There is no fundamental problem with defined benefit (DB) plans. In fact, as I will discuss in my next post, they have two distinct advantages over defined contribution (DC) plans. The risks inherent and unavoidable in DB plans are manageable and in fact have not been the cause of the angst currently facing many municipalities. The problems they have are simply one of design and making decisions based on politics rather than mathematics. Let’s look at some of those political decisions:
Giving retroactive pension increases: In lieu of pay raises which would come out of this year’s budget, municipalities have often given retroactive pension increases which will come out of some other elected official’s future budget. Going back to one of my original points: You can not simply print money. If it wasn’t put in, it won’t be there to take out.
Not fully funding the obligation: It is more politically expedient to fix potholes, build stadiums and host conventions than it is to put money in the pension fund. Again, if money is not put in, there will not be any money available to be paid out.
Allowing for the purchase of service credits: This could work, but only if they are purchased at an actuarially neutral amount and they are not used to vest someone who otherwise would not have vested. Unfortunately, these parameters are rarely met.
As for the design, I mentioned yesterday that a feature of a well-run plan would be the negotiation of the contribution, not the benefit. Let’s look at some of the drawbacks of negotiating the benefit.
Added risk of predicting final salaries: There is also the potential to game the system by “spiking” an employee’s final year salary in order to increase the pension.
Potential of under funding the pension obligation: This was discussed above.
Legally locking in a benefit payment years in advance: Once you promise a benefit, it can not be taken away or modified. Employees promised a benefit based on a formula consisting of years of service, retirement age and salary will be paid that amount regardless of what happens economically during his working career.
So what does my association’s benefit plan look like? Actually, it resembles a very generous guaranteed annuity. Firstly, we negotiate the amount that our contractors will pay into their employees’ pension fund. Currently that amount for journeymen wiremen is $4.35 per hour. This gives our trustees and our actuary real dollars on which to compute the retirement benefit. It also removes the potential for under funding.
The trustees, with the help of the actuary then set the accrual amount (the percentage the employee will receive in benefit, on a monthly basis, at retirement age). Currently, the accrual is 2.7%. In other words, assuming an employee works 2,000 hours in a year, he/she would have received $8,700 in their retirement account. At 2.7% they would be guaranteed $234.90 per month at retirement age. If the contribution and accrual percentage remained constant, a 30-year employee will retire with $7,047 per month. They will also receive Social Security and any money they saved on their own.
The beauty of this design is that only the current year and any previous accumulations are legally locked in. What has already been earned is guaranteed, but because we didn’t stipulate a final benefit, the Trustees can vote to change the accrual percentage for all future contributions. Also, the employee can go online at any time and know exactly what his monthly pension would be assuming he didn’t continue working. Any future accruals would simply be added to that amount.
Finally, we do not pay retroactive benefits and we do not allow the purchase of credits or make any other decisions based on factors other than the health of the plan and being able to provide our employees the pension they were promised.