Defined Contribution Retirement Plan: Good for Workers

Kent Gardner“And which retirement plan do you want?” Retirement?!! As a newly appointed Assistant Professor of Economics at Potsdam College of SUNY, I was 28 and starting my first real professional job. I was being asked to make a decision that would have little impact on my life for 37 years.

I was offered two options: The first was the NYS Employee Retirement System (ERS). If I stayed in state service and retired at age 65, I would be eligible for annual benefits equal to 70.5% of my final average salary (defined as the highest salary earned in three consecutive years). My contribution would have been 3% of salary for the first ten years. The remainder of the cost would be paid by the state. This is what is called a “defined benefit” retirement plan. Regardless of what happens to the invested money, NYS promises to pay out a specified benefit for as long as I live.

Or I could select the SUNY Optional Retirement Program (ORP). I would pay the same 3% of gross salary for the first 10 years. The state would contribute 9% of salary for the first $16,500 (today’s plan) and 12% of salary over that sum. I would be free to invest this sum however I chose. And, of course, live with the consequences. This is a “defined contribution” retirement plan. The state pays into my fund while I’m working but bears no responsibility for me after the payment is made.

If Governor Cuomo’s new Tier VI pension plan is approved by the NYS Legislature, every newly hired state and local worker will have the option now offered only to State University and City University employees.

Which plan is more generous? I thought I’d try to answer that question for the young Professor Gardner. The answer depends on three principal assumptions. First, how would my salary grow over time? This affects contributions to ORP and the all-important final salary calculation for ERS. Sneaking a look at the salaries of former Potsdam College colleagues (using EJ McMahon’s excellent SeeThroughNY website), it appears that their salaries have grown at a compound annual growth rate (CAGR) of around 3.5%. The second key assumption is the CAGR of my investments (if I chose the defined contribution plan). Did I make smart or dumb investment decisions? Finally, how long will I live after retirement? Were I to live to 100, then the defined benefit plan would be the way to go. But if I were to die two years after retirement at age 67, my heirs would get little and I would have lost the bet.

Retiring at age 65, living to age 85 and earning CAGR of 7.5% on my ORP investments would make the defined contribution plan roughly equal to the defined benefit plan. As a point of reference, the S&P 500 experienced CAGR of about 11% from 1983 to the present.

Back in 1983, however, the young Professor Gardner didn’t hesitate. “Sign me up for the defined contribution plan.” And I didn’t bother doing the math. At age 28, I couldn’t imagine that I would stay in the same job for my entire career or that I would work for state or local government in some capacity for 37 years.

The state’s defined benefit plan can be a life sentence for public employees. In my case, I was invited to come to join CGR in 1991 and resigned my tenured faculty appointment with SUNY. Had I selected the state’s defined benefit plan, those years would have contributed little to my retirement. While I could take with me the 3% of salary I’d contributed, my “retirement” from NYS would be delayed until age 55 (with a penalty) or 62 and would be based on my earnings in the 1980s. Instead, I left with my TIAA-CREF investment account intact. I still own the account and I have retained the power to invest it as I choose.

State workers all know that longevity matters. Many of my friends in state service confess that they would love to explore a job in the private sector—but that leaving before age 62 or until they’ve reached 30 years of service is just too costly. And with that attitude, perhaps their agency would also like to see them go. But instead they hang onto each other, like a couple that won’t break up because the sex is still good.

There’s another problem: I know a state worker who loves his job and would like to stay. But he’s fully vested—the share of final pay he’ll earn in retirement won’t improve if he works longer. If he retires, he and his wife can opt to share his retirement benefit and she’ll be well-cared for until her death. If, however, he dies before he retires, the death benefit she’ll receive will be, at most, three years of salary and her future will be at risk. So he’s retiring …

Finally, the defined benefit plan makes it difficult to enter public service temporarily. Were I to take a position with state or local government (except for SUNY and CUNY), I would accrue no retirement benefit at all unless I stayed for five years or more. Financially, I’d have to be offered a substantially higher salary to offset the contribution to my retirement now made by CGR.

So we have a system that traps workers who would like to leave, pushes out workers who would like to stay, and limits government’s ability to recruit seasoned professionals from the private sector. While a defined contribution system has its disadvantages, the defined benefit plan exercises a pernicious influence over the career decisions of our civil servants. Let’s offer new public sector workers a choice.


13 Comments

  1. Tom Gillett Says:

    Governor Cuomo’s Tier VI is not the same choice you were given all those years ago!

  2. Kent Gardner Says:

    I’m sure that you have a better understanding of the details here than I do–but my central point is that ERS is a pretty rotten deal if you choose to leave state employment in less than a lot of years. Tier VI would have to be really horrible to be worse than ERS for someone who works in the public sector for 10 yre or less. At least you get SOMETHING when you leave. With ERS, you get almost nothing.

  3. Paul Haney Says:

    Your analysis assumes contributions by the State of 9% and 12% to the DCP – that is history but not bloody likely in the future. You also assume that the S&P performance of 11% from the period of 1983 to the present will be the norm for the future. I sure wouldn’t want to assume that for my future retirement planning (I think 6% will be optimistic – post financial collapse, this is a new era). What has the S&P return been for say the last 6 or even 10 years? The landscape is littered with people who saw their DCP retirement benefits vanish in the financial collapse. And what about people like the Global Communications employees who saw their DCP plans vanish? In the private sector, DBPs are guaranteed by the federal govt. – DCPs are not. The massive movement in the last 10 years from DBPs to DCPs is one of the social travesties of this era.

  4. Groups layout support for pension reform as Cuomo escapes the shill label | The Empire Says:

    […] the centrist Center for Government Research, CGR’s lead economist Kent Gardner wrote a blog post extolling the virtues of the SUNY-style pension system via his personal […]

  5. Dan Ross Says:

    I have had both (TIAA-CREF early in my career and NYS retirement later). Your points about advantages of defined contribution are well taken–especially about locking in some benefits early in career and flexibility. However I think it requires, at the very least, really good education and counseling to help people avoid two risks–being too risk aversive early in their careers and too risk tolerant later since performance risk is shifted from the organization to the individual. I have got to think that with some creativity we could come up with a hybrid that would have some of the benefits of each.

  6. Peter A. Korn Says:

    Both Paul Haney and Dan Ross have hit the nail on the head. The issue is not really about mobility, but about providing a decent end-of-career pension for public workers, few of whom leave their local communities or state after starting a career. That also goes for the great majority of SUNY professors. The real concern is that DCPs don’t work, especially for the average worker-highway laborer, cafeteria worker, nurses aide and teacher/professor- who hasn’t the faintest idea how to invest for any purpose. Just ask the educated SUNY profesors, assistant school supts., physicians and associate personnel technicians who saw their retirement accounts wiped out in the past 3 years. Some never had much anyway because they were risk averse and put their contributions into money market funds or CDs. Without highly knowledgeable investment specialists with communication lines into Wall Street, retirement contributions won’t go up by 6-9%/year. Forced into DCPs, the average civil servant in NYS will surely be working until 75, as their grandparents did before social security.

  7. Kent Gardner Says:

    I hear you–and I’m not claiming that DC plans are perfect. But the benefit of portability is significant. When I signed up for my DC plan originally, I had exactly two choices–the CREF bond fund and the TIAA equities fund. Seems to me that the early 401(k)/IRAs had pretty limited choices, too. But we consumers clamored for choice and now we have the freedom to “invest” however we choose. Which most of us like, and not just folks with advanced degrees.

  8. Peter A. Korn Says:

    The benefit of portability is significant for the insignificant few who seek mobility outside NY local/state service or outside the state. The NYS Retirement System was established to provide a portable pension in NYS to those who spent their careers in government.It also rewarded loyalty and encouraged long service. Nothing wrong with that. I think you generalize from your personal desire and experience: “we clamored for choice”, “have freedom to invest” which “most of us like”. When did Rochester/Monroe County employees clamor for investment choice or freedom to invest? I’ve never heard it from downstate government employees, and now its the private sector folks who lost their pensions and were forced into 401-k plans who insist civil servants go on the same financial suicide mission they’re headed for.

  9. Kent Gardner Says:

    Certainly the stats on career churn among the young suggest that the kind of stability rewarded by a DB benefit is far less common than it used to be. Surely we can all agree that portability across public & private sectors would be a good thing. This is what’s wrong with providing health care through employers, too. A single payer system would improve labor mobility.

  10. Kris Berg Says:

    I have a question, the tia cref plan is based also on a annuity
    which is designed to protect retirees from outliving their savings atleast according to promoters, how does that portion
    work, I presume that after you stop working for the state they state no longer contributes , but with the defined benefit the state keeps contributing , although you have to stay long, vesting is only 5-10 years, so you can still get the defined benefit
    and use your 401k.

  11. Kent Gardner Says:

    You’ve asked several questions–can’t answer all of them. But let me help separate them out.

    The two big buckets are defined benefit v. defined contribution. TIAA-CREF is defined contribution–the state deposits money ONLY WHILE YOU ARE EMPLOYED and you get to use it when you retire, according to the rules established.

    You can put the money into a mutual fund and spend it until it is used up or save it and pass it to your heirs.

    You can also use this money to buy an annuity that is designed to pay you as long as you live. By “designed” I mean that you give the money to an insurance company and they estimate how long you’ll live and divide the money accordingly. So if your life expectancy is 20 years, they take the sum and give you 1/20th every year no matter how long you actually live. If you die next year, they only pay out one year and the company keeps the rest. If you live for 30 years, you still get 1/20th until you die–and the company loses money on you. If they estimate accurately, however, everything evens out for the company over a large number of people.

    In real life, it is more complicated than this. They have to estimate more than just your life expectancy. And they skim off a portion of the money for profit and a bit more to secure their profit just in case they’ve guessed wrong.

    But you don’t HAVE to purchase an annuity with a defined contribution retirement pool. I’ve a TIAA-CREF account that was started when I was a SUNY professor and the money is in an ordinary mutual fund.

    For a defined benefit plan, there is a contribution made to the state retirement fund while you are working, but the dollars don’t have your name on them. The sum paid in by the state or local government is determined partly by total salaries (yours being one of those salaries) and partly by how much money is already in the state pension fund. Back when the stock market was doing very well, the contribution required was actually close to zero for a year or two. Then when the market fell, the contribution rate rose quite a bit.

    How much you get out of the state retirement system depends solely on the benefit rules passed by the NYS Legislature. They have the power to decide what portion of your salary you get in retirement, how many years count in figuring your final average annual salary, how long the vesting period is, whether overtime counts for final average annual salary, etc. The NYS Comptroller’s office has to figure out how much money has to be in the pension plan to cover the sum that will have to be paid out for you.

  12. Kris Berg Says:

    I didn’t meant to bombard you with questions as I have researched the issue a bit, what I wanted to know in which answered
    was whether the annuity makes sense, that is since a defined benefit plan exists until you die
    whereas a dc does not, does the higher employer contribution equalize, for instance its kinda of like taking benefits early for ss at 62 but what happens if you live past say 78, in the case of a DC you have to save enough
    to cover extra life expectancy.

    A slight confusion was with a fers annuity, the federal government has a DC which replaced the DB, the annuity is half of the DB, but there is a DC thrift savings plan.

    I also found out that the DC plan is not adjusted for inflation, the cost of living index is only 1/2 the cpi, and while the min is 1%, max is 3%,
    this pensions are losing value, correct if investments are not beating inflation?

  13. Kris Says:

    The defined contribution plan is no longer generous as before and it has been watered down a bit repeatedly , if a state worker
    intends to go for a long time but 10 years instead of 20, the orp
    will not be attractive, so is the orp just an attractive option
    for temporary already mobile employees rather than than a true alternative to ers/trs, the federal government designed its system to have a dc as the alternative to the previous db, an annuity was cut in half and a thrift savings plan which is similar to the orp was added.

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