Defined Benefit vs. Defined Contribution - the armwrestling continues!

[John A]

jlf:

I went back through this thread to review your points. You do make some valid points and I at least partially agree that Chester owes you an apology for implying that you assumed 20% investment returns. But you also have so far not (refused to?) answered many questions posed, have refused to acknowledge that your viewpoint is an opinion, and have so far not admitted to being flat out wrong about a death benefit in DB plans never being funded from the invested assets of the plan.

Going back to your post of 10-20: the greater portability of most DC plans compared to most DB plans, the comparison of death benefits provided by the 2 types of plans, the different funding patterns by age of the typical plan in each type, and the "cold storage" vesting of most DB plans, are all valid points to discuss. Saying that each of these areas favors the employer is an opinion - these areas may or may not favor the employer depending on the employer's decisions about the plan. Your 10-20 post also mentions that in a DC plan the employer will be adding to compensation each month. I'm sure there are many employers who contribute monthly, but many do not. Also, keep in mind that you are either assuming a money purchase pension plan or you are assuming an employer that will fund the DC plan every year no matter what the employer's experience has been. You have never specified, and never been asked, whether the investments in the DC plan you are assuming are participant-directed or employer-directed. Given your preference for empowering the employee, is your preference for daily-valued employee-directed investments?

In my 10-29 post, I posed the question to you: If you were trying to convince an employer about what type of qualified plan they should adopt, what argument would you use to convince the employer to sponsor a DC plan, given that you believe a DB plan favors the employer? Please answer that question.

You also did not respond to whether or not you had considered the 3 situations I posed in my 10-29 post. Have you considered those situations?

I do appreciate your answers relating to the DC plan being a level % of salary plan and an explanation as to why you believe a DB plan is a wealth builder for the plan sponsor. In this post,you stress NON-PARTICIPATION IN THE "EXCESS EARNINGS," but you mention nothing about non-participation in any shortfall. If the DB plan provides a lump sum option at retirement (many, but not all, do provide a lump sum option), would that make a difference to your opinion? Note that how great the lump sum will be depends on the level of interest rates at the time of retirement, so to the extent that an employee takes a lump sum option, the employee is to some extent participating in the market's investment experience, if not the investment experience of the particular employer.

Who should own the "excess assets" inside a DB plan when it terminates has been the subject of much debate. The government's current answer when a plan terminates is to give the employer a choice: 1) give it all to the plan participants, 2) give some of it to plan participants, some of it to us, and keep some for yourself, or 3) give none to participants, give a very, very large chunk of it to us, and then you can keep some. With the exception of a sole proprietor, if an employer's primary objective was building wealth for the employer, I doubt if the employer would choose a DB plan as the best wealth-building vehicle.

My personal experience has been that the majority of plan sponsors that have terminated their DB plans have chosen to distribute all excess assets to participants. It would be unfair of me to extrapolate my personal experience to all plans, so I would be curious if anyone else has statistics on what percent of DB plans terminating in the last few years have chosen to give the entire excess to participants. Does anyone know? Oh, and in every case where there has been a shortfall, the shortfall was either made up or the owner of the employer decreased his own benefit by the amount of the shortfall.

jlf, you have not responded to pax's 10-31 post about what is your suggestion for improvement for a DB plan, unless I have missed it. What is your suggestion for improving a DB plan?

jlf, you have not responded to KJohnson's questions about multiemployer DB plans as the "champion" of the working man. What are your thoughts on his post?

jlf, you have not responded to my 11-1 post about which you would prefer between a $100,000 lump sum and a life annuity valued at $200,000. Perhaps I should have given you a third choice of an increasing annuity valued at $200,000. Please respond to this question. Which would you prefer?

No one has responded to your 11-1 post about the solution being to provide a CHOICE of plans. (Actually, Keith N did respond - my apologies Keith). Let me try, although others would better be able to answer this question. First, the answer depends somewhat on how the choice is provided. If employees are given a one-time choice that they must live with forever, the answer may be different than if they are allowed to choose each and every year. Depending on how the choice is given, the problem can be adverse selection. The older employee will choose the DB plan while the younger employee will choose the DC plan. As I said in an earlier post, I believe the best solution is to have both types of plans. Unfortunately, most employers cannot afford to sponsor both types of plans.

You mention that the DC plan is a wealth builder for the employee and I agree, but you also say that the DC plan is an income provider. In what sense does the DC plan provide income?

In your second post of 11-1, you mention that DB plans can only be defended when they share, in a meaningful way, their excess earnings with their former employees. While most plan sponsors that have increased the plan benefits have increased the benefits only for current employees, some have used the excess earnings to fund increased benefits for former employees (and I believe have displeased current employees by doing so). Does anyone else have experience or know statistics in this area?

You have not given any reaction to richard's 11-2 post. What is your reaction to his points?

jlf, in your 11-3 post, you state, "The death benefit DOES NOT come from the DEFINED BENEFIT PLAN'S INVESTED ASSETS." Would you please acknowledge that this is an incorrect statement when applied to all DB plans? Would you please acknowledge that some DB plans do indeed fund the death benefit through the DB plan's invested assets?

In your 11-4 post, you shift the subject by asking a question rather than acknowledging that you were wrong.

Before I forget, one other point from your 10-20 post, you say, "Under a typical DB plan the younger employee's own contributions are more than enough to cover the full cost of the defined benefits earned at the younger ages ..." I believe statistics would show that in the typical DB plan, employees do not make contributions at all. Would you agree?

One area that I do not believe has been discussed above is why so many DB plans have been terminated. jlf, you may find the reasons emloyers give interesting. Again, I do not have statistics to back me up, so the reasons I have seen are based purely on personal experience and I would like to know if anyone has statistics on this. The number one reason I have been told that employers were terminating the DB plan is that it was too expensive for the plan sponsor. This seems to fly in the face of the idea that the DB plan is a wealth-builder for the plan sponsor.

jlf, how would you explain a plan sponsor terminating a DB plan and putting in a DC plan to lower the cost of the plan sponsor? The other primary reasons I have seen have been: increasing complexity of government regulations and lack of appreciation and understanding of DB plans among employees.

To give some of my personal biases: the only plan my employer offers is a 401(k) plan. There is a match and my employer has us

[Guest reg]

[jlf]

Who agrees with my post of 11-3?

In any event like MoJo recently said we have gotten side tracked. I would like to share the following with you. The multi-billion dollar DB System for the public employees of NJ requires the member to contribute 5% of salary to his/her annuity savings account. If he terminates his membership with less than 3 years of credited service his withdrawal is credited with zero interest. (I leave it to Wessex to add the caps, just joking)

[david rigby]

I'll probably regret this, but

jlf, you have 3 posts on 11/3/99. which one are you asking about in your post of 11/10/99?

BTW, I'm curious, since the NJ plan requires EE contributions, is it on a pre-tax basis? Also, what benefit (formula) are you getting for your service and your 5%? Do you think it is a good benefit (at least good relative to your contribution)? My hunch is that you do not because you believe (in hindsight!) that you could have done better had you been able to invest the 5% on your own. Correct?

[This message has been edited by pax (edited 11-10-1999).]

[jlf]

Pax, I'm referring to the post of 19:36. Sorry for the confusion. I have to give your Quesion some thought. I'll get back to you, and I trust you won't regret it. jlf.

[MoJo]

Sorry jlf, as I said before, I haven't seen a db plan own insurance or pay a death benefit from insurance but maybe once or twice in the 17 years I've been doing this....

By the way, keep in mind that a government plan is but one flavor of a db plan, and in fact are very different from a non-governmental plans. I have credits in Ohio's STRS (State Teacher's Retirement System) which has mandatory "pick up" contributions of 8.7% (out of the employee's pay on a pre-tax basis), with an employer match equal to that, with a benefit formula expressed in db terms, with no interest without 5 years of "credited" service (with service based not on hours of service or years employed, but rather on "credit hours taught"). In addition, Ohio employees have opted out of Social Security, so no SS benefits accrue for service. As a part time teacher at Cleveland State for the last 10 years, I have accumulated .63 (yes, 63/100) years of service. No interest. If I were a full timer, IT WOULD BE A FABULOUS PLAN! My Stepfather had 17 years in the system and retired with 60% of final pay.... I would love that compared to the 401(k) plan and cash balance plan combination my employer provides to me now.

[Dowist]

Sorry - but this talk about "wealth building" leaves me cold. The point here isn't to become wealthy, but to be secure in retirement. Save the "wealth building" speech for the rubes buying penny stocks.

Has everyone forgotten about the "three-legged stool - social security, savings and pension?" Is this completely hoary, mossy and out-of-date? (I don't think so.)

For many persons, their ONLY savings are in a 401(k) plan - that's a 2-legged stool. It's a recipe for disaster - and when the stock market turns and if it turns hard, those are the people who will be begging the government for help.

If you have a pension plan, some of the risks in retirement are removed - you're sure you'll receive a base amount for life. But ideally you'll also have savings that will help you if there is inflation. If the value of your savings goes down, you always have the pension so your lifestyle may not change. If inflation rises, hopefully the value of your savings will also rise.

[jlf]

To Pax: The NJ Teachers' Pension and Annuity Fund uses the following formula: .0167 X Years of Service X Average of Highest 3 Years Salary. The member's 5% contribution is pre-tax. Assume the following: A member retires at 65 after 35 years of service. His average annual salary for the last three years is $70,000.00. His single life annuity is, therefore, $41,792.00 The Initial Reserve required to guarantee the annuity is $420,000.00

The member's account balance is $300,000.00.

The annuitant has, thus, financed 71% of the lifetime pension. I ask you, relative to the teacher's contribution, do you think this is a good benefit?

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[This message has been edited by jlf (edited 11-12-1999).]

[MoJo]

Pardon my jumping in, jlf, but why is it you insist that it is an employers responsibility to provide any benefit?

[david rigby]

Not bad. A DB plan that uses a 1.67% formula is better than almost all that I see. Also, a high 3 year average is better than most.

Your "inital reserve" of $410K is about right, although it might take quite a bit more than that to purchase a commercial annuity for that annual benefit, at least in today's interest rate environment.

However, I'm not sure where you get the $300K as the employee's "account balance". Could you elaborate on how this was developed or estimated?

[This message has been edited by pax (edited 11-12-1999).]

[jlf]

MoJo, I have never taken the position that the employer is responsible for providing any benefit.(except those mandated by law)

Pax; I made a small correction, please see above. The $300,000 was arrived at as follows: Starting salary of $5500 increasing by $2000 per year compounded at the actuarial AIR of 8.75%.

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[John A]

jlf,

Does the member have a choice between the $300,000 lump sum and the $40,915 single life annuity? If so and you were the member, which would you choose?

Is the $300,000 account balance based on actual investment returns or a guaranteed return stated in the plan?

If the account balance is based on actual investment returns, who had control of the investment decisions?

Whether or not the benefit is good relative to the member's contributions is a matter of opinion and perspective.

One way of getting (approximately) to your scenario would be to assume a starting salary of $19,175, 4% annual salary increases, and an 8.75% investment return. (Is my math correct? - I did not check it very carefully.)

One could argue that the benefit was not good because the employer should be expected to fund more than 27% of the benefit.

One could argue that the benefit was good because the member was offered an annuity that is more than the full economic value of the member's contributions (assuming the $300,000 balance is based on actual investment returns).

One could argue that the benefit was not good because, if actual investment returns were higher, say 10.5%, the member could be funding more than 100% of the annuity offered.

One could argue that the benefit was good because, if actual investment returns were lower, the employer would have funded a higher portion of the benefit, and the employer took the investment risk.

One could argue that the single life annuity is a bad option because, if the member dies after one year, the member forfeits a considerable amount of money that should have belonged to the member, and the annuity will lose its purchasing power due to inflation (of course, some of each payment could be invested to help cover this).

One could argue that the single life annuity benefit is a good option because it provided the member with a defined benefit that the member could plan on rather than with an account balance that would fluctuate with the market, and the annuity would also provide an income source that the employee would not outlive (although inflation could make the last years of this guaranteed income source not meaningful).

What percent of a benefit should an employer fund, and what percent should an employee fund?

[Guest P A Weick]

This is one of the best threads I have seen.

jlf seems to have a similar problem to that which Frank Sonier had with the Longshoremen's Retirement Plan. Sonier filed a declaratory action in Tax Court to have the Plan disqualified. One of his arguments (he represented himself) was that the Plan had an unfavorable rate of return and that it would be in his best interests to have a 401(k) type plan. The Tax Court dismissed his claim on the grounds that a low rate of return would not disqualify the Plan. The case is Sonier vs. Commissioner, T.C. Memo 1999-275.

This may be an area where enough dissatisfied beneficiaries may lead to some successful lawsuits, however I am not sure because plan design usually is not a fiduciary matter and the only theory other than disqualification I could see pursued would be a breach of duty claim claiming that too low return relative to alternatives not being in the participants interest and breached the fiduciary's duty to act solely in their interest. But then I am not a Plaintiff's attorney, and they are a real creative group.

Perhaps the focus in design matters ought to be Dowist's point of keeping all three legs on the retirement income stool rather than having just one plan.

[This message has been edited by P A Weick (edited 11-15-1999).]

[david rigby]

I'm somewhat confused (which is not necessarily surprising).

jlf, in your 11/12/99 postings, the numbers don't seem quite right.

If you start with a 5500 salary at age 30 and increase by 2200 per year to age 65, then the final 3 year average at age 65 is not 70,000, but is 71,500. I assume that is what you mean since the latter amount would yield the annual benefit of 41,792.

By "account balance" I am assuming you mean the accumulated EE contributions with interest. I also assume that you are using the 8.75% AIR because that is what the actual average yield was (or something close), not because the plan actually credits interest at this rate. If this is correct then I get a value for this "account" of about 266,000. This is, as you have pointed out, and is probably the major point you have been grying to make, about 63 percent of the total "value" of the age 65 retirement benefit.

That is a fairly high percent of a benefit for an EE to "finance", but it oversimpliflies the analyis by ignoring several things:

1. There are ancillary benefits that have been left out of this comparison.

2. The plan probably has a generous early retirement benefit that is no longer relevant at age 65.

3. The actual yield on the invested assets is the risk of the employer, not the EE. Therefore, it is not a valid comparison to impute the actual yield to the EE contibutions.

4. The benefit has a guarantee (that is the nature of the DB promise) that is unrelated to the amount of assets, contributions, yield, funding mechanism, etc. That guarantee is made by the ER, who is then asking the EEs to help with a fixed amount. If the EEs believe their share of helping is too high, then that is a perfectly valid position, but based on the market place for labor supply and demand. If actual yield had average 3%, the ER will not ask the EEs to contribute some more at retirement to make up the shortfall.

BTW, in NJ is there state law that says the benefit (that is the entire plan) cannot be diminished for any EEs? For example, if the state designed a benefit and 5 years later discovered that it was too expensive, could it be changed for existing EEs or only for new EEs? If the latter, then that is another guarantee, one I might add that does not exist outside of government employment.

[This message has been edited by pax (edited 11-15-1999).]

[jlf]

The 8.75% rate is the AIR used by the plan's

actuary in preparing the annual valuation of the plan's assets and liabilities. Based on this valuation, the actuary certifies the employer's annual contribution needed to keep the plan fully funded. The actual rate of return, will almost all of the time be higher or lower than the AIR.

The annuitant must annuitize his own 300,000 balance plus the 110000 that the State contributes. If I could I would rollover the 300,000 even if this meant forfeiting the State's portion. I would, however, first determine the actual rate of return on my compulsory annuity savings account to see how close it comes to financing the entire pension.The real rate of return may very well be closer to 10.5% than 8.75%. Note: the annual employee statement never includes accrued interest. The member's contributions accrue 2% interest if withdrawal takes place after completing 3 years membership.

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[david rigby]

so, the 300K is a ficticious amount?

BTW, I estimate that you would need a guaranteed investment of about 11% for the 300K to yield annual income of 41K. I doubt that is going to happen!

[This message has been edited by pax (edited 11-15-1999).]

[jlf]

Fictitious....that's right! The Plan is obligated to make up the difference between the employee's account balance and the required Initial Reserve, yet this difference is never disclosed. I would like to know why.

[david rigby]

Why is it not disclosed? Simple, because it doesn't matter. The plan is not promising to "make up" any difference. It is promising to pay a benefit, probably for the life of the retiree. If the investment of the funds is good, then more of the total cost is "paid" by investment earnings. If the investment of the funds is not so good, then more of the total cost is "paid" by the plan sponsor in the form of increased annual contributions. In either case, the EEs are paying a fixed amount, based on a percent of comp.

[This message has been edited by pax (edited 11-16-1999).]

[jlf]

There seems to be something fundamentally wrong when only the Plan administrator knows the final ratio. If the retiree does not know the actual (real) amount he has contributed to the required Initial Reserve he can be told that the State contributed a "fictitious" amount and the retiree has no way of proving or disproving it. In this case the annuitant must go to the plan administrator and request the annual investment yield for each of the 35 years. Is it the practice in the industry to keep the ratio from the retiree?

Could it be that the Plan Administrator does not want this ratio to be disclosed lest the participants will know of the minority contribution made by the employer when they have always been told that the employer contributes the lion share? Once the true ratio is known the employees may demand a separation of the compulsory annuity savings account that they fund from an employer funded pension and the employer cannot have that!

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[John A]

jlf,

In your post of 11-15-99, you state that you would choose a $300,000 lump sum over a life annuity of $41,000 per year. I might make the same choice, but let me analyze the numbers a bit first:

In the scenarios that follow, I am assuming that the $41,000 would be paid at the beginning of each month in the amount of $41,000/12. When I mention a an annual rate of say, 12%, I am applying that as 12/1=1% per month. So to determine what rate of return I would need to not touch the prinicpal of $300,000, I am solving for i in the equation: ((300,000-(41,000/12))*(1+i)=300,000. Solving for i in this equation, the interest rate need to never touch the principal would be a bit under 14%.

Using my calculation methodology above, it the investment return was 13%, the $300,000 would be gone in 22 years. At 10%, the $300,000 would be gone in 13 years.

If it is not necessary to use the money for income, then the comparison is between investing a $300,000 lump sum and investing monthly payments of $41,000/12. If the investment return is 10%, the annuity will overtake the lump sum in 13 years. If the return is 13%, it will take 22 years. If the return is near 14%, the annuity will never overtake the lump sum.

The same type of analysis could be applied to taking $30,000/12 per month and investing the $11,000/12 per month and the results would be the same. This would also be a way of hedging against inflation.

It seems pretty clear to me that if you expect to earn 10% and expect to live more than 13 years, you would be better off taking the annuity. If you expect to earn 13% and expect to live more than 22 years, you would be better off taking the annuity.

The reasons I can validly see for choosing the lump sum would be:

1) You are not in great health.

2) You expect to get an investment return of almost 14%.

3) You require a death benefit in the first few years following age 65.

4) You do not need the money for retirement income and have a need or desire to spend the amount sooner rather than later.

5) You expect investment returns to be very high in the first few years and low in following years.

On the other hand, even with the "guaranteed loss of purchasing power", the annuity provides a lifetime retirement income, part of which can be saved as a hedge against the loss of purchasing power, at little or no risk of being reduced to zero, which the lump sum can do if used as a source of retirement income.

Are annuities evil and lump sums the hero of the person being paid? If the payee receiving an annuity dies after one year, or if investment returns are high, the payee will probably take that view. A payee who is still living at age 99 who has seen a bear market or two during the 34 years of being paid may take the opposite view.

By the way, jlf, what I find inherently unfair about the plan you describe is the possiblity that two employees will contribute vastly different amounts and receive the same benefit. This would be the case if two employees have vastly different salaries for 32 years, but have the same final average salary (for example, one employee is as you described above - 5,500 initial salary increasing by 2,000 each year, compared to an employee who has an initial salary of 5,500 increasing by 1,000 each year until the last 3 years are increased to match the first employee).

On other subjects, I fully admit that I do not know how much the state is contributing compared to employees. If the state is misrepresenting the benefit that is being provided, I would see that as a problem.

jlf, if you are not already aware of it, you would probably be interested in the current discussions and legislation involving employers converting their traditional final-pay type defined benefit plans to cash balance plans. Cash Balance plans are defined benefit plans that are designed to look and act more like defined contribution plans - younger employees accrue benefits much faster and are shown a "lump sum" cash balance on the annual statement of benefits. The problem with the conversions has been that some conversions have ended up giving employees who are currently older the worst of both worlds - smaller accruals when they were younger and now smaller accruals while they are older. Employers have been accused of much less than full disclosure in this reduction of benefits for older employees.

In terms of the compulsory savings account and the ratio you accuse the plan administrator of knowing, I would be very surprised if the plan administrator had ever tried to determine either. Both the employee's contributions and the employer's contributions go into a pool of assets that are not assigned to any particular employee. The pool of assets is compared to the expected liabilities of the entire group of participants, using assumptions determined by the actuary. The pool of assets will be affected by investment returns, employer and employee contributions, plan expenses, and benefit payments. The liabilities will be affected by mortality experience and turnover, among other things. The employee and the employer can calculate the benefit that is due to the employee at any point in time, and that benefit is unaffected by the experience of the plan. There is no reason for a plan to attempt to calculate how much a savings account would be because the assets are not assigned as accounts to participants.

It is worthwhile for a participant to compare the benefit being purchased with the 5% contribution to what the participant believes could be accumulated by saving 5% of compensation outside of the plan. If the participant is free to decline participation in the plan and believes that an accumulation outside of the plan would be a superior use of the money, the participant may do so.

[jlf]

Dear John; In my post of 11-15 I said before I would accept the 300000 I would ascertain the actual investment rate of return for each of the last 35 years.

Let's now assume the $300,000 is reality; do you agree with me when I say it is bad public policy to say to an emloyee "you must annuitize your $300,000 ($30,000 a year for life) in order to receive an additional lifetime annuity of $11,000 a year financed with an employer contribution of $110,000?

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[This message has been edited by jlf (edited 12-03-1999).]

[Greg Judd]

While this terrific thread has examined almost every fundamental concept of the tradeoffs inherent in DB vs. DC plan designs, no one's squarely addressed the 'ownership' issue that pax touches on. If pensions are 'merely' deferred wages (as I understand it, this concept had a lot to do with the Sup Ct finding them a valid collective bargaining item, thus expanding corporate sponsorship of them, decades ago), then the tension between the 'ultimate owners' (those whose wages were deferred) and the 'custodians'(the plan's representatives)on all kinds of issues, investment strategy & results among them, is understandable and probably inevitable.

So, big surprise, relationships among the stakeholders in the bundle of ownership rights that is a pension promise are complex.

I lean toward the participants NOT owning the assets that generate payment of the deferred wages; I lean even farther toward setting stringent provisions to assure that the deferred payments are made, by an entity other than PBGC.

Several others have asserted the validity and value of a DB pension promise vs DC benefits; in 'normal' times, the primacy of their position is much easier to recognize.

That said, here's a holiday hope for a lengthy extension of our abnormal economic conditions, as regards implementing long term financial security plans.

[david rigby]

It is bad policy to discuss it at all. That is not the purpose of the plan!

If you insist on viewing the 300K as "yours" (it is not), then perhaps you should consider that you are getting free money. That is, for putting up 30K per year, are getting that back with an additional 11K annual bonus.

[jlf]

Pax; How can any academic discussion be "bad policy"? I for one feel it is an outrage for only one party to know the contribution ratio. You have put an interesting twist into the discussion. The annuitant should think of his $11,000 employer funded annuity as a "bonus". If this is how you view the employer's legal obligation then why shouldn't the retiree be entitled to all of the settlement options available under Federal law for his portion (300,000)?

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[david rigby]

Sorry, bad phrasing. I do not mean that this "academic discussion" is bad policy. I was trying to state that it is not part of the EE comunications of the plan because it does not matter. My "free money" analogy (oversimplification) was an attempt to illustrate that the plan (typically any DB plan) is a single entity, not two separate "accounts".

The "options" available are a design decision. If the primary purpose of a DB plan is to provide reirement income, then it may be counterproductive to include an unlimited lump sum option in such a plan.

If jlf is disappointed that he does not have such option, or even any input into what the options are, then that seems to me to be a personnel policy issue more than a benefits issue. Perhaps employees who feel strongly should request such input; you sure won't get the opportunity without asking. If he feels that the portion of the total he is "paying" is high, he may have a legitimate gripe. I hope he gripes to the right people and shares with us how that goes.

However, I still return to the "primary purpose" of the plan and to who is making the promise and committment. It seems that the ER is making the promise of a lifetime retirement income (in the case that jlf describes, it is the taxpayers who are making the promise). That promise has nothing to do with the assets available, thus the ER is taking the entire investment risk. To me, that is a very significant feature of the entire plan structure. (Others may not care, but they would care if asset yields over the past 15 years had been similar to the prior 15 years.)

[This message has been edited by pax (edited 11-23-1999).]

[jlf]

Pax; Your statement of 11-23-99 is a throw back to pre ERISA days. In fact your feelings are a throw back to an era when the employee had no rights at all. A period of American history when the employee served the boss at the boss' personal pleasure. Your statement belongs to an era that became extinct with the "great depression".

A legal arrangement that allows the minority investor to dictate to the majority investor the distribution options is morally reprehensible and should be challenged in court. Does anyone care to recommend a lawyer?

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[jlf]

Happy post- Thanksgiving to all!

The current participant handbook of the Teachers' Pension and Annuity Fund of New Jersey states in part: "Contributions are made by the State on behalf of contributing employees". Hows that for full disclosure?

I haven't found an attorney yet. Let's have some names.

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[jlf]

Based on my assumptions of 11-12-99 a participant who retired at age 65 after 10 years of service credit financed 64% of his own lifetime pension? You see, an "irrational exhuberance" generated an average annual return of 14.3% over the past ten years. The holdings are split in about a 3:2 ratio of stocks to bonds.

Pax, How much of the pension would have been finance by the participant if the holdings were invested in a "highly speculative scheme" like the SP 500?

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[jlf]

To Pax, I refer you to yours of 11-23-99.

How can you justify your statement that the 300K does not belong to the employee? I view such a statement to be the equivalent of financial apartheid.

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yes

[This message has been edited by jlf (edited 12-28-1999).]

[John A]

jlf,

I still intend to answer your question in your 11-22-99 post at some point, but I am not quite ready to answer right now. However, I do have some questions for you about the NJ Teachers plan:

1. Am I correct that participation in the plan is a condition of employment? If so, I would very much dislike that condition, not because I think the plan is a bad plan, but because it is difficult to see how the 5% deducted from my salary was ever "salary" if I had no choice about it being deducted. I'm beginning to think this condition is a common feature of government plans but rare in plans that are not government plans. Anyone else have any thoughts on this condition?

2. Am I correct that the NJ plan provides cost-of-living (COL) increases? If so, what are the increases provided and how much value does that add to the present value numbers you have previously provided (which I believe were based on a non-increasing single life annuity at age 65)? (If there is a COL in the plan and you specify what it is, perhaps pax or another actuary could help out with what the present value of the COL would be at age 65.)

I'll try to give you an answer to your 11-22-99 post in January.

In the meantime, I hope you've had a wonderful holiday season so far and that you will have a terrific New Year.

[MoJo]

I think pax's point is that the money is legally the plan's, and only is distributable to the participant upon the happening of specified events. jlf - you still seem to be insistent that a retirement plan is an investment of the participant - it is not. It is a retirement plan - with features that take it out of the realm of, and not comparable to, individual investments.

[jlf]

Dear JohnA;

The NJ Plans provide a 60% COLA beginning the 13th month of retirement. Make sure to have a healthy new millennium!!!

Dear MoJo;

Why does the employer consider the DB plan an investment while the employee must consider it a "retirement plan"?. What should the suvivors of my hypothetical employee think of the arrangement when the employee dies in-service and they receive the employee's accumulated annuity contributions with 4% interest? Up until retirement it is simply a mandatory investment plan and an outrageously bad one at that. It only becomes a retirement plan if the employee lives to actually retire.

[This message has been edited by jlf (edited 12-29-1999).]

[This message has been edited by jlf (edited 12-29-1999).]

[jlf]

Hi out there!!! Happy millennium to all.

Let's continue with this fantastic thread topic.

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[John A]

jlf, your 11-22-99 post was:

Let's now assume the $300,000 is reality; do you agree with me when I say it is bad public policy to say to an emloyee "you must annuitize your $300,000 ($30,000 a year for life) in order to receive an additional lifetime annuity of $11,000 a year financed with an employer contribution of $110,000?

Pax’s response:

It is bad policy to discuss it at all. That is not the purpose of the plan!

If you insist on viewing the 300K as "yours" (it is not), then perhaps you should consider that you are getting free money. That is, for putting up 30K per year, are getting that back with an additional 11K annual bonus.

My response now:

jlf, even if I accept the whole premise of the employer “making up the difference” between the accumulation of the participant contributions and the value of the annuity (a premise I do not completely accept), I still do not believe it is bad public policy to provide the annuity rather than a lump sum.

jlf, in the DC plan you describe as the hero of the employee, does the employer do the investing or do participants get to self-direct?

I reviewed the Dow returns from 1/1/1896 to 12/31/99 and applied the returns to the 35 year accumulation for the participant with a starting salary of 5500, increasing 2000 per year, and 5% of salary contributions. For convenience, I assumed that the entire contribution was made on January 1 (before the salary was actually earned).

Before I mention some of the results, I’d like to bring up 3 principles of money accumulation and withdrawal that I do not think are discussed nearly enough:

1. When money is being saved on a periodic basis for a certain number of years, the investment return at the end of the period is much more important than the early investment returns.

2. When money is being withdrawn from a lump sum on a periodic basis for several years, the investment returns at the beginning of the withdrawal period are much more important than later returns.

3. If returns are applied to a lump sum with no added contributions and no withdrawals, then the order of the annual investment returns makes no difference.

The first 2 principles really just mean that the investment return (positive or negative) on a large amount has a much greater effect than the investment return on a small amount.

To some of the results I found (and if anyone would like to check my calculations, please do):

The highest annualized return over a 35-year period was 7.6% from 1965-1999.

The lowest annualized return over a 35-year period was 0.6% 1898-1932 (the end of the depression).

The accumulation assuming a constant 8.75% return would be approximately $270,000. (jlf, please check my math as I believe you came up with $300,000 rather than $270,000).

The accumulation assuming the Dow returns through 1999 would be approximately 487,000, well above the 410,000 present value of the annuity.

The accumulation for the 35 years ending in 1994 would have been appoximately $216,750.

The accumulation for the 35 years ending in 1981 would have been approximately $91,500.

The accumulation for the 35 years ending in 1932 (the end of the depression) would have been about $42,500.

From 1955 (the first year the accumulation would have been above $200,000) through 1999, the accumulation would have been less than $200,000 24 times and more than $200,000 21 times (9 of which were in the 1990’s).

Taking 41,000 annually from the lump sums that accumulated and continuing the Dow returns on the accumulation, the money ran out within 10 years almost always until the 1990s.

Even with the wonderful accumulation at the end of 1999, if the returns for 2000 and 2001 happened to match the returns for 1973 and 1974, it is likely the money would run out within 10-12 years.

In studying this topic I have (for now) come to the following conclusions (and please keep in mind that I am a fan of both DB and DC plans and would prefer a situation in which every employer could provide both):

1. DC plans as retirement vehicles are a form of Retirement Roulette or Retirement Lottery. In other words, there are major winners and major losers. If a participant is fortunate enough to have an environment like 1991-1999 (not a single losing year, 20%+ returns 5 of the years) at the end of their DC plan accumulation and the beginning of their withdrawals for retirement use, the DC plan certainly would be considered a hero to that participant. If a participant is unfortunate enough to have their 35-year accumulation in the DC plan experience investment returns like the Dow returns ending in 1981, the participant will probably curse the day the DC plan was created. A DB plan would have provided the same benefit defined in the plan to each of these participants, despite the large difference in accumulation.

2. DB plans are inherently fairer since they do not reward or punish participants because of the vagaries of the market. A DB plan does not discriminate based on what calendar year a participant retires.

3. If you want the employer to do the investing for the DC plan, then you are in favor of some form of paternalism.

4. If you want participants to be able to self-direct (as is the case with most current 401(k) plans, then the rich will get richer and the poor will in general get poor investment returns. If you do not believe this, I would urge you to read a 9/98 article in Worth Online called “Disaster in the Making.”

5. The biggest problem with DB plans is the portability issue, which is only partially solved by the greater ability of a DB plan to provide for a meaningful retirement benefit in the last few years before retirement.

jlf, in your 12/3/99 post, you say:

Based on my assumptions of 11-12-99 a participant who retired at age 65 after 10 years of service credit financed 64% of his own lifetime pension? You see, an "irrational exhuberance" generated an average annual return of 14.3% over the past ten years.

Irrational exuberance does not refer to what has happened for the past 10 years but to what expectations are for the future. The 1990s were just about the best of all possible worlds for investors. Suppose 2000-2009 duplicates the returns of 1965-1974? That said, here’s hoping 2000-2009 more closely resembles 1990-1999.

Anyone who is counting on withdrawing from a lump sum for retirement income needs to know that even if the annualized investment return for the next 20 years is 10%, the lump sum may quickly disappear if the first few years of the 20 years are substantial investment losses and the high rate is due to substantial gains near the end of the 20 years.

Also note that "excess gains" in DB plans, if used properly, act as a "rainy day" source to be sure assets are sufficient for future retirees.

pax, any idea what the added value of the 60% COLA (jlf, 60% of what?) would do to change the $410,000 present value?

If anyone is still reading at this point, I apologize for the length. I hope you found something worthwhile in my discussion.

[This message has been edited by John A (edited 01-21-2000).]

[david rigby]

Thanks John A for your (long) post.

Time out! A 60% COLA! On What? This needs clarification.

As a very general rule of thumb, if a DB plan gave a 3% annual COLA, that will increase the plan's cost (and hence the value of the retiree's benefit) by about 50%. In previous discussions, we "valued" the annuity at about $410K (as best I remember). So, if there is a COLA, its value must also be added in.

jlf, we need more discussion on the definition of this COLA.

Oh, maybe this is it: could it be that the plan gives a COLA of 60% of the CPI? Is it annual or occasional?

If so, we can estimate the cost impact of that by answering these questions:

1. Is the COLA part of the plan, or is it ad hoc, awarded at the discretion and timing of the plan sponsor? If the latter, what frequency has it been actually applied?

2. What have been the last actual COLA percents? I prefer to have the last 10, as well as a good definition of how the COLA is determined (and frequency).

3. Any minimum or maximums that apply to the COLA?

[This message has been edited by pax (edited 01-24-2000).]

[jlf]

The DC plan I'm championing is TIAA-CREF.

The public pension plans of NJ provide a cola of.6 of the cpi starting with the 13 month of retirement; and annually thereafter.

It is my position, and has been for many years, that under the guise of guaranteeing lifetime fixed dollars to the pensioner the DB plan was also adopted to help finance government programs (or corporate operations in the private sector) with the "excess" earnings. I trust we all agree that this is a given. Until such time as a fully funded DB plan distributes its "excess earnings" to the active and retired participant I will consider the employer's motives in maintaining such a plan suspect at best.

While I appreciate the statistical data going back to 1896, I believe going back to the beginning of the post WWII era, which began in 1945, would be much more relative.

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[david rigby]

"It is my position, and has been for many years, that under the guise of guaranteeing lifetime fixed dollars to the pensioner the DB plan was also adopted to help finance government programs (or corporate operations in the private sector) with the "excess" earnings. I trust we all agree that this is a given."

I'll probably regret this, but here goes:

Absolutely not. Your statement quoted above is not a "given", and completely ignores the very nature of a common trust fund and the nature of investment returns.

You have accused the state of using "excess" earnings to finance other projects. Pretty strong words. Do you have evidence to back it up? Are you accusing the state of a breach of fiduciary duty? intentionally misleading taxpayers? fraud?

Is the money invested in a trust? If so, how would the state be using that money?

By the way, there is no such thing as "excess" earnings in a trust fund.

OK, now to the COLA. If the COLA is 60% of the CPI, then I will estimate that (not having lots of historical data in front of me right now) as an annual increase of between 2% and 5%. Again using general approximations, my estimate is that would increase the plan's cost by about 40-50%. The previous estimate of $410K for the cost of the annuity described would then range from $575K to $615K. Thus, the benefit is substantially more valuable than previously discussed.

[John A]

Throwing out all years prior to 1945:

The 35 year accumulations (based on the Dow returns) ending in 1979 through those ending in 1990, followed by withdrawals of 41,000 per year, would have been gone by the end of the eighth year of withdrawals.

The accumulation ending in 1991 would be less than $50,000 at 12/31/99.

Accumulations ending in 1993-1999 would have increased even with the withdrawals.

If the retirement benefit is based stictly on what contributions accumulate to, then the 1981 retiree gets gets 19% of the benefit te 1999 retiree gets. The 1990 retiree gets 37% of the benefit the 1999 retiree gets. The 1993 retiree gets 46% of the benefit the 1999 retiree gets. The 1994 retiree gets 45% of the benefit the 1999 retiree gets. the 1998 retiree gets 85% of the benefit the 1999 retiree gets.

[jlf]

Pax, here is the evidence you requested from P. 1, paragraph 3, of the 49th Annual Report of NJ State Investment Council for FYE 6-30-99:

"The income generated by the investment of the pension funds also contributes to the funding of services and benefits provided by the state to its citizens and thus directly benefits the taxpayers of New Jersey."

This proves my point that a DB plan's trustees serve two masters: one is the plan participant and the other is the sponsoring employer (public or private). If memory serves me well I believe the Supreme Court has ruled that any holdings not needed to pay promised benefits may, at the sponsor's option, revert to the sponsor or be used to pay additional employee benefits. Pax, this is all perfectly legal.

John A, our hypothetical employee was earning $31,500 in 1979, therefore, your withdrawal amount or pension of $41,000 is wrong and is the reason the pension reserve is depleted after 8 years. Please re-do. Thanks.

John A, it is wrong to use the DJIA as a proxy. A 70 billion dollar portfolio such as the one we are talking about does not invest all of its equity holdings in 30 very large companies. Reminder the hypo case has 60% in equities and the balance in investment grade bonds and mortgages. Please use the SP 500 and the Lehman Bros. Bond index as a proxy for our hypo investment returns when you recalculate for us. Thanks.

yes

[This message has been edited by jlf (edited 01-26-2000).]

[This message has been edited by jlf (edited 01-26-2000).]

[John A]

jlf, where did you get $31,500 in 1979? The hypothetical employee would be earning $73,500 at the end of each 35-year accumulation period, including 1945-1979. My calculation used $73,500 for 1979 when it was the end of the 35-year accumulation period.

If you will provide the returns for the S&P 500 and the Lehman Brothers Bond Index for each year from 1/1/1945 to 12/31/1999, I would be happy to redo the calculations using the 60%, 40% mix.

[jlf]

John A: The economic and world landscape from 1945-1979 was quite different, to say the least, compared to the economic and world landscape from 1965-1999. I believe, therefore, it is wrong to use a salary schedule and pension payout from one time period and investment returns from another. Pax, what is your opinion?

Ques: If these DB plan sponsors are solely interested in guaranteeing a fixed and or variable income for the life of their former employees why did they go to the trouble of establishing and maintaining a DB plan? Surely a fixed and variable annuity could have been funded through an insurance contract. This is exactly what the colleges and non-profits have done since 1918 via TIAA-CREF.

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[jlf]

Hey! Where did everybody go?

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[david rigby]

Probably just tired of the fruitless arguments.

[jlf]

Re: Retirement Plan Distributions Q&A; by Martin Silfen,Esq.

Question 246 to Mr. Silfen reads: "Are there any guidelines for choosing the best pension plan payout option?"

Mr. Silfen's answer in part states "I am not aware of any meaningful guidelines. There are so many variables, including your marital status, your financial situation, your current and projected tax brackets, your life expectancy, your investment acumen, your financial savvy, your discipline, and the current and future inflation and investment environments."

Assuming Mr. Silfen's answer cannot be disputed, why is lifetime annuitizing the rule rather than the exception with DB payout options? Do we all agree that one size does not fit all?

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[richard]

I've been reading this thread for several months now. I added a comment several months ago, and I think I'll risk adding another one now.

This is directed more to the pension practitioners than to jlf. Jlf obviously is in favor of DC plans, and raises arguments and numbers that the pension practitioners have taken issue with.

Here's the key dilemma. I suspect that many individual employees agree with jlf. They would rather have the money in their own accounts, invest the money with their own discretion, and reap the significant rewards.

Now, let's assume that most of the arguments of the pension practitioners are correct and most of jlf's arguments are wrong (jlf, please accept my apologies and bear with me).

What can/should the pension practitioners do? By the time they are proven right (a 5-year bear market, for example), the damage will be done.

Worse yet, think about the following. The runup in stock prices from 1990 to 2000 has perhaps been fueled (in part) by the baby boomers reaching midcareer (currently ages 35-55). You know, supply and demand.

Now look at the year 2020. These baby boomers will be ages 55-75, and will be taking money out of the stock market. With this large group of money moving for the exits, who will be buying? Demographically, the was a dropoff of births after 1965 for 10, maybe 15 years, I think. Will stock prices (and hence retirement savings) drop precariously?

I don't know, but by then in a DC world, it will be too late for individual employees.

[John A]

http://www.nasra.org/level2/dbvsdc.html

[John A]

http://www.bergen.com/region/pensionc200003284.htm

Who owns surplus assets?

[Guest Franklin Evans]

quote:

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Originally posted by John A:

http://www.bergen.com/region/pensionc200003284.htm

Who owns surplus assets?

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For an active plan? Usually, "surplus" assets reduce future contributions or help cover past service liabilities.

For a terminated plan, I prefer the simple approach. Pay for the guaranteed, accrued benefits, the rest reverts to the plan sponsor(s) minus the taxes.

In my opinion, "surplus" assets in a Defined Benefit plan is a useless concept. DB participants, by definiton, are not entitled to a share of the assets, the are entitled to a benefit. The rest is legal shenanigans.

[jlf]

Franklin, you are right on target! This is why a DB plan is potentially a wealth builder for the plan sponsor; while a DC plan is an income provider and wealth builder for the participant.

Does anyone know of a fully funded DB plan that pursuant to its plan document distributes all of its "surplus" in the form of additional benefits?

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[Guest Lorne Dauenhauer]

With the exception of defined benefit plans whose sponsor was in bankruptcy, every defined benefit plan termination I've been involved with allocated the surplus assets to the participants either directly or through a transfer of the excess assets to a successor defined contribution plan.

I venture that most sponsors would rather provide their participants with increased benefits than handing over half of the reversion to the IRS in the form of the 50% reversion tax.