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Switch to Defined Contribution Pensions Could Leave Retirees Short
As public pension funds seek to reduce liabilities, putting new hires in 401(k) plans weakens retirement security, new research suggests.
Many U.S. public pension funds are struggling to balance long-term needs against tight state budgets and dwindling performance from traditional investments like stocks and bonds. In some states that means putting new employees into defined contribution plans in an effort to limit pension obligations. But doing so can leave retirees short of income, according to a recent study from the University of California, Berkeley. Still, unfunded liabilities in public pension funds keep growing. Rebalancing portfolios toward specific tactical themes instead of simply trying to hit target allocations might help to solve the problem.
In their study Nari Rhee, manager of the retirement security program at the UC Berkeley Center for Labor Research and Education, and William Fornia, founder and president of Pension Trustee Advisors, a Centennial, Coloradobased consulting firm for public pension plans, modeled how retirement income would shake out for teachers on three types of pension: the current defined benefit offering from the $186 billion California State Teachers Retirement System for hires since 2013, an idealized 401(k) plan and a cash balance plan with guaranteed 7 percent annual interest on contributions. Cash balance plans give retirees the choice of taking a lump sum and forgoing interest, or spreading out that payment through annuities.
Focusing on how long teachers worked before receiving benefits was crucial, Rhee contends. There has been a bit of a bait and switch in the studies that look at defined benefit plans and compare them to 401(k) plans because they only look at new-hire attrition, not the tenure pattern of the teaching workforce and what benefits they receive at the end, she says.
CalSTRS pension plan rewards teachers who stay on the longest 20 to 30 years. When Rhee looked at retirement income earned from the 401(k) plan, she discovered that older teachers would have to work much longer than 30 years because they wouldnt have the money to retire.
Why are 401(k) plans a bust for teachers? Blame the asset mix. The Berkeley study shows that 401(k)-based retirement income varies among participants over the life of an account because retail investments in public equities and fixed income fluctuate with market conditions. According to its models, teachers on the idealized 401(k) plan would either end up with income exceeding what they put in by at least one third or would face a shortfall of one third or more. Participants can't control which group they fall into because everything hinges on the state of the market when they retire. Even with the cash balance plan delivering a favorable interest rate of 7 percent, benefits in those plans are front-loaded, so teachers receive less retirement income than those in the CalSTRS plan at the time of retirement.
What we see with target-date funds, which serve as common default options in 401(k) plans, is that the investments get more conservative nearer to retirement, Rhee says. But that also means that returns get lower at the exact point when theres the most money in the account, she explains. Defined benefit plans dont work that way; they are able to maintain a steady asset allocation.
Defined benefit pensions run on a large and diverse pool of investments in addition to employee contributions. But participants in 401(k) plans are priced out of high-performing areas like private equity, opportunistic credit strategies, hedge funds and private real estate, all of which typically require investors to put up millions of dollars. So even if employees contribute regularly, they dont get the highest returns, and its much harder to make up any losses.
At West Sacramentobased CalSTRS, the performance difference between public and private investments is stark. In the third quarter of 2015, the funds fixed-income portfolio lagged its benchmark by 16 basis points, and U.S. public equities holdings tumbled along with U.S. indexes. As of last September, CalSTRS private equity portfolio, which accounts for 9.9 percent of total assets, had posted a net internal rate of return of 13.21 percent since inception. In a single asset class, those returns dwarf the idealized 401(k) plan, where portfolio income and returns vary by the age of teacher. For the fiscal year ended June 30, 2015, alternatives accounted for the bulk of CalSTRS positive returns, keeping total return at 4.8 percent gross.
Jay Rose, a partner at the La Jolla, California, office of pension consulting firm StepStone Group, says public pension allocators are becoming savvier about building portfolios, but its taken time to get there. Investment committees have had to learn to invest for outcomes, not just allocation targets, he notes: Often you see portfolios where staff has changed, and so there is a mixed bag of exposures and corresponding GP relationships, and then you see institutions selling when its uneconomical. Focusing on themes relevant to current market conditions increasing exposure to distressed debt, for example is a way to avoid uneconomic deals or, in the case of private equity, getting too overweight in a certain vintage year, Rose adds.
These lessons are already bolstering pension funds like CalSTRS, but they remain out of reach for 401(k) investors. Sponsors that oversee defined contribution plans will have to start focusing on outcomes too, Berkeleys Rhee says. In particular, public employers will really need to look at what they are creating if they want to shift over to these plans; the portability of a 401(k) simply doesnt solve for the other insecurities that come with these plans, she explains. Those insecurities will still pose a risk to state budgets if you have large groups of people who cant retire or need other assistance.
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