Dear Inquiring:
The answer to this question is “it depends.” You are quite correct that both types of plans are popular with municipalities, but they have very different risks, benefits, and features. To decide which is better for a particular community, it is important to understand those factors.
To begin, let’s step back and consider what features are desirable in a retirement program in general. First, there are the financial considerations. The price tag must be reasonable. Moreover, the employer cost should be fairly stable and predictable from year to year. Municipal budgets certainly do not like any surprises. And you want to get the most bang for your buck. In other words, each dollar contributed to the plan should provide the most retirement benefits to its members. There is also the concept of intergenerational taxpayer equity, meaning that today’s taxpayers should be paying for the benefits that are being earned by today’s active plan members, not for benefits earned a generation ago.
Next, there are some staffing considerations. A retirement program is an important employee benefit, so it often plays a key role in recruiting and retaining top talent. Therefore, the benefits one plan offers may need to be comparable to those offered by surrounding towns or other “competitors,” or at least provide something valuable in the eyes of potential employees. The provisions of the program will also affect when people retire, so it is helpful if the structure allows you to create predictable and desirable retirement patterns. And it is preferrable that the benefits be easy for the members to understand. If the benefits are clear to employees, they are more likely to value those benefits and correctly anticipate their retirement income. Lastly, municipalities usually want to provide a benefit to members that become disabled while working, especially for public safety members.
From the employee’s perspective, the ideal retirement benefit would provide lifetime income, would have some built-in inflation protection, and would not decrease over time.
As you can imagine, there are usually trade-offs between these different goals. Let’s first look at how a traditional DB plan measures up. A DB plan typically provides monthly benefits in retirement that are based on the member’s pay and length of service. The benefits are paid for the member’s lifetime (and sometimes even in part to a surviving beneficiary) and can be paid upon disability or preretirement death. Benefits can be indexed to increase with inflation, and retirement income can be easily estimated so employees can understand the plan provisions and be prepared for retirement. Plan investments are pooled and managed for the plan as a whole by investment experts. This results in lower fees and higher returns than individual DC accounts. DB plans therefore produce a significantly higher level of benefits for the same amount spent. In fact, one study found that a DC plan needs almost twice as much in terms of contributions to fund the same level of benefits as a DB plan.1
On the downside, investment returns are volatile, and this volatility translates to unpredictable contributions for the plan sponsor. Note that DB plan members are not directly affected by market volatility—their contributions and benefits are not impacted unless benefit provisions are changed. In the same manner, the plan sponsor is responsible for providing lifetime benefits, so the sponsor takes on all the risk of members outliving the expected benefits (known as “longevity risk”). Some of this risk is reduced because it is pooled for all plan members (some of whom will live longer than expected and some shorter), but if longevity improves for the group overall, the plan sponsor bears the cost. Lastly, plans that become underfunded may shift costs to future generations of taxpayers, which is not ideal.
Figure 1: Traditional DB plan risks
The structure of a DC plan is quite different. A traditional DC plan provides contributions (that are based on pay) during the employee’s working lifetime to an investment account. On the plus side, employer contributions are very predictable and easy for employees to understand. Benefits are portable, meaning members don’t lose their contributions when they leave that employer. However, the investment of the funds is managed by the plan members, meaning they bear all the investment risk and, as we noted earlier, they result in a lower benefit on average. Benefits available at retirement are hard to predict, and there is a risk that retirees will outlive their plan savings. Additional issues that affect municipal plans in particular are that it is difficult to provide meaningful disability and preretirement death benefits outside of a DB plan, and the shorter working lifetimes for police and fire groups make it hard to accumulate sufficient balances in a DC plan.
Figure 2: Traditional DC plan risks
Figure 3: Retirement plan scorecard
Figure 3 summarizes the various features of traditional DB and DC plans. You have likely concluded that there is no clear winner when it comes to DB vs. DC plans. On some parameters, it may not even be clear which plan type is better. For example, when it comes to recruiting, for some groups such as police, not having a DB plan may be a real problem, but other groups may actually prefer a DC plan if they are more familiar with this type of plan from the corporate world and/or prefer the portability and employee management aspects.
But don’t despair! Now that we have laid out the risks and benefits, you can decide which is more important or relevant to your community. And you are not limited to choosing one or the other. You can implement a hybrid plan, which is a combination of a modest traditional DB and a modest DC plan. This hybrid approach would balance the risks between the plan sponsor and the members, and give you the best of both worlds. More complex hybrid plan designs are also available, but I will leave that to a discussion with your actuary.
Figure 4: Hybrid (DB + DC) plan
There has also been renewed interest in an alternative type of DB plan called a variable plan, which shares the risks between the plan sponsor and members by adjusting member benefit amounts to reflect the plan’s investment performance. You can read more about this type of plan here.
If you are interested in learning more or modeling various plan designs for your community, reach out to your actuary.
- Your Milliman Actuary
This edition of Dear Actuary was written by Yelena Pelletier, ASA.
1 Rhee, N., & Fornia, W.B. (December 2014). Still a Better Bang for the Buck: An Update on the Economic Efficiencies of Defined Benefit Pensions. National Institute on Retirement Security. Retrieved from https://www.nirsonline.org/reports/still-a-better-bang-for-the-buck-an-update-on-the-economic-efficiencies-of-defined-benefit-pensions/.