Copyright © 2013 GRS – All rights reserved.

DB vs. DCA False Choice in Retirement

Plans

Presented By:

James J. RizzoPiotr Krekora

Gabriel, Roeder, Smith & CompanyJim.Rizzo@gabrielroeder.com

Piotr.Krekora@gabrielroeder.com

Florida Government Finance Officers Association

Nature Coast Chapter

Citrus Hills Golf & Country ClubApril 16, 2014

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There had been a debate swirling around corporate and governmental employers for many decades as to which is better:

► Defined benefit (DB) retirement plans, or

► Defined contribution (DC) retirement plans

Let’s defined the terms first by examining their characteristics

DB Plans and DC Plans

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Traditional Defined benefit (DB) plans► Benefits paid are defined by formulas and rules► Contributions by employer are actuarially determined► Pension plans usually pay monthly pensions for life► Like the pension part of FRS► Like local police and fire pension plans► Like Social Security

Traditional Defined contribution (DC) plans► Employer contributions are defined by a formula► Account balance plans that credit interest equal to the

actual earnings of underlying investment assets► Like the Investment Plan part of FRS► Like 401(k) plans in the private sector► Like so-called 401(a) plans and 457 plans in the

government sector

DB vs. DC Debate

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Individual Account Balances Account Interest Credited Investment Risk* Predictability of Contributions* Unfunded Actuarial Accrued Liability* Retirement Planning* Longevity and Other Risks* Benefit Skew* Form of Benefit* Portability Vesting Funded Status Operational Expenses* Education and Communication * Most important

distinctions

Distinguishing Features

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DB vs. DC Comparison

Core Features(Page 1 of 2)

Individual Account Balances YesNo individual account balances, just a defined

benefit promise; pooled assets and pooled liabilities

Account Interest Credited Actual return of the underlying assets Not applicable

Investment Risk Borne 100% by the employee Borne 100% by the employer

Predictability of Employer Contributions 99% predictable

Much less predictable due to contribution being subject to investment performance and demographic

experience

Unfunded Actuarial Accrued Liability None Yes, if less than 100% funded

Retirement planning Unpredictable due to primary reliance on unpredictable investment earnings

Employees can plan on a predictable stated (or easily calculated) percent of pre-retirement income

Longevity and Other Risks Borne 100% by the employee Borne 100% by the employer

Traditional Defined Contribution (DC) Retirement Plans

Traditional Defined Benefit (DB) Retirement Plans

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DB vs. DC Comparison Core Features(Page 2 of 2)

Benefit Skew Benefits are skewed toward younger shorter service employees

Benefits are skewed toward older, longer service employees

Form of Benefit Almost always paid as a lump sumPaid as a lifetime pension with options for

survivorship

Portability Can be rolled over to an IRA; often not used for retirement income

Retained and paid as a lifetime pension upon retirement eligibility

Vesting Flexible in the design Flexible in the design

Funded Status Always 100% fundedFunding Policy determines funded status; rarely

100% funded

Operational ExpensesHigher investment-related expenses (in bps) than DB plans due to use of mutual funds, often subsidizing

recordkeeping and communications expenses

Lower total operational expenses (in bps) than traditional DC plans

Education and Communications

Employee education meetings and materials required for effective investment elections; often name-brand mutual funds, online information and investment

choices; quarterly account balance statements

Autopilot, little flair and fanfare; often unappreciated (until taken away)

Traditional Defined Contribution (DC) Retirement Plans

Traditional Defined Benefit (DB) Retirement Plans

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A hybrid plan is a single plan that has some features of a DB plan and some features of a DC plan

An arrangement with side-by-side DB and DC plans

► Two separate plans► This arrangement is not really a hybrid plan► Although some people use the term “hybrid” when

describing a side-by-side DB and DC► But consider a Toyota Prius – gasoline and electric in

one car

Two broad types of hybrid plans1. Cash Balance Plans2. Variable Benefit or Variable Annuity

Hybrid Plans

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1. Cash Balance Plans► “Looks” more like a DC plan (each member has an

account balance)► Implementations

• Recently proposed in State Senate for FRS, but more recently amended out

• At OUC and JEA (electric utilities in Orlando and Jacksonville), Cash Balance Plans in the last few years

• In some other states and jurisdictions outside Florida• At many private sector employers

► Employer contributes a fixed amount into each employee’s account; employee contributes as well

► Interest is credited to each account• Different plan designs credit interest differently• Interest credit is not permitted to equal the rate earned by the

actual underlying assets► Benefit is usually paid out in a lump sum at termination

or retirement; sometimes annuitized pension is permitted

Hybrid Plans

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2. Variable Benefit or Variable Annuity► “Looks” a lot like a DB plan (lifetime pensions paid)► Implementations

• State of Wisconsin• City of Ocala GE• Some private sector employers

► Monthly benefit amount varies depending on certain trigger points built into the plan design

• Investment Return Trigger - Some change the multiplier for the current year depending on investment returns for the year - higher multiplier for higher return; lower multiplier or zero for lower returns. Other plan designs pay additional “dividends” on benefits

• Employer Contribution Trigger - Some change the multiplier for the current year (or all years retroactive to transition date) in order to keep the employer contribution predictably within a pre-set corridor – higher multiplier for low employer contribution; lower multiplier for high employer contribution

Hybrids Plans

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Hybrid Features

Core Features(Page 1 of 4)

Cash Balance Variable Benefit

Individual Account Balances Yes YesSome designs have individual annuity

balances; some do not

No individual account balances, just a defined

benefit promise; pooled assets and pooled liabilities

Account Interest Credited Actual return of the underlying assets

Older designs apply a fixed rate or tied to short-term yields. Alternatively, can be partially related to actual return on underlying assets (e.g., with smoothing,

floors and caps)

Designs with annuity balances might index benefits to final average earnings,

while others index to CPI; and still others can be partially related to actual

return on underlying assets

Not applicable

Investment Risk Borne 100% by the employee

Older designs put 100% on employers; recent designs share the risks/rewards between employee and employer (e.g.,

floors and caps)

Some designs share the risks/rewards between employee and employer; while other designs put 100% of the risk on

employees.

Borne 100% by the employer

Predictability of Employer Contributions 99% predictable

Older designs are as unpredictable as traditional DBs; recent designs that

share risk have predictability in between traditional DBs and DCs

Less predictable than DC plans but more predictable than traditional DB

plans

Much less predictable due to contribution being subject to investment performance and

demographic experience

Traditional Defined

Contribution (DC) Retirement

Plans

Hybrid Plan Designs Traditional Defined Benefit (DB)

Retirement Plans

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Hybrid Features

Core Features(Page 2 of 4)

Cash Balance Variable Benefit

Unfunded Actuarial Accrued Liability None Yes, if less than 100% funded Yes, if less than 100% funded Yes, if less than 100% funded

Retirement planning

Unpredictable due to primary reliance on

unpredictable investment earnings

Some designs have ending cash balances that depend only on future

salary and are just as predictable as DB plans; but most designs depend mostly

or partially on unpredictable investment returns or yields

Some designs depend mostly or partially on unpredictable investment

returns, while others have future benefits that fall within a predictable

minimum and maximum

Employees can plan on a predictable stated (or easily calculated) percent of pre-

retirement income

Longevity and Other Risks Borne 100% by the employee

Almost always borne 100% by the employee Borne 100% by the employer Borne 100% by the employer

Benefit SkewBenefits are skewed

toward younger shorter service employees

Skewed toward younger shorter service employees

Skewed toward older, longer service employees

Benefits are skewed toward older, longer service

employees

Traditional Defined

Contribution (DC) Retirement

Plans

Hybrid Plan Designs Traditional Defined Benefit (DB)

Retirement Plans

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Hybrid Features

Core Features(Page 3 of 4)

Cash Balance Variable Benefit

Form of Benefit Almost always paid as a lump sum

Almost always paid as a lump sum, unless prevented from doing so by plan

design

Paid as a lifetime pension with options for survivorship

Paid as a lifetime pension with options for survivorship

PortabilityCan be rolled over to an IRA; often not used for

retirement income

Can be rolled over to an IRA; often not used for retirement income

Retained and paid as a lifetime pension upon retirement eligibility

Retained and paid as a lifetime pension upon retirement eligibility

Vesting Flexible in the design Flexible in the design Flexible in the design Flexible in the design

Funded Status Always 100% fundedFunding Policy determines funded

statusFunding Policy determines funded

status

Funding Policy determines funded status; rarely 100%

funded

Operational Expenses

Higher investment-related expenses (in bps)

than DB plans due to use of mutual funds,

often subsidizing recordkeeping and communications

expenses

Lower total operational expenses (in bps) than traditional DC plans;

approximately same as traditional DB plans

Lower total operational expenses (in bps) than traditional DC plans;

approximately same as traditional DB plans

Lower total operational expenses (in bps) than traditional DC plans

Traditional Defined

Contribution (DC) Retirement

Plans

Hybrid Plan Designs Traditional Defined Benefit (DB)

Retirement Plans

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Hybrid Features

Core Features(Page 4 of 4)

Cash Balance Variable Benefit

Education and Communications

Employee education meetings and materials required for effective investment elections;

often name-brand mutual funds, online

information and investment choices; quarterly account balance statements

Minimal employee communications, but depending on method of crediting

interestinterest; quarterly or annual account balance statements

Employee education is needed for how accrual multipliers might vary

Autopilot, little flair and fanfare; often unappreciated

(until taken away)

Traditional Defined

Contribution (DC) Retirement

Plans

Hybrid Plan Designs Traditional Defined Benefit (DB)

Retirement Plans

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Primary motivations for moving from DB to DC plans1. “The corporate world has moved from DB to DC

plans.”2. “ We got rid of our DB plan where I work(ed).”3. “I never had a DB plan; neither should they.”4. “ The conservative think-tanks and legislatively active

organizations say we should move to a DC plan.”5. “My political party leaders say DB plans are bad.”6. “DB plans are more dangerous than DC plans in the

hands of politicians.”7. “I don’t trust elected officials to stand firm against the

unions by not refusing retroactive benefit improvements for DB members.”

8. “Employer contributions to our DB plans have become unbearably and unreasonably high.”

9. “Employer contributions need to be more predictable.”

10. “Employer (taxpayers) should not bear the investment risk.”

Hybrids Plans

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Driving principles from City Council

► Roll back future benefits to bend the cost curve soon

► Future benefits should resemble FRS

► Share risks between employees and employer

► Make employer contributions more predictable

Case Study: City of Ocala GE

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Bend the expected cost curve

► Changing benefits for new hires alone will take a very long time to bend the expected cost curve

• So putting in a DC plan for new hires alone won’t do much• Putting in a new DB formula for new hires alone won’t do much

► Must change benefits for all employees (current and new) in order to bend the expected cost curve in a reasonably short time

• Either all in a DC or• All in a less generous benefit structure for future service

► Not permitted to roll back benefits for current retirees or for current active employees eligible for normal retirement

► Not permitted to roll back benefits retroactively, i.e., cutting accrued benefits below what active employee have earned now

Case Study

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Bending the expected cost curve

► Freeze the benefits for current actives at what they earned as of the transition date; call it Part A

► Start the new and less generous benefit structure for future service; call it part B

► Final benefit is Part A plus Part B

Case Study

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Make the employer contribution more predictable . . .

By sharing the risk with employees► Moving to a DC plan for new hires alone will take a

very long time to share the risk► Not permitted to share the risk with current retirees or

with current active employees eligible for normal retirement

► Not permitted to share the risk on benefits earned at transition

Part B benefit structure is the hybrid plan design► Part B monthly projected benefit can go up or down,

depending on the trigger mechanism, thereby sharing the risk and reward

► Part A monthly benefit is fixed and frozen at the transition date

Case Study

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Case Study

Without a VBH feature in the legacy DB plan -- It will take over 40 years to reach a 50-50 risk-sharing with employees; in 20 years City/taxpayers still bear 85% of investment risk

0%

50%

100%

0%

50%

100%

2022 2032 2042 2052 2062 2072

Total Risk-sharing ComparisonClosed DB plus DC for New HiresWith and Without VBH Feature

Closed DB w/ VBH plus DC for New Hires Closed DB w/o VBH plus DC for New Hires

Employees Bear 100% Risk

City/taxpayers Bear 100% Risk

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Part B starts out with a 1.6% multiplier, like FRS Regular Class

► Multiplier can go up, but not above a cap of 2.55%

► Multiplier can go down, but not below a floor of 1.0%

► Depending on the level of the actuarially required contribution

► As long as the actuarially determined contribution (ADC) stays within a pre-set employer contribution budget, the multiplier remains unchanged; improves predictability

► Makes the employer contribution more predictable

Case Study

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If the ADC were to go above the top of the budget corridor:

► The multiplier is reduced in order to keep the ADC inside the corridor

► Employee bears the risk above the corridor.

If the ADC were to go below the bottom of the budget corridor:

► The multiplier is increased in order to keep the ADC inside the corridor

► Employee reaps the reward below the corridor

Makes the employer contribution more predictable by sharing the risk (and reward) with the employee

Case Study

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Proj

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ontr

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ay

Fiscal Year Ending

Total Projected City ContributionsClosed DB Plan with Future Benefits Rolled Back to 1.6%

With 8% DC Plan for New HiresPositive and Negative Stresses at Year 11 Outside the VBH Corridor

Corridor City Alternative 2

Stress Test on City Alternative 2 Better than Expected Asset Returns on City Alternative 222

Case Study

Witha VBHFeature:

BudgetCorridor

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This presentation shall not be construed to provide tax advice, legal advice or investment advice.

Readers are cautioned to examine original source materials and to consult with subject matter experts before making decisions related to the subject matter of this presentation.

This presentation does not necessarily express the views of conference sponsor, nor Gabriel, Roeder, Smith & Company, and may not even express the views of the speaker.

Disclaimers

Questions

and

Answers ?

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