A cost-risk analysis of a proposed hybrid defined contribution/defined benefit plan proposed for California shows that it would provide marginal overall cost savings to government, CalPERS analysis has revealed.
The fund, which is the largest in the US with combined assets of more than $235 billion, prepared the analysis as part of the California legislature’s ongoing examination of Governor Jerry Brown’s 12-point reform of the state’s pension system.
CalPERS and other public pension funds in California face the prospect of losing new members to a hybrid scheme.
The resulting cut in the flow of contributions would make it harder for CalPERS, which is a 75 per cent funded ratio, to meet its ongoing liabilities.
In addition, a closed fund would affect CalPERS’s investments strategy, forcing it to shed risk and increase liquidity as its frozen membership aged and went into retirement.
Because retirement benefits are protected under US law, cutting back a defined benefit (DB) system could also have the unintended consequence of higher costs to government as the DB schemes’ returns decline, forcing employers to contribute more to meet liabilities.
A key driver for the Californian government in introducing a defined contribution (DC) component is to control the costs of providing public employees’ pension plans. Costs are volatile, as the government has to bear the brunt of investment risk.
It is also part of a broader push to bring public pensions in line with private employees, who are predominately part of DC retirement plans.
The National Conference of Public Employee Retirement Systems (NCPERS) predicts that there will be modest growth in hybrid plans over the next two years.
In its 2011 Public Funds Survey, NCPERS found that approximately 5 per cent of public entities in the US already offer hybrid plans and that about 3 per cent of public entities plan to offer a hybrid system in the next two years, while roughly 20 per cent provide DC plans. Five per cent of respondents said they planned to offer a DC option in the next two years.
The proposed hybrid
As part of the reforms, Governor Brown proposes a hybrid plan that would replace 75 per cent of a public employees’ average wage calculated over three years upon retirement.
This 75 per cent retirement benefit would be generated from equal one-third contributions from DB, DC and social security components.
CalPERS also analysed a plan where social security was not included and where two-thirds of the replacement salary consisted of a DB component.
In addition to finding that the employee would bear more of the investment risk, CalPERS analysis also revealed that members in a hybrid plan would receive lower retirement benefits than current employees on a DB plan.
“Even though the total retirement benefits provided to the member by the proposed hybrid plan are lower than those currently in place, the expected savings are generally not significant and for the State plans cost increases for some plans may largely offset cost savings in other plans,” the report states.
“For school employers, cost savings are expected to be about 2 per cent of payroll for new employees. For local agencies cost savings will vary significantly but are expected to be greater than for the State.”
While the details of the hybrid plan as proposed by Governor Brown are still unclear, CalPERS used a range of assumptions – provided by a legislative committee investigating the state’s pension system – as well as its own actuarial assumptions in The Cost Analysis on Creation of Hybrid Plan.
CalPERS assumed that a DC plan would return 100 basis points less than the current assumed rate of return of 7.75 per cent for a CalPERS DB plan.
This assumption was based on three studies comparing the performance of DC to DB plans conducted by Pension Trustee Advisors, CEM Benchmarking and Towers Watson, a company that has been comparing such performance for more than decade.
Towers Watson points to historic performance figures that show that larger plans outperform smaller ones because they have access to a wider variety of investment options, economies of scale and more investment expertise.
The three studies also indicate that DC plans typically return between 80 and 180 basis points on average less than a comparable DB plan.
The CalPERS report finds that more than 6 per cent of a miscellaneous members’ salary and 11 per cent for safety classifications such as police and fire officers would be required in a DC plan to replace 25 per cent of a member’s salary on retirement.
The normal cost in a DB plan for these same members would be up to 4 per cent to replace the 25 per cent of salary and up to 16 per cent to replace 50 per cent for a safety member salary in retirement.
Lower risk, higher cost
Governor Brown has called on all State employees to eventually share investment risk over time, as pure DB schemes would be frozen to new members under his reform package.
Under Brown’s proposal, the employer is expected to see reduced risk in the form of a smaller, less volatile DB component.
CaLPERS finds that the lower risk of this hybrid proposal does not necessarily result in lower overall costs over time.
Its analysis reveals that, while risk is lowered, this has to be balanced against the cost savings associated with a DB scheme.
CalPERS examined a cost comparison of a DB plan that replaced 75 per cent of final compensation with a hybrid plan, finding the costs where higher for the hybrid plan.
This typically resulted in an increase in costs to employers of more than 3 per cent of payroll if they aim for between 75 per cent and 50 per cent of final compensation for a miscellaneous member.
CalPERS then examined whether the risk trade-off for the employer would offset this higher cost, resulting in overall savings.
It found that any expected reduction in risk for using a hybrid plan was virtually cancelled out by the increase in cost for an employer when providing for a miscellaneous employer’s retirement benefit.
This applied to using DB to achieve a 50 per cent replacement target, which is where social security made up a third of the retirement benefit, and when comparing a pure DB scheme replacing the whole 75 per cent replacement target.
In terms of safety members, the expected relative increase in cost for using a hybrid plan was more than the expected reduction in risk.
CalPERS did not include in its analysis the cost of closing its existing DB plan to new members.
In previous report it flagged that if a DB plan was closed to new members, more assets would have to be shifted into asset classes such as fixed income, where cash flows were more predictable.
It would also have to increase the overall liquidity of the fund, which would also potentially impact returns.
CalPERS research shows that between 1997 and 2004, its cost of managing a DB scheme was 0.25 per cent of total assets.
Its previous research finds that annual management fees for a DC plan can be as high as 2 per cent of total assets. The expense ratio for an average stock mutual fund is 1.1 per cent.
It has previously found that returns are on average 1 per cent more in DB plans and costs are typically 0.5 per cent higher in a DC plan.
This would result in a 1.5 per cent difference annually to a DC plan which, compounded over 25 years, can equal up to 20 per cent less for a DC plan compared to a standard DB plan.
CalPERS is currently reviewing its actuarial assumptions and is due to decide on what its new settings will be for calculating its ongoing funding position in March.
To read the full CalPERS analysis, click here.