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18.10.09

Move to compulsory defined-contribution best for LA

Tomorrow, Louisiana legislators will look at the possibility of converting the major retirement systems of the state into compulsory defined-contribution plans and no longer give the option for a defined-benefit program. It’s sure to create controversy, but needs to happen.

About two decades ago, for some retirement systems the state began to give new enrollees the option of enrolling in a defined-contribution plan, where a certain variable amount of an employee’s salary plus a fixed amount from the employee, tax free at the time go into an investment account that the employee with restrictions can manage. Prior to that, the only choice was a defined-benefit program where after a certain number of years one could get vested into the system and, depending on the length of time in state service, upon retirement (after a certain age) one could get as much as 100 percent of a declared three-year average of salary drawn (usually the last three years since they would be the highest) paid annually in retirement.

Up until this time point, the sole us of the defined-benefit strategy had several repercussions. First, it tended to discourage talented employees who held attitudes of rapid upward mobility. The state civil service being what it is, advancement and especially salary increases were glacial, and since vesting took some years, those really on the go didn’t want to wait around for that benefit to kick in so they would leave state employment. Second, also discouraged may be those talented individuals thinking of state employment but who are put off by having to wait around years to collect the promise of a benefit they can’t enjoy unless they stay awhile, instead of getting part of it immediately even if they can’t get at it immediately. They might already have a defined-contribution plan from elsewhere that they would prefer to see supplemented, not set aside.

Third, it tended to encourage the modestly-talented to stay, as once they got vesting they could cruise along with essentially guaranteed annual increases (a flaw about to be rectified) so the promise of retirement at perhaps full highest salary made them want to hang on as opposed to leaving for similar-paying jobs without such a benefit. Fourth, at the same time it may have trapped others in a sense, in that they come to points in their careers where they would rather do something else but stay only because they have to hit certain marks for retirement purposes and don’t want to “waste” the time already put in.. These less-motivated employees likely would perform more poorly as a result.

Fifth, it aggravated what had become a problem by the time it no longer was compulsory, a burgeoning unfunded accrued liability in the retirement system. Vesting required a certain amount be set aside to pay off retirees claims, but the defined-benefit regime encouraged long tenures and actuarially mistakenly allocated too few dollars and/or at too low of rates of return to full fund all expected claims. Thus, a huge deficit estimated at $12 billion has accumulated, which must be paid off presently by 2029.

Going exclusively to a defined-contribution plan would address positively all of these aspects. Salaries could be increased by the amount set aside statutorily by the state less its contributions to attract better employees. Employees also would not feel that they are hanging on or trapped in the system, as these plans are portable so if there are incentives for them to leave, they can, just as others may be attracted by bringing and perhaps leaving with benefits intact. The nature of the program also would make it easier for the state to manage and, while it would be tough medicine, kick the state into actually dealing with the unfunded accrued liability problem which it barely has done in two decades since the current system of paying retirees with present contributors’ dollars creates disincentives for dealing with it now.

The only real point of concern is that now employees themselves would have to manage their own accounts. For those with acumen, they could end up far better off than under the present system. For those who don’t the plans are administered by nongovernmental entities such as financial services companies where agents are assigned to employees who can dispense with advice. Still, that could go sour as well, and it’s argued that, since investments can gyrate substantially in value, somebody might be unfortunate enough to want to take retirement in a down phase for his investments and get less out than under a defined-benefit system.

However, this should not be a real concern. For example, these plans typically have investments options that are fixed rate that vary with interest rates and have no investment risk. Let’s say that somebody starts working today even with a crummy 3 percent fixed-rate risk-free return, at $30,000 annually and 8 percent is removed from salary, matched 4 percent by the state. Over 40 years, assuming annual 4 percent salary increases in the same job, what begins as $3,600 a year contribution balloons to an annuity paying about $28,500 a year for 30 years. That’s not great, but it’s not bad, either. If the risk-free rate of return was bumped to 5 percent throughout, which is closer to historical norms, that annual annuity figure becomes almost $54,000. In other words, patient investing even in low-risk instruments should yield a pretty decent retirement income from just that source.

Thus, the vast majority of state retirees and certainly its taxpayers will be better off if the discussion tomorrow leads to an eventual decision to make a defined-contribution plan mandatory for all employees hired after July 1, 2010.

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