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Straight Talk: The DB Versus DC Pension Problem

Straight Talk: The DB Versus DC Pension Problem 

The DB Versus DC Pension Problem

 

By Orange County Supervisor John Moorlach

 

For some reason a Rosanna Rosanna Danna skit comes to mind. “What’s this I hear about the AC/DC pension problem?” “That’s the DB versus DC pension problem.”  “Oh, never mind.”

 

What's the difference between a defined benefit and a defined contribution pension plan? If we’re in a major debate over traditional pension plans, what are we talking about?

 

A defined benefit (DB) pension plan provides for a formula that is effective at the time of retirement. Let’s use a male public safety employee (Deputy Sheriff) as an example. If he starts at age 25 with a “2% @ 50” formula, then 25 years later, he can retire at age 50 with half of salary (2% X 25

years) for the remainder of his lifetime, plus an annual 3 percent cost of living adjustment (COLA).

 

A defined contribution (DC) plan sets aside a specific percentage of an employee’s salary during his or her employment.  The most common DC plan is funded by employee contributions through payroll withholdings and may include matching contributions by the employer. This is commonly

known as a 401(k) plan.

 

With a DC pension plan, the employee takes the risk of the investment returns during his or her lifetime. For a DB plan, the employee does not; instead the employer takes the risk by guaranteeing that a certain formula, plus COLA, will be paid out for the remainder of the employee’s life.

 

In order to establish a DB plan, the employer will need the assistance of an actuary. The actuary will inform the employer of the contributions that must go into the pension plan every year in order to accumulate enough funds to meet the retirement obligation when the employee severs his services.

 

Let’s imagin

Straight Talk: The DB Versus DC Pension Problem

The DB Versus DC Pension Problem

By Orange County Supervisor John Moorlach

For some reason a Rosanna Rosanna Danna skit comes to mind. “What’s this I hear about the AC/DC pension problem?” “That’s the DB versus DC pension problem.” “Oh, never mind.”

What's the difference between a defined benefit and a defined contribution pension plan? If we’re in a major debate over traditional pension plans, what are we talking about?

A defined benefit (DB) pension plan provides for a formula that is effective at the time of retirement. Let’s use a male public safety employee (Deputy Sheriff) as an example. If he starts at age 25 with a “2% @ 50” formula, then 25 years later, he can retire at age 50 with half of salary (2% X 25

years) for the remainder of his lifetime, plus an annual 3 percent cost of living adjustment (COLA).

A defined contribution (DC) plan sets aside a specific percentage of an employee’s salary during his or her employment. The most common DC plan is funded by employee contributions through payroll withholdings and may include matching contributions by the employer. This is commonly

known as a 401(k) plan.

With a DC pension plan, the employee takes the risk of the investment returns during his or her lifetime. For a DB plan, the employee does not; instead the employer takes the risk by guaranteeing that a certain formula, plus COLA, will be paid out for the remainder of the employee’s life.

In order to establish a DB plan, the employer will need the assistance of an actuary. The actuary will inform the employer of the contributions that must go into the pension plan every year in order to accumulate enough funds to meet the retirement obligation when the employee severs his services.

Let’s imagine that you are the actuary. First you would have to make some significant assumptions.

? How much will the funds in the pension plan earn during the employee’s earning and retirement years? Let’s assume an average annual return of 7.5 percent. This assumption is on the low side for a public employee DB pension plan, but on the high side for private sector DB plans.

?You will also have to assume how long will the employee be with the employer? For a Deputy Sheriff you can assume a starting age of 25 and a retirement age of 50 – 25 years of service.

?How long will the employee live? The average life expectancy is approximately 78 years, but let’s use 80 years as medical science is improving.

?What will be the employee’s annual increase in pay? Let’s assume 4 percent. One would think this is a high annual increase in salary, but it is lower than the experience rate at the County of Orange. In recent years, the County has significantly increased the retirement formulas and reduced the minimum retirement ages. Consequently, the County has experienced an exodus of employees qualifying for retirement. This has caused the remaining employees to advance in the corporate structure and receive higher than normal salary increases.

?How much will the public safety employee chip into this equation? Let’s assume 6 percent of salary.

What about inflation? To make your first lesson a little less complicated, let’s assume zero inflation.

The Deputy Sheriff starts at a salary of $50,000 per year at age 25. By age 50, the Deputy Sheriff is earning $133,292 per year. In order to accumulate enough money in 25 years to pay this retiree “2% @ 50” in the 26th year at age 51, plus a 3 percent annual COLA, the employer will need to have $1,161,997 set aside. This will take the employee’s 6% annual contribution, plus an employer contribution of 14%, plus an average annual net investment return of 7.5%.

The first annual benefit will be $66,646 and by age 80 the benefit will be $157,055. If all goes as planned, the funds will be exhausted in the retiree’s 81st year.

Now that we’ve plugged all of this information into a spreadsheet, what have we learned? The Deputy Sheriff earns $2,215,587 in wages during 25 years of service to the County. Then $3,332,474 will be earned during the remainder of his or her lifetime in retirement benefits; all for an employee investment of only $132,935.

If all of these assumptions were applicable to the DC plan, the net payouts would be identical. So where’s the rub? There are several. The first is that retirees are living longer, so you will run out of the funds accumulated before the conclusion of the guaranteed income stream.

The second rub is the granting of benefit enhancements in the middle of the game. Let’s say that the formula was improved from “2% @ 50” to “3% @ 50” in the employee’s 25th year of employment. One would expect such a benefit enhancement to be prospective, but in the government world, logic is scarce and this benefit is made retroactive to the date of hire. Now the employer needs $1,742,995 accumulated by the 25th year and is $580,998 short! Using this example, you can see why Orange County’s contribution rates have risen from around $50 million per year at the beginning

of this decade to more than $330 million per year at the end of it.

Multiply the $580,998 shortage by 1,800 impacted employees and we’re talking a billion dollars! Take that debt at 7.5 percent over 30 years, and you can add another $1.5 billion in interest costs! While the taxpayers are trying to figure out how to pay this debt, the Deputy Sheriff will now receive

$4,998,711 in retirement benefits for the same investment of only $132,935.

That is why, as an elected official, I’m interested in rescinding the granting of retroactive benefits and negotiating back to the old formula (“2% at 50”). As my mother used to say, “I am not made of money.” Neither are the taxpayers of Orange County. That’s why moving the County toward DC

plans and addressing the egregious enhancements through a roll back is so critical to pursue. The alternatives are bankruptcy filing or reductions to retiree benefit payouts due to the lack of funds. That’s the DB versus DC pension problem.

e that you are the actuary. First you would have to make some significant assumptions.

e that you are the actuary. First you would have to make some .

 

? How much will the funds in the pension plan earn during the employee’s earning and retirement years? Let’s assume an average annual return of 7.5 percent. This assumption is on the low side for a public employee DB pension plan, but on the high side for private sector DB plans.

 

?You will also have to assume how long will the employee be with the employer? For a Deputy Sheriff you can assume a starting age of 25 and a retirement age of 50 – 25 years of service.

 

?How long will the employee live? The average life expectancy is approximately 78 years, but let’s use 80 years as medical science is improving.

 

?What will be the employee’s annual increase in pay? Let’s assume 4 percent. One would think this is a high annual increase in salary, but it is lower than the experience rate at the County of Orange. In recent years, the County has significantly increased the retirement formulas and reduced the minimum retirement ages. Consequently, the County has experienced an exodus of employees qualifying for retirement. This has caused the remaining employees to advance in the corporate structure and receive higher than normal salary increases.

 

?How much will the public safety employee chip into this equation? Let’s assume 6 percent of salary.

 

What about inflation? To make your first lesson a little less complicated, let’s assume zero inflation.

 

The Deputy Sheriff starts at a salary of $50,000 per year at age 25. By age 50, the Deputy Sheriff is earning $133,292 per year. In order to accumulate enough money in 25 years to pay this retiree “2% @ 50” in the 26th year at age 51, plus a 3 percent annual COLA, the employer will need to have $1,161,997 set aside. This will take the employee’s 6% annual contribution, plus an employer contribution of 14%, plus an average annual net investment return of 7.5%.

 

The first annual benefit will be $66,646 and by age 80 the benefit will be $157,055. If all goes as planned, the funds will be exhausted in the retiree’s 81st year.

 

Now that we’ve plugged all of this information into a spreadsheet, what have we learned? The Deputy Sheriff earns $2,215,587 in wages during 25 years of service to the County. Then $3,332,474 will be earned during the remainder of his or her lifetime in retirement benefits; all for an employee investment of only $132,935.

 

If all of these assumptions were applicable to the DC plan, the net payouts would be identical. So where’s the rub? There are several. The first is that retirees are living longer, so you will run out of the funds accumulated before the conclusion of the guaranteed income stream.

 

The second rub is the granting of benefit enhancements in the middle of the game. Let’s say that the formula was improved from “2% @ 50” to “3% @ 50” in the employee’s 25th year of employment. One would expect such a benefit enhancement to be prospective, but in the government world, logic is scarce and this benefit is made retroactive to the date of hire. Now the employer needs $1,742,995 accumulated by the 25th year and is $580,998 short! Using this example, you can see why Orange County’s contribution rates have risen from around $50 million per year at the beginning

of this decade to more than $330 million per year at the end of it.

 

Multiply the $580,998 shortage by 1,800 impacted employees and we’re talking a billion dollars! Take that debt at 7.5 percent over 30 years, and you can add another $1.5 billion in interest costs! While the taxpayers are trying to figure out how to pay this debt, the Deputy Sheriff will now receive

$4,998,711 in retirement benefits for the same investment of only $132,935.

 

That is why, as an elected official, I’m interested in rescinding the granting of retroactive benefits and negotiating back to the old formula (“2% at 50”). As my mother used to say, “I am not made of money.” Neither are the taxpayers of Orange County. That’s why moving the County toward DC

plans and addressing the egregious enhancements through a roll back is so critical to pursue. The alternatives are bankruptcy filing or reductions to retiree benefit payouts due to the lack of funds. That’s the DB versus DC pension problem.