Defined Contribution Retirement Plan: Good for Workers

Posted by & filed under CGR Staff, Rochester Business Journal.

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.