By: Keith Brainard
Keith Brainard is research director for the National Association of State Retirement Administrators.
Concerns are growing about how to best manage risk in retirement. Traditional defined benefit plans can impart considerable risk to employers, while 401(k)-type plans place all or most risk on employees.
Shared-risk retirement plans are garnering attention and excitement around the globe. Outside the U.S., developments include “defined ambition” plans of the Netherlands and New Brunswick, Canada. There are also several striking examples of shared-risk plans right here at home. In fact, most U.S. state and local government retirement systems today embed risk-sharing features, and many new models have been developed in recent years. These retirement plan models provide ideas and inspiration for other retirement plans.
A New Model
The degree to which risk is shared between employees and employers varies widely across plan designs. Some of the new approaches to sharing risk include novel ways to handle fluctuations in investments, contributions, inflation, and life-expectancy risk, among others.
In the U.S. public sector, retirement benefits are targeted at a variety of objectives relevant to different stakeholders: public employees and employers, and taxpayers. Balancing these groups’ objectives (which may conflict with or complement one another) is a key challenge when designing a public sector retirement plan. Employees want a competitive compensation package that includes financial security in retirement. Taxpayers want services delivered in a cost-effective manner. Public employers need to attract talent, maximize training and experience invested in employees, and manage the orderly progression of personnel, including a timely retirement.
Margins for Adjustment
Most U.S. states and municipalities today offer defined benefit plans, with some also having supplemental or alternative defined contribution or hybrid plans. One method of implementing risk-sharing is that virtually every state requires employees to contribute toward the cost of their pensions. In addition, this contribution can often be adjusted, depending on plan funding levels. Several states, including Arizona, Iowa, Nevada, and Pennsylvania, have variable employee contribution rates depending on the plans’ actuarial and investment performance. When actuarial and investment experience are favorable, employees and employers both contribute less, and when performance lags, employee and employer costs go up.
Public employees in at least 16 states participate in retirement plans where participant benefits are exposed to some combination of investment risk, the risk of inflation, and higher required contributions. Several of these public hybrid retirement plans have been in place for decades, and others have been established more recently.
For over half a century, the majority of municipal and county employees in Texas have participated in plans in which the value of retirement benefits depends on a combination of contributions from employees and employers, guaranteed minimum annual accruals and potential dividends, and the employee’s age at retirement. Investments are pooled, minimum age and service requirements must be met, and distributions generally must be taken in the form of an annuity.
South Dakota also has risk-sharing in its benefit design. Specifically, it relies on fixed statutory contributions for both employers and employees, as well as statutory funding thresholds for benefit adjustments and cost-of-living adjustments linked to the plan’s funded status. Starting this year, newly-hired public employees in South Dakota will participate in a new benefit structure, called Generational Benefits. This new model has a traditional defined benefit component, as well as a variable retirement account (VRA) which credits a portion of employer contributions to each active participant’s account. The value of the VRA is linked to the fund’s actual investment returns and will be payable as a lump sum, rollover, or an annuity when participants qualify.
Another example of shared pension system risk can be seen in the Wisconsin Retirement System (WRS). Here pensioners’ benefits are adjusted (up or down) based on a five-year average of the pension fund’s investment return. If returns are strong, retiree benefits rise, while if returns fall short of expectations, benefits are reduced, potentially to as low as they were when the employee first retired. This self-adjusting feature of Wisconsin’s retirement plan design dampens volatility in the plan’s cost and protects its funding level.
Retirement plan design innovations abound in the U.S. public sector. These plans must balance competing stakeholder objectives, which is achievable though sometimes difficult. States are constantly designing diverse and innovative plan features, including new approaches to risk-sharing.
This piece was originally posted on May 1, 2017, on the Pension Research Council’s curated Forbes blog. To view the original posting, click here.
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