an individual covering lifetime benefits on their own. 

Applying some of the best features found in DB and DC plans, along with modern financial technology, the PRO Plan can meet both employer and individual employee needs for a more effective retirement plan. Rather than attempting to fix current plans, the PRO Plan is a design that should be considered throughout the public sector as a plan that policymakers can fully implement today. 

The post A better public sector retirement plan for the modern workforce  appeared first on Reason Foundation.

With most private firms shifting workers to 401(k)-style defined contribution (DC) retirement plans since the 1980s, the state and local government market is effectively the last bastion of traditional defined benefit (DB) pension plans. However, even among governments, the ubiquity of traditional pension plans has been slipping. And much of the movement away from traditional DB plan designs has been caused by accumulated unfunded liabilities that are fiscally burdening both the pension plan and jurisdictions’ budgets.

Public pension reform has been seen as a binary choice: the traditional DB or a 401(k)-style DC plan, with the latter option frequently presented as a standalone retirement option. In practice, a traditional 401(k) on its own will rarely comprise a core, or primary, retirement plan. This is because this type of plan was designed, and functions best, as a supplemental, employer-sponsored, tax-deferred savings plan.

This study presents a new retirement plan design, the Personal Retirement Optimization— or PRO Plan, which is built on a DC foundation but designed to operate more like a traditional pension. The DC foundation for the PRO Plan was chosen because it allows more public employees to accrue valuable retirement benefits regardless of length of service compared to defined benefit approaches. The design uses cutting-edge financial technologies to focus on providing plan participants with a predictable and customizable retirement income. It uses a liability-driven contribution (LDC) approach, tailored to individual situations and needs, for determining necessary contribution levels. Primarily concerned with risk-managed income adequacy in retirement, it addresses wealth accumulation only as a secondary objective. The PRO Plan provides participants the flexibility to choose an asset distribution methodology but uses several types of currently available annuities as a default method. The annuity default, combined with proper financial education and advice, tailor the PRO Plan income to an individual’s unique situation.

This study illustrates the effectiveness of the PRO Plan design in meeting individual retirement needs while effectively managing employer workplace expectations. To do so, the study elaborates on various scenarios that are relevant for the public sector. This analysis compares the relative funding requirements for three separate longevity scenarios:

• Scenario 1: Do-It-Yourself (DIY) – the individual self-insures their personal longevity for the entire period until age 95.
• Scenario 2: QLAC (deferred annuity) – the individual purchases an IRS Qualified Longevity Annuity Contract to address longevity risk from 85 to 95.
• Scenario 3: 100% Immediate Annuity – the individual purchases an immediate life annuity at retirement age 67 for the entire stream of payments.

Each scenario’s funding requirement is based on an actuarial analysis of net present value of a stream of inflation-adjusted payments starting at age 67 until age 95 (or death). We found that a DIY scenario was the costliest PRO Plan alternative. Our analysis shows that a typical mid-level earner at age 67 would require $1,050,000 under the DIY scenario. The QLAC scenario requires 28% less funding, or only $760,000. The 100% Immediate Annuity scenario requires 38% less funding than the DIY scenario, or $652,000, to achieve the same retirement income.

To show how the PRO Plan would work when the target benefit accumulation is greater or lesser than needed, we analyzed both a shortfall and excess $100,000 in plan accumulations at age 50. These scenarios showed that PRO Plans would better protect individuals by positioning them to adjust savings rates up or down as needed. Similar to the baseline scenarios, the QLAC and 100% Immediate Annuity options require lower additional contributions to allow participants in shortfall situations to reach the target retirement benefits.

This study serves as a hands-on tool for public fund managers willing to implement the PRO Plan option. In addition to providing the reader with various scenarios, it details all the plan features necessary for its successful implementation. The PRO Plan is an innovative way of incorporating the benefits of 401(k)-style solutions into modern-day public sector retirement plans that give their workers flexibility and predictability of their benefits.

A state or local government employer seeking to implement a new retirement plan or redesign their existing retirement plan should always begin by clearly identifying sound retirement benefit design principles and using those principles to determine and articulate the objectives of that plan. The principles and resulting design should include as the primary objective providing a share of lifetime income, attributable to the employee’s tenure, enabling the employee to maintain their standard of living in retirement. The design of the plan should provide the flexibility to meet the needs of employees in varying circumstances. Of course, other workplace objectives of the employer and financial realities for plan sponsors should also be considered.

Standard DB and 401(k)-type DC plans are often compared with little regard to the simple question of what design elements provide the greatest utility to the greatest number of employees while still serving the employer’s workforce management objectives. Many arguments have been advanced on all sides of the issue, some valid, others not so much. The real answer to the question of what type of plan most aids recruiting and retention is a plan that best meets the varying needs of most employees.

This analysis concludes that providing retirement benefits and savings solutions that adjust to meet the different and changing needs of employees is what will more likely aid employers in attracting and retaining quality employees.

The PRO Plan design is specifically crafted to be adaptable to the needs of the broadest cross-section of employees possible. The focus of the plan is on providing employees with the target retirement income replacement ratio determined by the employer. Income replacement is the primary objective, with wealth accumulation a secondary consideration. Importantly, the plan, based on employer-specific criteria, can have a longevity annuity default that can be opted out of by employees meeting certain specific criteria. The mandatory contribution rates for both employer and employee, as defined by the employer, combined with the investment design and distribution controls, are all designed to minimize risks for the employee while meeting employer workplace objectives.

The Personal Retirement Optimization Plan: An Optimized Design For State And Local Government Employees

Frequently asked questions about the Personal Optimization Retirement Plan

Webinar: The Personal Retirement Optimization Plan

The post Designing an optimized retirement plan for today’s state and local government employees appeared first on Reason Foundation.

The PRO Plan is built on a defined contribution foundation but is designed to operate more like a traditional pension plan. The DC foundation for the PRO Plan was chosen because it allows more public employees to accrue valuable retirement benefits regardless of the length of service compared to defined benefit approaches. 

This discussion and study serves as a hands-on tool for public fund managers willing to implement the PRO Plan option. The Personal Retirement Optimization Plan is a way of incorporating the benefits of 401(k)-style solutions into modern-day public sector retirement plans that give their workers flexibility and predictability of their benefits.

Full Study: The Personal Retirement Optimization Plan: An optimized design for state and local government employees

Frequently asked questions about the Personal Optimization Retirement Plan

The post Webinar: The Personal Retirement Optimization Plan appeared first on Reason Foundation.

Built on a defined contribution foundation, the Personal Retirement Optimization Plan described fully in this new study improves on traditional designs with clear and measurable objectives on maximizing benefits for a wide range of individual situations, flexibility in both investment and benefit distribution options, and an emphasis on guaranteed lifetime income through annuities.

In short, the PRO Plan blends the risk management benefits to employers associated with DC plans with the lifetime income protections public workers value in pension plans. Executed correctly, the PRO Plan could provide a more secure DC benefit at a lower cost to governments and taxpayers.

Full Study: Designing an optimized retirement plan for today’s state and local government employees

Webinar: The Personal Retirement Optimization Plan

The post Frequently asked questions about the Personal Retirement Optimization Plan appeared first on Reason Foundation.

While a one-year negative investment return should not be the basis for making long-term funding policy decisions, it does provide an opportunity to ask the fundamental question: Who should own funding risk policy for public pension plans? The answer is important because negative investment results can have a direct and substantial effect on public pension contribution rates—a financial burden born ultimately and primarily by taxpayers. 

The current state ownership of pension funding risk policy was addressed, in part, by the National Association of State Retirement Administrators (NASRA) in two papers examining the governance of state-sponsored public pension systems. The papers describe public pension governance systems with wide variations from state to state in the distribution of governance powers and duties between the state legislatures as the creator and settlor of the pension plan and trust, the plan’s chief executive function, the plans’ trustees, and, in some cases, separate pension oversight bodies. The stakeholder governance model theory described in the NASRA papers holds that it is valuable to disperse governance functions to “prevent one group from accumulating excessive authority in one area.”    

The NASRA papers note, however, that in most states, the actuarial funding policy and methods are set and managed by the pension boards of trustees. Similarly, the investment policies for plan assets are usually set and managed by the pension trustees or, in some states, a separate pension plan investment board. The historical rationale for this delegation by the state legislatures of funding and investment risk policy is the reality that legislatures are simply not well equipped to set and manage public pension systems, and it is reasonable to defer to experts to help. The problem with this delegation of pension funding risk authority to the pension and investment trustees is that it violates the principles of the stakeholder governance model theory by allowing one group of stakeholders (pension plan staff and trustees) too much authority over how much actuarial and investment risk to take. Investment policy and actuarial funding policy are too often established without due regard to the needs of the plan sponsor and participating employers to manage the costs of offering the pension plan on an ongoing basis.  

In a 2010 paper, the American Academy of Actuaries recognized the problems that occur when there is a structural misalignment of risk management functions for public pension systems. The paper noted there is, in many cases, a lack of aligned stakeholder incentives and a lack of reliable risk information for the stakeholders and their agents. It further noted that a major structural issue is the diffusion of responsibilities and controlling authorities amongst stakeholders. The paper observed that: 

“Absent an external, independent authority or regulator, the need for a risk management system becomes critical. Such a risk management system can and should: 

• establish boundaries of risk-taking; (emphasis supplied) 
• establish policies and mechanisms to support the following priorities: 

• continuous funding,  
• education of administration and employees (unions) to better understand the risk of current benefit structures,  

• develop processes for identifying plan provisions that create misaligned and/or mispriced risk incentives for plan participants and sponsors; and 
• identify stakeholder incentives that clash with the health of the system as a whole.” 

The immediate question then becomes, ‘what is the best way to create this better division of pension governance authority?’ The answer is to create, within each state, the very thing that is missing: an external, independent authority that owns public pension funding risk policy.  

Examples of state public pension oversight bodies currently exist. The Texas Pension Review Board (PRB) is an independent state agency charged with reviewing state and local retirement systems’ actuarial soundness and compliance with state law. Another is the Ohio Retirement Study Council (ORSC), which provides oversight of the state’s retirement systems and advises the legislature on matters pertaining to benefits, funding, investment, and retirement system administration. The Louisiana Public Retirement Systems’ Actuarial Committee (PRSAC) reviews and studies the actuarial assumptions, methods, and funding policies used by public retirement systems in the state.  

These examples of existing pension oversight bodies are a step in the right direction, but more is needed. It is time to consider expanding the authority of these oversight bodies to be more than mere oversight and guidance. They need to become the external, independent authority that actually establishes and manages the pension funding risk policy. This would generally require the public pension oversight body to set the boundaries of actuarial assumptions and methods that are used to determine the necessary funding for the pension plan. It would also mean the pension review board would be responsible for setting the boundaries of investment risk that can be taken by those charged with investing plan assets to properly manage contribution funding risk for participating employers. The fiduciary bodies for the pension plan, the pension administration, and investment boards would be responsible for executing their responsibilities in compliance with these independently set risk policies. The result would be a better allocation of authority among the pension plans’ stakeholders to better protect taxpayers from misaligned risk-taking. 

The post Who should be responsible for a public pension plan’s risk management policy?   appeared first on Reason Foundation.

This is a review of Alaska’s defined contribution retirement plan (DCR), also referred to as Tier 4, and the Alaska Supplemental Annuity Plan (SBS-AP). The comments relate to the efficacy of these plans for employees’ retirement, with an emphasis on public safety employees.

In this analysis, we’ve used the leading best practices from our policy brief, Defined Contribution Plans: Best Practices in Design and Utilization, outlining the gold standard as a measure of the two plans. Alaska’s retirement plans meet best practices in some areas but need some improvement in other areas, as described below.

Summary of Alaska’s Pension Plans

• Alaska Defined Contribution Retirement Plan (DCR): The DCR is a retirement plan within the Public Employees’ Retirement System (PERS). It is a defined contribution, multiple-employer public employee retirement plan established by Alaska to provide pension and post-employment health care benefits for eligible state and local government employees hired after 2006.

As of June 30, 2020, 152 employers were participating in PERS-DCR. According to the state’s annual report for the fiscal year ending in June 2020, there were 23,478 plan members, of which 21,243 were general employees and 2,235 were peace officers and firefighters.

There are three benefit components: 

• DCR Plan—a 401(a) plan
  • The PERS Retiree Medical Plan (RMP), which provides retiree health insurance (after 25 years of service and retirement directly from active employment) and a Healthcare Reimbursement Arrangement Plan (HRA)
  • The Occupational Death and Disability (OD&D) Plan, which pays 50% of covered compensation (nontaxable)
• Supplemental Annuity Plan: This plan, SBS-AP, is a defined contribution plan that was created under Alaska statutes effective January 1, 1980, to provide benefits in lieu of those provided by the federal Social Security system. All state employees who would have participated in Social Security if Alaska had not withdrawn from it now participate in SBS-AP instead.  Other Alaska employers whose employees participate in PERS and meet other requirements are eligible to have their employees participate in SBS as provided by Alaska statute. There were 21 participating employers in SBS-AP, including the state, and 49,552 participants in the plan as of June 30, 2021.

Note: Teachers covered under the Teachers Retirement System (TRS) are not eligible to participate in the SBS-AP. Not all public safety employees of political subdivisions participate in the SBS-AP, only those of the state and the few political subdivisions that have adopted it. According to the Alaska Division of Retirement and Benefits, just 25 of 199 PERS employers offer access to the SBS-AP.

Definition of Plan Objectives

Employee communication materials for the plan continually refer to meeting employee objectives, but a well-defined pension plan objective is not clearly stated in authorizing statutes or the primary informational handbook. The defined contribution plan handbook says: “Your retirement plan is designed to keep pace with your career; on your very first day of work you are in control. Your defined contribution retirement account is participant-directed, requiring your attention and understanding as you choose investment funds that fit your needs.”

While this is a welcome approach, there ideally would be a more explicit statement of what the pension plan is working to achieve on behalf of participants. The SBS-AP handbook does not address the plan’s purpose other than noting it exists instead of Social Security.

Communication and Education

The DCR plan and SBS-AP make various communication and education services available to participants. Services range from group seminars and meetings to individualized advice and guidance offerings. Individual participants should be cautious about using higher-priced managed account services that may not be necessary.

Automatic Enrollment

New employees are automatically enrolled in the plan, and contributions are directed into an age-appropriate target date fund until the employee makes a positive election. This approach satisfies the auto-enroll best practice.

Contribution Adequacy

Given that state and most political subdivision public employees in Alaska do not participate in Social Security, total contribution rates (employer plus employee) of 13% for PERS employees and 15% for TRS employees are inadequate on their own to adequately fund a retirement benefit that will enable a retiree to maintain their standard of living following a career of employment.

Fortunately for PERS employees, when SBS-AP benefits are considered, the total employer and employee contribution rates increase by 12.26% for a total of 25.26% for PERS employees. Additionally, 3% of pay is contributed to the HRA benefit.

TRS employees, however, do not participate in the SBS-AP, leaving their 15% DCR contribution substantially below the target contribution range of 18-25% for those not covered by Social Security.

There is also a potential major shortcoming in the Alaska DCR for public safety employee participants. Public safety employees generally retire at an earlier age than general classification employees because of the requirements of their jobs. Funding an earlier retirement date requires a higher contribution rate. It is generally accepted that without Social Security and earlier retirement ages, the total contribution rate for police and fire employees should be a minimum of 30%. With public safety workers participating in PERS and not participating in Social Security, the combined 25.26% contribution rate is well below the suggested 30% contribution.

There is also a chance that some public safety employers are not offering the SBS-AP benefit, which would put those police and firefighters woefully below suggested levels in contributions.

Retirement-Specific Portfolio Design

The investment menu for Alaska’s DCR plan generally meets best practices. Single-choice target date options are available, and for individual participants desiring a more customized portfolio, the plan offers a range of advice and guidance services. The primary menu includes 16 options, including mutual funds and Alaska-managed balanced funds. In plan annuity, accumulation period options are not offered.

Portable Benefits

Accumulations attributable to employee contributions are, of course, immediately vested.  Accumulations attributable to employer contributions are not fully vested for five years. Vesting is on a pro-rated scale beginning with 25% vested after two years of service and growing to 100% after five years. Full and immediate vesting of these employer contributions would be preferred to meet the needs of today’s more mobile workforce. A five-year vesting timeline is especially long for a defined contribution retirement plan.

Distribution Options

The plan makes various distribution options available ranging from leaving the assets in the plan to various fixed-period and lifetime annuities. The offerings cover best practices, but other than distributions required by regulations, there are no requirements for a lifetime income.

Disability Coverage

Alaska’s DCR plan presents itself as a hybrid plan because of the non-retirement benefits it provides to public employee participants. These benefits include disability and retiree health care. These benefits appear to be generous and satisfy best practices.

Sept. 14, 2022—Editor’s note: This piece has been corrected to reflect the fact that TRS members are not eligible to participate in the SBS-AP Social Security replacement plan.

For more information and an in-depth scorecard, please see:

Does the Alaska Public Employees’ Retirement System Meet Defined Contribution Plan Design Gold Standards?

The post How Alaska’s defined contribution plan and supplemental annuity plan compare to the gold standard appeared first on Reason Foundation.

• Social Security does a lot to prevent old-age poverty but could do more to protect the middle class.
• Tax expenditures and incentives for retirement savings are heavily skewed toward those at higher income levels, with the middle class having relatively weak tax incentives.
• Geographic and racial inequities in retirement savings are exacerbated by the inequality of tax expenditures and incentives for higher income levels.

The Missing Middle report proposes solutions it says are needed to combat the inequalities it suggests. For example, the report proposes higher Social Security income replacement rates for the middle class, eliminating the income tax deduction approach for incentivizing retirement savings and replacing it with refundable tax credits, improving access to retirement plans through state-facilitated “Secure Choice” type retirement savings plans for private-sector workers who are not offered an employer-based plan, and general curbing of so-called retirement savings abuses that allow individuals to transfer wealth between generations – e.g., when the SECURE Act of 2019 increased the start age for required minimum distributions from 70.5 to 72.

The report’s focus on tax expenditure differences between the income classes leads to an “inequality” and “unfairness” discussion that ignores several points.

First, high-income cohorts are being cast as benefitting unfairly under a tax system that takes more from them both in dollars and as an effective tax rate, even after all tax deductions are considered.

Second, the report ignores that individuals can and do move between income tax brackets through their working years, with many choosing to backload their retirement savings when they are older and earning more income. Shouldn’t it be good to provide tax incentives to help that happen? 

Third, the analysis ignores that tax incentives provided for retirement benefits are capped under the Internal Revenue Code (IRC). For 2022, IRC Section 415 limits defined benefit pension benefits to $245,000 in 2022, and defined contribution plan annual contributions are limited to a maximum of $61,000. These caps effectively limit the amount of tax benefits that can accrue to any individual from retirement plans.

Fourth, the analysis ignores the fundamental purpose of a retirement plan is to provide an appropriate amount of income replacement during retirement years at all income levels, which are typically defined in the retirement industry as being between 70% and 90% of pre-retirement income. The federal tax incentives for both defined benefit and defined contribution plans allow these employer plans to provide different retirement benefits for different compensation levels to help achieve these income replacement targets. Essentially, these plans are doing what they are designed to do. Should we abandon this concept?

Lastly, the NIRS report’s focus on tax expenditure inequality distracts from more critical actions that can be taken to improve financial security in retirement, the most important of which is increasing the level of meaningful participation in available employer and individual retirement benefit and savings plans.

The Bureau of Labor Statistics reported in 2021 that 68% of private industry workers had access to retirement benefits through their employer, with 51% choosing to participate. In contrast, 92% percent of workers in state and local governments had access to retirement benefits, with 82% participation. The take-up rate—the share of workers with access who participate in the retirement plan—was 75% for private industry workers and 89% for state and local government workers. Why the difference? 

The most significant factor is mandatory participation. Most state and local government plans do not give employees a chance to not participate in their retirement. Another key design feature is that most state and local government plans require mandatory pre-tax employee contributions. Private sector employers generally are not eligible to offer 414(h)(2) contribution features. Instead, most use pre-tax 401(k) options for voluntary employee savings. The voluntary nature of employee retirement savings accounts for most of the participation gap in our retirement security policy in the private sector. 

To try to rectify the participation gap, the U.S. has already added multiple complex layers of tax and Employee Retirement Income Security Act (ERISA) provisions to try to create incentives for increasing voluntary participation in retirement plans, including useful auto-enrollment and automatic savings plan design solutions. And yet, we still have the participation gap noted previously.

The use of tax expenditures as a tool for shaping the behaviors of individuals can reasonably be questioned. It is a blunt instrument that often does not work well to further desired results. However, taking away tax incentives is not likely to help lower- and middle-class workers, and providing more tax incentives through refundable tax credits would further distort an already distorted tax system. Focusing on tax expenditure differentials distracts from some of the more effective approaches policymakers could take for improving retirement security, such as incentivizing participation, auto-enrollment, and automatic savings solutions.

The post Policymakers should focus on improving participation rates in retirement plans appeared first on Reason Foundation.

Inflation’s impact on the purchasing power of retirement benefits and savings needs to be managed when designing and funding effective retirement plans. Periods of high inflation show how important properly designing inflation protection measures is in public sector defined benefit (DB) pension plans.

These plans have addressed this dilemma in different ways over the years with varying degrees of effectiveness. More recently, public sector pension reform efforts have often significantly changed how cost-of-living adjustment (COLA) and post-retirement benefit increase (PBI) features are designed and funded.

This brief focuses on how state and local government defined benefit public employee retirement systems have used cost-of-living adjustment benefit features to address inflation’s risk to retirement security. It also provides a set of best practices to help guide policymakers and stakeholders in designing and funding inflation protection design elements for their defined benefit pension plans.

Executive Summary

Cost-of-living-adjustment (COLA) benefits are a common feature of many public employee retirement systems used to provide a level of protection against loss of purchasing power in retirement resulting from inflation. Public defined benefit (DB) pension plans use a wide variety of COLA benefit designs and funding methods that have led to a mixed bag of outcomes for retirees and have often exacerbated existing underfunding problems.

The principal problem with most COLA benefit provisions is failing to treat it as one of the plan’s core benefit objectives and to prefund it the same way as the primary retirement benefit. Instead, too many plan sponsors apply ad hoc COLAs unevenly. In addition, there is an issue of inconsistent timing. Moreover, not enough thought is given to how actual inflation impacts those who receive the increase. And finally, too little consideration is given to how the increase impacts the total program’s long-term funding.

This brief identifies several proposed best practices to guide public plan sponsors to a more coherent and financially sustainable COLA benefit design and funding for their pension systems. The best practices include:

• Best Practice #1 – Public pension plan sponsors should create a formal cost-of-living adjustment benefit policy that is an integral part of the overall retirement plan objectives. This provides clarity for the retirees, sets expectations properly, and provides guardrails for future policymakers when faced with changing circumstances.
• Best Practice #2 – The COLA benefit design should clearly identify 1) who is eligible for the COLA, 2) what benefit the COLA applies to, and 3) when it is payable. This is necessary to force recognition of the reality that the plan cannot and should not provide unlimited inflation protection for all participants.
• Best Practice #3 – The COLA amount should reflect an objective inflation benchmark. This helps provide a more predictable amount of inflation protection and more equitable distribution of benefits for similarly situated retirees.
• Best Practice #4 –The COLA Benefit amount should be consistent, predictable, and clearly communicated to the retirees. Retirees need to have a firm understanding of what COLA benefits will or will not be provided to set expectations and to allow them to manage their retirement assets and income more effectively.
• Best Practice #5 – The COLA benefit amount should be limited. This recognizes that inflation varies over time and that the COLA benefit design distinguishes between “normal” inflation and periods of high inflation that are more difficult to predict. Establishing limits or caps on the COLA benefit is needed to allow more sustainable funding approaches.
• Best Practice #6 – COLA costs should be pre-funded as part of the overall normal cost of the retirement plan. Pre-funding of COLA benefits is essential to ensure the consistent delivery of inflation protection to retirees and to avoid the creation of unfunded liabilities. It also avoids the creation of complicated and unpredictable COLA funding schemes, such as investment gain sharing or actuarial funding margin reserve allocations.
• Best Practice #7 – COLA benefits should be subject to change for future accruals and new employees. COLA benefits should be subject to adjustment for future accruals for current active employees and for new hires to create benefit design and funding flexibility under changing circumstances.
• Best Practice #8 – Plan sponsors must stop making the same mistakes. This recognizes that it is important to break the cycle of suboptimal COLA practices.
• Best Practice #9 – New practices must refrain from trying to fix all past inflation. Not all past inflation has to be fixed. This recognizes that there are limited public funding resources, and prioritization among competing demands for the public treasury is necessary.

Cost-of-living adjustment design and funding are complicated at many levels. The need for some inflation protection for public pension retirees is clear, but resources to provide protection are limited. This means public pension plan sponsors should carefully craft COLA benefit and funding policies that help maintain financial security for retirees but do so in a financially prudent and risk-managed basis.

Following the best practices outlined in this paper should provide some important guardrails for designing effective COLA benefits, which will help plan sponsors as they strive to strike the proper balance between cost, risk, and benefit in a way that works for both employees and employers.

Full Brief — Best Practices for Cost-of-Living Adjustment (COLA) Designs in Public Pension Systems

This policy brief is part of the “Gold Standard in Public Retirement System Design Series,” which reviews the best practices of state-level public pensions and provides a design framework for states that are struggling under the burden of post-employment benefit debt.

The post Best practices for cost-of-living adjustment designs in public pension systems appeared first on Reason Foundation.

Which plan type does a better job of actually delivering benefits to the most people?  

It is important to understand the often-overlooked concept of benefit efficiency in concrete conditions. To demonstrate, a hypothetical retirement plan called PERS (Public Employee Retirement System) can serve as a stand-in. This hypothetical pension system uses common characteristics among public retirement plans that offer both DC and DB options. A full list of parameters used for this modeling is provided at the end of this piece. 

Using these parameters and other turnover and mortality data, this piece will examine how a DB plan compares to a DC plan for a cohort of 1,000 employees by comparing their accumulated benefits over a potential lifetime (based on mortality rates). This analysis demonstrates that the DB plan does become optimal when compared to a DC plan for an individual around age 55-60 depending on the entry age. However, for a group of 1,000 employees and for certain entry ages like 22, the DB plan as a whole is never more valuable than the DC plan as a whole. 

For this hypothetical plan, only 33% of workers starting at age 22 remain in their jobs after five years, which is in line with expected retention rates for most public pension plans. For later entry ages, retention beyond the first five years goes as high as 50%. At the 30-years-of-service mark, only about 8%-to-12% of employees remain in their jobs, depending on the entry age. 

DB vs DC analysis for a group of employees 

To include a valuable comparison of how portable DB benefits are compared to DC benefits, the comparison of accumulated benefits will only be made for employees who leave the system. This analysis assumes that a person in a DB plan will try to attain their maximum possible benefit, meaning that if a PERS employee separates (in other words, take another job) at age 35, this comparison would be for their accumulated DC balance to the maximum possible DB benefits they could collect by waiting until the pension systems retirement eligibility. 

The first scenario looks at the cumulative benefits distributed between DC versus DB plans for a standard entry age of 22. Figure 1 shows the cumulative benefits of a DC versus DB plan for every new employee that leaves the system. The first thing that stands out is the stark increase in balances at age 60 for both the DC and DB plans.  

This increase is for two reasons: a spike in retirement rates and a spike in individual DB benefits. For retirement rates, about 940 people leave the system by age 60 and within just six years only two-thirds of them remain. Therefore, even though the individual DC balances grow steadily over time, the cumulative DC balances also spike because this analysis looks at cumulative balances for those who leave the system.  

As for the spike in individual DB benefits, it is a little more nuanced. The DB benefit becomes better than the DC benefit for an individual around age 56 when the person has worked for 34 years and is eligible for full retirement under the “Rule of 90” (see appendix). This relative value of a DB over a DC plan increases and peaks at age 60 where the maximum possible DB benefit at age 60 is 35% more valuable than the DC plan. This combined with increased retirement rates leads to a massive spike in cumulative DB balances around age 60.  

Despite the rise, the DB never crosses the DC plan in cumulative terms for this entry age. That is because the DB plan eventually becomes worse than the DC plan if the person waits too long to retire, specifically at a cutoff point around 70. While the annual benefits will increase for those working longer, a person may not live long enough to reap the full benefits, and thus it is no longer advantageous.  

Figure 1: Cumulative Benefits Distributed (Entry Age 22) 

This trend differs slightly but is still similar to other entry ages. In Figure 2, the ratio (vested DB benefits to vested DC benefits) is used to make a similar comparison of cumulative benefits for an aging workforce using different ages of entry. 

Figure 2: Ratio of Cumulative Benefits (DB/DC) for different entry ages 

At the entry age of 52, the defined benefit plan quickly becomes a better option when compared to the defined contribution plan due to early retirement eligibility. Of course, entering the workforce at 52 is not a typical scenario for most people and neither is staying at a job long enough to enjoy the comparative advantage of a defined benefit plan, as this analysis shows based on the retention rates.  

Conclusion 

The claim that a defined benefit plan is more efficient than a defined contribution plan, purely on a basis of cost, overlooks a larger and more meaningful perspective regarding benefit distribution. Most members of a DB plan do not stay at their jobs long enough to enjoy this “efficiency.”

Using the hypothetical PERS plan, fewer than 12% of employees make it to full retirement across all entry ages, yet the advantages of the DB retirement benefits seem to be tailored to this select group only. The vast majority of workers are better off with a defined contribution plan because the benefits they earn are not frozen when they leave for other employment. 

Additional notes on this analysis

Key Parameters 

1. Assumed Inflation – 2.25% 

2. Salary Growth Rate – 3.50% 

3. Vesting Period – 5 years 

4. Final Average Salary – 5 years 

5. Interest Credit – 6.5% 

6. Benefit Multiplier – 2.00% 

7. COLA – 0% 

8. Assumed Rate of Return – 7% for DB Plan, 6% for DC Plan 

9. Employee Contribution rate – 7% for DC and DB Plan 

10. Employer Contribution rate – 7% for DC and DB Plan 

Retirement Conditions 

1. Regular Retirement 

• Age 65 with 5 years of service 
• Age + years of service >= 90. Known as the rule of 90 

2. Early Retirement – Age 60 with 5 years of service 

This analysis assumes a 6% return for the defined contribution plan and a 7% return for the defined benefit plan. This is based on the NIRS assumption that the DB plan is managed by sophisticated fund managers and can therefore generate higher returns. This point was rebutted in the previous piece based on returns generated by pension funds vis-à-vis index funds to highlight the value of fund managers. This analysis focuses on benefit distribution, so the assumption of a higher DB return is used. 

The post Examining the populations best served by defined benefit and defined contribution plans appeared first on Reason Foundation.

A 2021 Black Rock survey indicates that 96 percent of 225 large 401(k) and 403(b) plan sponsors feel responsible for helping participants generate and/or manage their income in retirement, and 82 percent of plan sponsors that do not currently offer a product that provides lifetime income such as an annuity are likely to add one in the next 12 months.

A 2020 Retirement Income Institute research paper found that 81 percent of defined contribution plan participants indicate that they are somewhat or highly likely to prefer a retirement plan that substitutes guaranteed income for bond investments. Despite these and similar survey trends showing a growing interest in guaranteed income solutions in defined contribution plans, a Profit Sharing Council of America (PSCA) report in 2020 shows that only 16.3 percent of defined contribution plans surveyed actually offer a retirement income solution for participants.  

While there is some evidence that public sector DC plans may have better numbers, the reality is that retirement income solutions continue to be an afterthought in the design of defined contribution plans. The reasons stated in the PSCA report for the disparity in DC plan sponsor intent and actual adoption of retirement income solutions include lack of demand from participants, product and administrative complexities, high perceived costs, lack of portability, and perceived fiduciary risks. Another reason is that only 19.9 percent of plan consultants and advisors recommended retirement income solutions for their clients’ plans. Why the reluctance to recommend retirement income solutions to their plan sponsor clients? If the need for guaranteed retirement income in retirement is recognized and plan sponsors agree that providing retirement income solutions is a high priority, then the slow adoption rate needs closer examination.  

The array of available retirement income solutions for DC plans can be daunting to those only familiar with the standard array of mutual fund-driven investment menus. Finding the right fit includes the need to understand how each product type works and how to mesh it into a coherent plan design that does not overwhelm participants. Plan sponsors and their advisors need to come to grips with a variety of products including immediate and variable annuities, deferred annuities (including qualified lifetime annuities), and guaranteed minimum withdrawal benefit solutions, all in addition to the usual do-it-yourself and managed payout options typically offered.  

Interestingly, the hesitation to add income options may have more to do with a failure by plan sponsors and their consultants to make retirement income the explicit and primary purpose of the plan. Making this simple change of perspective (i.e., retirement income first and wealth accumulation second) as recommended by Reason Foundation’s best practices for defined contribution plan design would by necessity lead to increased use of the available retirement income solutions. This has been the case for higher education DC plans for decades.    

Policymakers should also know that reluctance borne from concerns of complex and hard-to-implement administration is misplaced. The ability of third-party recordkeepers to include retirement income solutions into both their plan and participant services while providing a customized set of retirement income planning services currently exists. These services should mitigate plan sponsor and advisor concerns about administrative complexity. 

Some of the fiduciary risk concerns have been addressed with the passage of the Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act), which provided greater safe harbor protections for limiting the plan sponsor’s liability if the annuity provider is not able to fulfill the annuity contract. While this safe harbor does not technically apply to public sector plans, the fiduciary prudence practices provided should be useful nonetheless.   

The concerns regarding fiduciary risk due to the use of lifetime income solutions are also questionable given the fact that private-sector defined benefit plan sponsors have been using group annuity purchases as a de-risking tool with a record sales volume of over $38 billion in 2021. This level of annuity purchase activity in the private sector provides some valuable assurance that the level of risk involved in using retirement income solutions for providers of DC plans can be successfully managed.  

Moving the needle toward an expansion of retirement income products in defined contribution plans would be a meaningful step in better addressing retirement financial security. The benefits to the retirement security of DC plan participants are well worth the effort.  

The post The case for in-plan lifetime income solutions for DC plans is clear, so why the reluctance to implement?  appeared first on Reason Foundation.

Members of the committee, thank you for the opportunity to offer our brief analysis of the Thrift Savings Plan proposed in Senate Bill 553.

My name is Zachary Christensen, and I am a managing director of the Pension Integrity Project at Reason Foundation, a national 501(c)3 public policy think tank, and prior to that, I was a public pension analyst for the Hoover Institution at Stanford University.

Through our pro-bono work with public officials and stakeholders looking to improve resiliency and promote retirement security of their retirement plans, the Pension Integrity Project has helped design and implement comprehensive and sustainable solutions that work for both government employers and their employees. We have played a technical assistance role in over 50 state-level retirement system reforms in states like Texas, Michigan, Arizona, Colorado, South Carolina, and New Mexico since 2015.

Senate Bill 553 establishes the Kansas Thrift Savings Plan, which would offer a defined contribution retirement benefit for all state employees—excluding police, firefighters, judges, and correctional officers—hired on or after July 1, 2024. Since it would become the primary vehicle for providing a secure retirement for most public workers, it is important to assess the proposed Thrift Savings Plan’s adequacy and ability to meet the needs of retirees and employers.

While decades of experience with public sector defined contribution plans have demonstrated that they can be an effective means to providing adequate retirement income for public workers, not all governmental—or even private-sector—defined contribution plans are the same. Not all DC plans meet the definition of an effective plan designed to yield a secure retirement, and many could be improved by incorporating best practices.

Upon review, the Pension Integrity Project found that the proposed Thrift Savings retirement plan in Senate Bill 553 reflects a high-quality public sector retirement plan design that incorporates best practices from national experience.

First and foremost, the plan proposed in this bill does not take away funding from the current legacy retirement plans and requires previously promised pension benefits to continue to be properly funded. This would ensure a smooth transition from past retirement offerings to the proposed future benefits. Thanks to specific provisions in SB 553, existing employees and retirees will continue to see their benefits funded at the same levels as before, and the creation of this new plan will not affect the state’s funding of benefits already promised to public workers.

Senate Bill 553 importantly avoids a shortcoming of many retirement plans by providing a formal statement of legislative intent and plan objective for the Thrift Savings Plan that is consistent with retirement best practices. This language will help members understand the goals of the plan and will serve as a foundation for future decisions by policymakers and plan administrators.

The proposed Thrift Savings Plan also satisfies the critical best practice of providing adequate contributions. Retirement experts agree that a total contribution rate of between 10% and 15% is necessary over a career to adequately fund retirement (when combined with Social Security and personal savings). The contribution design of 10% (6% from employees and 4% from the employer) with potential additional contributions and matching through the supplemental deferred compensation retirement plans offered by employers will meet these best practice contribution standards.

One common concern about DC plans is ensuring protection against longevity risk, the risk that beneficiaries outlive their retirement savings. SB553 directly addresses this risk by requiring the offering of robust lifetime income options for purchase. Providing a variety of in-plan life insurance annuities as distribution options allows retirees to eliminate the risk of outliving their retirement savings.

The proposed Thrift Savings Plan is also a good fit for a public sector workforce that is increasingly mobile and will complement the needs of government employers who are now more reliant on shorter-tenured, non-full-career workers. With employees more frequently changing jobs and remaining in positions for shorter periods, the modern workforce values more individualized and portable retirement benefits that are more in line with private-sector retirement plan offerings. Since the plan proposed in SB 553 is inherently a portable retirement benefit, it would be an appropriate default retirement plan to match the overall dynamics of your public workforce.

On the subject of making this a valuable retirement plan for the modern workforce, we have identified one possible area of improvement for the proposed Thrift Savings Plan. As currently structured, SB 553 would require five years of employment before members will be able to vest into the contributions made by employers. Our experience indicates that this is a vesting period longer than most DC plans, and it may lead to many public employees missing out on a critical part of their compensation.

All that said, the Pension Integrity Project finds the plan established in Senate Bill 553 to meet the primary objectives of retirement best practices, meaning it would serve its members well while meeting the needs of the state and its employers.

Thank you again for your time, and I would be happy to answer any questions.

The post Testimony: Assessing the proposed Kansas Thrift Savings Plan in Senate Bill 553 appeared first on Reason Foundation.

Since public pension plans smooth their asset returns over a number of years to manage market volatility, any properly risk-managed retirement-focused investment will somewhat underperform the market in up years but outperform the market in down years. For this reason, and others, any praise for the good investment results for public pension plans is justified and should not be dismissed. At the same time, while there is ample reason to be happy about excellent asset returns, there is also a danger that plan sponsors and retirement systems may sit back and rest on their one-year laurels.

Public pension plans should always examine an important question— Are the designs of their plans still working?

While the pressure to improve investment performance is somewhat, or temporarily, lifted, policymakers should take this time to focus on the retirement plan design issues that may be impacting their long-term ability to meet their primary objectives of enabling public employees to maintain a certain standard of living in their retirements after careers of public employment.

If pension plan sponsors do not examine the design of public retirement systems, it’s difficult to know whether things have drifted off course. This is especially important considering the changing career mobility of state and local government employees. According to the Bureau of Labor Statistics, the median tenure of a state government employee in 2020 was just 5.6 years. While this is longer than the 3.6 years for all private-sector employees, it is hard to escape the conclusion that workforce mobility and benefit portability issues for public employees are an increasing concern to their retirement security.

The Employee Retirement Income Security Act (ERISA) is the set of regulations governing private-sector retirement plans. While not directly applicable to the public sector, ERISA is often recognized as providing best case designs across all employment sectors. Many public plans have vesting periods longer than the ERISA maximums. Vesting forfeitures and the decreasing value of frozen deferred benefits for public employees who leave before retirement eligibility clearly have a large negative impact on employees’ retirement security. 

While no single plan design will perfectly meet the needs of all employees as well as all employers and taxpayers, some newer public pension system designs can effectively address today’s realities of employee mobility while still providing for lifetime income security.

The backbone of new retirement plan designs is the advancement in financial technological capabilities that enable defined benefit-like investment and lifetime income solutions to be utilized at the individual plan participant level. Technology enables this optimization approach to be provided to individuals at a low cost compared to what it would have taken some years ago to provide the same capabilities. With this new retirement optimization approach, individualized retirement savings and benefits can be structured to more effectively adjust to changes in an individual’s career and life circumstances and provide flexibility to select the level of lifetime income needed to reflect differences in expected longevity, dependent needs, and the availability of other financial and income resources. This will both better meet employee needs and better manage costs for employers and taxpayers.

The traditional “one-size fits all”  defined benefit plan long favored by public retirement systems falls short of meeting the retirement security needs for too many state and local government employees, particularly younger, newer employees. Now is the time for policymakers to aim higher by focusing on their current retirement plan designs. Failure to do so may mean that a retirement plan will continue to fall short in providing optimal retirement options to new public workers to the detriment of employers, employees, and taxpayers.

The post Amidst great investment returns, public pension systems should reassess plan designs appeared first on Reason Foundation.

Despite these significant challenges, some states and cities provide good examples of what successful public pension reforms should look like. For example, the pension reforms made by Oklahoma between 2011 and 2014 have resulted in the public pension system being almost 100% funded in 2021.

Oklahoma Defined Benefit Pension Reform

In 2014, Oklahoma’s state legislature capped a multi-year effort to improve the funding and sustainability of the Oklahoma Public Employees Retirement System (OKPERS), which provides benefits for state and local government employees. The pension system was only 66% funded in 2010. A 2014 Reason Foundation interview with Oklahoma State Rep. Randy McDaniel summarized the two major changes made to OKPERS between 2011 and 2014:

• 2011 – Elimination of future cost-of-living adjustment (COLA) benefit increases without full advance funding, which reduced pension liabilities and improved funding levels from about 66% to over 80% on an actuarial asset basis.
• 2014 – Freezing the OKPERS defined benefit plan to new entrants after Nov. 2015 and creation of a new defined contribution plan – the Oklahoma Pathfinder Retirement Plan — for new hires after that date.

In the Reason interview, Rep. McDaniel outlined some of the key principles that led to these successful pension reform efforts, including “acknowledging the problem” and “teamwork”, but he put a particular emphasis on tenacity:

“The final issue is tenacity. Reforms were required if we were going to have a sustainable Oklahoma. We could no longer make excuses and turn our backs on a problem that was impacting all of our other funding priorities. There is no substitute for hard work and dedication to mission accomplishment.”

These public pension reforms, as well as the state’s proactive pension contribution and assumption policies, helped OKPERS improve its funding and reduce pension debt at an impressive rate.

In 2010 the system was only about 66% funded. But, a combination of actuarial assumption adjustments, legislative funding, and benefit changes dramatically improved the financial solvency of OKPERS in the last decade and the most recent actuarial reporting shows the system reached 99.5% funded in 2021.

Figure 1. Oklahoma PERS Unfunded Liabilities (2001 -2021)

How did Oklahoma achieve moving from 66% funding in 2010 to 99.5% funding in 2021 when many other public pension plans struggled to improve their solvency over that same period?

The keys to the state’s success include:

• Eliminating the automatic cost-of-living adjustments in 2011, which reduced OKPERS’ pension debt by $1.7 billion in a single year.
• Maintaining a 16.5% statutory employer contribution rate on total OKPERS and DC Pathfinder covered payroll, which exceeds the actuarial determined employer contribution rate of 13.41% (a surplus contribution of 3.09% of pay in the 2020 actuarial valuation). This provides a funding cushion against future actuarial negative experience. This cushion set the stage for the system to make real progress on eliminating pension debt by $360 million between 2006 and 2020.
• Continuing the 20-year closed amortization period methodology adopted in 2007 (which pays off unfunded liabilities more quickly).

The combination of these benefit changes and funding policies resulted in a nearly 100% funding level by 2019 (98.6%), which allowed OKPERS to take on additional de-risking measures. OKPERS reduced the investment return assumption (ARR) from 7.25% to 7.00% in 2017, and from 7.0% to 6.5% in 2020. The recent reduction to 6.5% increased reported unfunded liabilities by about $545 million and reduced the funded status from 98.6% to 93.6% in 2020. However, OKPERS significantly reduced the risks of unexpected growth in unfunded liabilities in the future by lowering its assumed rate of return.

The chart below provides a breakdown of the changes in unfunded pension liabilities by major category for the 2006-2021 period. The red bars indicate an increase in pension debt while the green bars indicate a reduction in liability.

Figure 2. Cause of OKPERS Pension Debt (2006-2021)

The Oklahoma “Pathfinder” Defined Contribution Plan

The design of the new Pathfinder defined contribution plan for new hires launched in 2015 received substantial consideration and debate by Oklahoma policymakers. Rep. McDaniels noted in the 2014 Reason interview how important it is that public pension plan design balance the needs of employees with sustainable and affordable contribution levels for taxpayers. The predictability of costs associated with the Pathfinder was also an important factor supporting the state’s ability to maintain adequate funding of the legacy defined benefit plan.

While defined contribution (DC) plans have been used as public retirement plans for many decades, not all DC plans meet the definition of an effective retirement plan. Reason has identified a few straightforward plan design principles, that when carefully incorporated into DC plans, serve to create a sound retirement plan that checks all the boxes.

The Oklahoma Pathfinder Plan meets many of these DC retirement plan principles including an adequate total contribution design. It provides a 6% employer contribution, a mandatory 4.5% employee contribution, and an additional employer match of 1% if the employee makes an elective 457(b) deferral of at least 2.5%. The 10.5%-to-14% contribution range meets what Reason Foundation’s Pension Integrity Project and most other retirement experts consider best practice, which is a 10%-15% total contribution rate.

There are, however, some remaining areas of improvement for Oklahoma’s defined contribution plan that could be considered by the state. Vesting in employer contributions is currently 20% per year with 100% vesting after five years of service. Shorter vesting periods are preferred as a best practice to help preserve retirement savings for shorter service employees.

Another concern is the plan does not offer any lifetime income solution for participants notwithstanding the authorizing legislation for the Pathfinder plan does allow the OKPERS Board to offer lifetime income solutions to Pathfinder participants. Oklahoma Statutes §74-935.9 provides in relevant part:

“In selecting investment options for participants in the plan, the Board shall give due consideration to offering investment options provided by business entities that provide guaranteed lifetime income in retirement such as annuities, guaranteed investment contracts, or similar products.”

While the statutory directive to the OKPERS Board is not prescriptive, it does indicate legislative intent that retirement income is an important consideration. The OKPERS Board has elected to only offer a participant-directed investment menu of mutual funds with a target-date series. The default investment is a custom-balanced fund. According to the most recent annual financial report, about 91% of assets are in the balanced fund, largely because of this default feature.

The summary of the investment policy statement in the annual financial report for the Oklahoma Pathfinder is wealth accumulation oriented with no focus on lifetime income as a plan objective. It provides the following purpose statements, which are focused on wealth accumulation:

1. “To provide participants with a prudent menu of investment options to diversify their investment portfolios in order to efficiently achieve reasonable financial goals for retirement.
2. To provide education to participants to help them build portfolios which maximize the probability of achieving their investment goals.”

The Pension Integrity Project recommends the state and the OKPERS Board consider making retirement income a formal objective for the Pathfinder plan with the addition of appropriate lifetime income solutions. Strengthening the current statutory language to provide more direct guidance to the OKPERS Board should also be considered.

Conclusion

The public pension reform efforts in Oklahoma are a success story that can guide other state and local governments as they address their own unfunded public pension plans. Oklahoma’s successful reforms can be partially attributed to being tenacious in pursuing sound funding policy for the legacy defined benefit retirement system, along with reforms to manage runaway costs for new members going forward. Such policy improvements preserved the promised benefits for those employees while ensuring a sound retirement plan for future employees. Also of note, Oklahoma did not view the 2011 and 2014 pension reforms as one-time efforts, but rather the beginning of a long-term and ongoing process of monitoring changing fiscal circumstances.

Oklahoma has remained willing to rake additional measures to ensure the resiliency of its public retirement system for the benefit of participating employers, employees, and taxpayers.              

The post Oklahoma’s pension reforms have led the state employees’ plan to full funding appeared first on Reason Foundation.

The Michigan legislature is currently considering two bills (House Bill 4733 and HB 4734) that bring the existing defined contribution plans for K-12 school employees and other public workers more in line with current retirement industry best practices.

One of the most important defined contribution design best practices is to provide an investment line-up that is focused on long-term retirement savings rather than simple near-term wealth accumulation.

Another best practice is helping an employee to receive an income throughout their retirement that they cannot outlive. Just providing for a lump-sum distribution of assets at retirement and leaving the employee to “figure it out” from there is inconsistent with some of the very reasons to offer a retirement plan.

These design principles address the critical concerns of investment performance and longevity risks that must be tackled by any retirement plan that hopes to meet its objectives. The bills in Michigan are intended to address both of these critical areas.  The bills state:

“In addition to the categories of investments provided by the investment board under subsection (1), the retirement system shall offer access to 1 or more fixed annuity options and may offer access to 1 or more variable annuity options provided by an annuity provider selected under this subsection. While a qualified participant is employed by the employer, the annuity options offered under this subsection must allow a qualified participant the ability to purchase a fixed rate annuity and an annuity with a guaranteed lifetime income option, and may allow a qualified participant the ability to purchase a variable rate annuity. Subject to subsections (4) and (6), the investment board shall select 2 or more annuity providers based on a competitive proposal process.”

Adding fixed and variable annuities to the investment selections available under the DC plans addresses the need to have long-term investments available to participants. It helps move the Michigan retirement plan to one focused on lifetime income and not solely on maximizing asset accumulation.  Further, the bills specify that a qualified participant must have the ability to purchase an annuity with a guaranteed lifetime income.

The key is that this provision enables the ability to purchase the lifetime income from within the plan during an employee’s time of service.  Without this ability, a participant wanting a lifetime income annuity would be forced to take a lump-sum distribution at retirement and then purchase an annuity on the spot market, where economic conditions may not be favorable.  Being able to purchase future income throughout the asset accumulation stage of a career and then convert to a lifetime payout annuity could very well result in better retirement outcomes.

Michigan’s defined contribution retirement plans have evolved over time and adopted a range of best practices for a well-designed public sector primary DC retirement plan. The improvements addressed in House Bill 4733 and HB 4734 would continue that tradition of ongoing retirement plan enhancement.  The investment offering and lifetime income provisions are two of the most important and impactful design elements in any retirement plan.  The improvements in these areas addressed in these bills greatly impact an employee’s ability to have a financially secure retirement, which also helps employers meet their recruiting and retention goals.

The post Annuity Offerings Can Help Improve Michigan’s Defined Contribution Retirement Plans appeared first on Reason Foundation.

If enacted Senate Bill 176 will close the current South Carolina Retirement System (SCRS) defined benefit plan to new entrants after June 30, 2021, and provide new hires a choice between a new “Shared-Risk Defined Benefit” pension plan and an improved version of South Carolina’s Optional Retirement Plan (ORP). The ORP, the defined contribution plan currently offered in the state, would be redesigned and renamed the “Wealth Builder – Primary Retirement Savings Plan” (WPRS) and would be the default retirement plan if an employee does not choose to opt-out of the plan within 60 days.

Since WPRS would become the new default retirement plan, it is important to assess its adequacy and ability to meet the needs of retirees and employers. Upon review, the Pension Integrity Project finds that the proposal reflects a high-quality retirement plan design that incorporates best practices from national experience.

While decades of experience with public sector defined contribution (DC) plans have demonstrated that they can be an effective means to providing adequate retirement income for public workers, not all DC plans meet the definition of an effective retirement plan.  There are a number of straightforward plan design principles that when carefully incorporated into DC plans serve to create a sound retirement plan that meets the needs of employees and employers.

The proposed WPRS retirement plan conforms to most of the best practices of public sector defined contribution plans, and other elements could be addressed to ensure the plan is as effective as possible.

Senate Bill 176 importantly avoids a shortcoming of many retirement plans by providing a formal statement of legislative intent and plan objective for the WPRS that is consistent with retirement best practices:

“The intent of the General Assembly is for the State of South Carolina WealthBuilder-Primary Retirement Savings Plan (WPRS) to be the primary retirement plan for participants of the state’s retirement system. The objective of the WPRS is to provide participants with a path towards having a secure retirement through a focus on lifetime retirement income in order to maintain a participant’s standard of living, following a full career of employment.”

This formal declaration of plan intent and objective is a critical guideline for the administrative and investment fiduciary for the WPRS and provides clear direction to the Public Employees Benefits Association (PEBA) as the plan administrator for the WPRS and the South Carolina Retirement System Investment Commission (RSIC) under PEBA, which is responsible for the investment structure.

The WPRS also satisfies the critical best practice of automatically enrolling eligible employees into the plan as well as providing adequate contributions. Retirement experts agree that a total contribution rate of between 10 percent and 15 percent is necessary over a career to adequately fund retirement (when combined with Social Security and personal savings). The WPRS contribution design of 16 percent (9 percent employee; 7 percent employer) for most employees would meet these best practice contribution standards.

The bill also allows an auto-escalation feature that would increase employee contributions by up to 1 percent per year up to a maximum employee contribution of 15 percent. The employer will also make matching contributions up to 2 percent for employee contributions made above 5 percent. If an employee maintains their default contribution, this would automatically trigger the full 7 percent employer contribution.  However, employees are allowed elect a minimum employee contribution of 5 percent, and if they chose to do so, the resulting 10 percent aggregate contribution rate that would still fall within the lower bound of benefit adequacy. That said, a higher floor for employee contributions, such as 7 percent, might be warranted to secure the ability to fund lifetime financial security in combination with Social Security and reasonable personal savings.

The investment structure for the WPRS has not yet been established. However, SB 176 does provide substantial guidelines by authorizing the use of a wide variety of investments under the plan including annuities, mutual funds and other similar investment products and professionally managed portfolio options. If these guidelines are followed there is a strong likelihood the retirement plan will provide a variety of investment options and allow participants the ability to create a portfolio that best meets their retirement needs.

One potential area of divergence from best practice is the multiple vendor configuration of the state’s current ORP, which would be retained under the WPRS. Vendors are the wealth management and financial firms that states contract to administer and manage defined contribution assets and benefits.  The large number of plan provider options currently offered in the ORP may be confusing for employees, and the current level of complexity is not necessary nor considered a best practice.  If the multiple vendor configuration is continued for the WPRS it is important to consider additional educational steps to ensure employees know what retirement income services each vendor provides.  For example, not all the vendors currently offer lifetime annuity solutions.

Under the proposed legislation, accumulations attributable to employer contributions into the WPRS are vested in the employee 20% per year with full vesting after 5 years of service.  This is a substantial change from the current 100% immediate vesting of the ORP.  While 5-year graded vesting is longer than desired, it is still shorter and provides better portability than the DB plan’s 8-year cliff vesting. Nonetheless, full and immediate vesting is best practice and would be preferred.

The distribution methods offered under the WPRS will depend on the vendor but will generally include annuities, full or partial lump-sum withdrawals and periodic payments.  SB 176 also requires at least one vendor provide lifetime fixed and variable annuity products but does not include a provision allowing PEBA or an employer to require annuitization of some or all assets.  This creates more flexible retirement income choices for employees, which is valuable, this approach also increases the chance that some employees may outlive their retirement assets from the plan.  PEBA and RSIC can address this shortcoming by emphasizing the income-focused and annuity options being provided and considering lifetime income investment options as the default.

Disability coverage in the WPRS is the same as in the DB pension plan. This is an improvement over the current ORP structure, which provides no disability benefit for ORP members. Employers are required to make separate contributions to help fund the benefit.  While the consistency between plans is good, the DB disability benefit is not available until an employee has eight years of creditable service, which seems excessive and not in line with best-practice standards.

Overall, the new default WPRS has an excellent foundation upon which to build a sound and effective modern retirement plan for public employees in South Carolina.

Full Senate Bill 176 Scorecard 

The post Evaluating South Carolina’s Proposed Defined Contribution Retirement Plan appeared first on Reason Foundation.

For traditional defined benefit pension plans, these common elements include a benefit accrual formula based on salary, years of service, and a benefit multiplier.

Defined contribution plans typically just focus on variations of employer and employee contribution amounts.

Retirement plan characteristics can also involve eligibility, participation, and vesting rules, as well as the rules for when benefits can be paid (e.g., normal and early retirement dates) and in what form (e.g., annuity, lump sum, periodic payments).

But are these elements enough to adequately address the many other factors that can greatly impact an individual’s ability to secure a financially secure retirement?

The Society of Actuaries 2011 report, Managing Post-Retirement Risks—A Guide to Retirement Planning, effectively listed the major retirement risks and factors that can impact an individual’s ability to have a financially secure retirement. These factors included:

• Longevity risk—outliving your retirement assets
• Investment risk—market losses can reduce retirement savings
• Interest rate risk—impacts market returns and annuity payouts
• Inflation risk—devalues fixed incomes
• Employment patterns and the effect on employer plan accruals—switching or losing jobs can create gaps in benefit accrual
• Business (employer) continuity and strength—the employer or company sponsoring the plan or annuity could go out of business
• Health care cost risk—including availability/local access to affordable caregivers and facilities
• Housing costs and needs—e.g., rent, property, taxes, and insurance
• Public policy risk—e.g., the funding of programs like Social Security and Medicare
• Marital and dependent status—including care for aging parents
• Homeownership—significantly affects net assets.
• Other unforeseen expenses

If one looks at the traditional defined benefit and defined contribution plan designs offered by governments today, it does not take long to conclude that many of these retirement security risks are either completely ignored or only partially or incidentally addressed in the typical retirement plan elements.

For example, a specific blind spot for defined benefit plans is their inability to account for worker mobility. The pension benefits in these plans can take 20-plus years to vest in and thus no longer serve today’s increasingly mobile workforce. For defined contribution plans, the most significant examples of risk are the management of investment and longevity risk of a retiree potentially outliving their savings.

The traditional definition of retirement benefit adequacy is a target retirement income is 70-90 percent of pre-retirement income. But this definition is also in need of examination because it ignores the reality and variability of actual expenses individuals may face in retirement, like growing health care and housing costs.

In these days of rapid-fire public pension reform and redesign efforts, overly simplistic proposals often fall short of addressing these broader measures of retirement risk for individuals. Policymakers are often too caught up in political battles and pension reforms rarely result in a significantly better public retirement plan that adequately meets the needs of employers and employees.

With all this in mind, is it necessary or appropriate to try and design retirement programs to address each and all these additional risk factors?

One might answer this question by looking at the venerable and sometimes misunderstood Pareto Principle, more commonly known as the 80/20 rule that states 80 percent of results come from approximately 20 percent of inputs or causes. Traditional retirement design would seem to say, “We are covering 80 percent of retirement income needs by including the major risks that make up about 20 percent of the variables that can be addressed, so it is not efficient or effective to try to do more.”

It is time to challenge and test this type of thinking. It should not be okay for retirement programs to accept that 20 percent of retirees’ needs are not going to be met. Even a cursory assessment of traditional defined benefit and defined contribution designs would conclude that many retirement security risk factors are not being adequately addressed.

A better way to think about public retirement plans could be to use another application of the same rule, a concept commonly known as Pareto Efficiency or optimality. Pareto Efficiency asks, can we address more retirement risk factors in the design of a retirement program without having undue negative impacts or costs? How can leading-edge plan-based technologies, big data, individual advice and financial planning services, investment management strategies, lifetime income solutions, and benefit portability features be more completely and efficiently included?

If policymakers ask those questions as they look to create the next generation of retirement solutions, it will become apparent that there are still unused tools, both new and old, that could help produce better retirement outcomes.

The post Addressing the Retirement Risks Facing Today’s Public Workers appeared first on Reason Foundation.

Around the latter part of the 20th century, the private sector began to move toward a defined contribution retirement plan design. With an aging workforce that was growing more mobile, the traditional defined benefit pension became difficult for employers to support financially and fewer employees were achieving a benefit in retirement that enabled them to sustain their desired standard of living.

In the public sector, however, the defined benefit plan has held on longer as the standard.

At first, this made sense, as there was less mobility among public sector workers, and lower salaries were able to be offset by richer benefits in retirement. Public employers generally saw the higher retirement income provided by pension plans as an acceptable tradeoff for lower salaries. Today, however, salaries are generally seen as essentially equal between the public and private sectors or, even higher in the public sector, and the mobility of the public workforce is similar to the private workforce.

Throughout this evolutionary process, many public sector-defined benefit plans have suffered financially due to poor design and ineffective political oversight.

Crippling unfunded actuarial liabilities, which are commonly referred to as pension debt, have grown to unsustainable levels. This causing the need for major pension reforms in states and municipalities across the nation. These reforms have included increasing the contributions made by public employers and employees into the pension plan; lowering the benefit tiers for new and future hires along with higher contributions from them; freezing cost-of-living increases; lowering the expected rate of investment return assumptions to more accurately account for the obligations promised to public workers; and many other types of changes to either slow the growth of runaway costs and pension debt or to increase the amount going into these funds each year.

Notably, because the modern employee rarely stays in a job long enough to fully, or even partially, vest in a public pension benefit, some of the reforms to debt-riddled pension plans are making them less and less desirable for public workers.

In many jurisdictions, the increasing costs and volatility of the traditional defined benefit plan have led policymakers to call for their state and local governments to switch to a defined contribution (DC) plans going forward.

Those arguing for a switch to DC plans argue about the increasingly harmful and unsustainable unfunded liabilities caused by defined benefit plans. They point out how high contribution requirements are cutting into spending on other critical governmental services, like education and infrastructure. They also highlight the inability of traditional defined benefit pension plans to meet the needs of a mobile, modern workforce.

Those in favor of keeping defined benefit pension plans say the lack of income guarantees in defined contribution plans, as well as the shift in investment risk from the employer/taxpayer to the employee, is harmful to workers. The defenders of defined benefit plans often portray the typical government employee as an unsophisticated investor, incapable of making the defined contribution plan work for themselves.

While a number of the arguments for and against defined benefit and defined contribution plans have merit, they fail to get to the root of the problems. Politicians and government officials frequently do a bad job of managing public pensions. And if poorly designed defined contribution plans are implemented in their place, some of the designs may threaten employees ability to support themselves in retirement

In state capitols across the country, the political battles over pension reform can be fierce. They often pit employee unions against legislators and taxpayer groups. In many cases, efforts at reform fall short in completely addressing the core issues that threaten the long-term success of a retirement plan. Decision-makers are left nibbling around the edges, adjusting earnings assumptions, and making difficult decisions about what other public services to cut in order to find the money for to make their legally-mandated pension contributions. These changes at the edges rarely represent a comprehensive fix to a pension plan’s structural problems. What’s worse, they often serve to kick the can a little further down the road.

It is time for public retirement plan stakeholders to get creative. Combining aspects of traditional defined benefit and typical defined contribution retirement plans to better meet the needs of all stakeholders is absolutely possible, despite being an option often overlooked by policymakers.

The priority of public retirement reform efforts should be finding effective solutions. Yes, out-of-control public pension debt is a significant problem. But it’s also a problem if states replace them with poorly designed defined contribution retirement plans that don’t offer employees the retirement security or income they think they’ll have. Neither issue should be ignored.

The long-term answer to government-sponsored retirement problems probably lies in taking certain aspects from defined benefit and defined contribution plans, combining them into unique structures that address employees’ long-term retirement needs while recognizing the very real funding concerns for employers and taxpayers. Such an approach could better balance the goals of taxpayers and retirees, providing at least some guaranteed income to employees, but avoiding out-of-control costs that plague many traditional defined benefit plans today.

Making the retirement reform process revolve around data and common goals improves the chances of implementing retirement benefits that work for both public workers and taxpayers.

The post Rethinking Public Employee Retirement Plans appeared first on Reason Foundation.