Saving Public DBs a Matter of Pension Fund Math

In a paper published by the Callan Investment Institute, Callan Associates Chairman and CEO Ron Peyton and Senior Vice President and Consultant in the Capital Markets Research group Karen Harris say DB plans are proven to be extremely cost effective and reliable in delivering basic retirement income security—when the rules of DB finance are followed.

“The National Institute for Retirement Security wrote a paper in 2008 that evaluated the cost of funding a DB versus a DC [defined contribution] plan, and found the cost of funding retirement income in a DB plan was 48 cents on the dollar of the cost of creating the same retirement income in a DC plan,” Peyton tells PLANSPONSOR. “It’s hard to believe until you think about how DBs are set up. DBs pool contributions and savings, and also pool mortality—employees don’t have to save as much to cover their longevity.”

He also notes that DB plan investments are better managed institutionally so they have lower costs, and says there are large return differences between investments managed by individuals versus commingled funds. The Callan DC Index reveals DB plans have outperformed DC plans by an annualized 78 basis points since 2006.

In DC plans, individuals have to figure out how much to save and how to invest to cover the possibility of living to 95 on their own, Peyton adds. “They have to be both a disciplined saver and a disciplined investor, and how many people are that?” he queried.

In several states where legislators have suggested moving public workers from DB plans to DC plans, studies have warned that the move would be costly and not produce intended results.

As the funded status of public employee DB retirement plans continues to garner debate in the industry and press, the goal of saving these plans is urgent, Peyton and Harris contend in the paper. They state that many public DB plans are underfunded today, but not because of paltry long-term returns. It is primarily because plan sponsors’ contributions were neither sufficient nor consistent enough to properly fund the benefits promised.

“Public plans just need to be disciplined,” Peyton says. “If you grant benefits, at the same time you have to put money away at the plan’s assumed rate of return so the liabilities will be covered.” He notes that liabilities compound just as investment returns do, so if plan sponsors promise liabilities, but don’t fund them right away, the liabilities will ramp up rapidly over 20 years, but the assets in the plan will not keep up.

If promised benefits haven’t been paid for up front, plans need to put in a funding scheme to pay for them over the long-term, Peyton says. He points out that public DB plan sponsors cannot just depend on market returns to fund liabilities;  average returns is all one can expect over the life of the plan—at times the market will outperform the assumed rate of return, but at other times it will underperform.

In response to the effect of the recession and market conditions over the past several years, many public funds have lowered their rate of return assumptions. The average now stands at 7.75%, down from 8% in 2012. A recent study suggests plan may need to further lower their assumptions, but Peyton doesn’t agree.

“An assumed rate of 7.75% hasn’t been too high in the past; assumptions have been achieved if you look at history. The average public fund in our database has earned 8% over the last 30 years,” he notes. “It’s not the actuarial funding rate that’s the problem, the problem has been that contributions are not there.” Despite market volatility, the public funds that have made the necessary contributions are nearly all fully funded right now, he adds.

According to the paper, “Saving Public Defined Benefit Plans,” healthy DB plans are underpinned by a sustainable benefit design, a strong governance process, and the sponsor’s commitment to regularly fund the plan. “Don’t give up, it’s a battle, but it’s a worthy cause,” Peyton says.

It requires employers paying their required annual contributions, benefit improvements being funded when adopted, and getting rid of spiking measures (double overtime in final years, for example), and looking forward, being reasonable with mortality rates, Peyton suggests.  “There are things that can be done that are common sense—obey pension fund math.”

The paper points out that:

• Large DB plans are critical to well-functioning capital markets. By their sheer size, they can drive markets, command economies of scale, and also advance social and shareholder rights agendas. Through private investments, they are able to seed new companies and technologies.
• When retirees spend pension payments they support state and local economies. These amounts may be critical to sustaining small and rural communities.
• For state systems that opted out of Social Security, the DB plan is the only means for guaranteed lifetime income.

Peyton says the paper is intended to help lay people make its points to legislators. The paper is available here.