Historically, state and local governments have considered defined benefit (DB) plans to be the fundamental component of a successful employee retirement program. Today, deep-rooted financial issues and political realities such as unfunded benefit mandates are challenging the sustainability of traditional DB plans. Demographics play a role as well, with not enough people paying into the system to pay retirees, and longer life expectancies increasing governments’ retirement obligations. For some states and municipalities, the ability to deliver on promised benefits is seriously in question.
To address these and other challenges, state and local governments are in the midst of examining the structure of their retirement plans. A number of states and municipalities have initiated changes focused on boosting the financial predictability and sustainability of their plans while still providing an appropriate level of retirement income to their employees.
For example, this year the state of Rhode Island will restructure its core retirement program for public employees to be a combined defined benefit/defined contribution program (DB/DC) that will initially cover an estimated 30,000 employees. Under this hybrid model, employees continue to participate in the state’s defined benefit pension plan, but also contribute to a defined contribution plan designed to emphasize a long-term approach to creating a secure retirement for plan members. Employees are required to make a pre-tax contribution to the defined contribution plan, with the state and municipality also contributing to each employee’s plan. By taking a hybrid approach the state expects it will be able to treat all employees fairly and spread the market risk of the system across both taxpayers and employees. Going forward, participants will pay a smaller portion of their paychecks into the defined benefit portion of the plan, while contributing to their own retirement security through a risk-managed defined contribution component in which their money can grow over time.
The hybrid approach is one among several alternative plan designs that governments are exploring today. To help sponsors understand the issues, we will periodically comment on these alternatives on this website. Following are some of the questions raised by the hybrid approach taken by Rhode Island and other jurisdictions.
What defines a good risk-managed hybrid plan?
First, it’s structured around outcomes for individual participants and focused on providing employees with lifetime income. Participants do not simply accumulate a nest egg; instead, they receive educational tools and objective advice to help them plan for their financial well-being throughout their retirement.
Second, it’s designed and structured to afford protection to plan sponsors, whether that’s the government or, more broadly, taxpayers. It should also afford an additional level of protection against unfunded mandates.
Third, it contains proper risk-management guardrails, such as an appropriate number of well-diversified, low-cost investment options, to provide a high probability of achieving appropriate income-replacement ratios in retirement.
How can a well-designed hybrid plan increase the probability that employees can replace their income in retirement?
Studies show that in order for individuals to maintain their standard of living in retirement, their income should generally be 75-80% of their pre-retirement earnings. For a hybrid plan to be used to meet these goals, it should include three characteristics:
First, its investment structure should be limited to provide simplicity to individuals, while also offering appropriate investments, low fees and customized portfolio solutions that feature genuine diversification.
Second, the plan should provide robust education and advice to participants. For those investors who want to be actively involved in managing their portfolio, it’s important for there to be independent, third-party investment advice with no direct costs to the plan participant. As part of the advice offering, there should be a fund lineup that covers the appropriate asset classes with the right kind of funds and the right share classes.
A third element is distribution. The defined contribution component should be operated as a core retirement plan, not a supplemental savings plan. As such, distributions such as loans or hardship distributions should be permitted only in circumstances that justify a deviation from the core retirement purposes of the plan. We also believe that sponsors should allow for some portion of the DC plan assets to be distributed to participants as lifetime income.
How can a hybrid plan save money for governments and make their retirement budget more predictable?
Although governments may still have existing unfunded liabilities to manage, under a hybrid plan, they are less likely to continue to accrue such liabilities in the future.
A hybrid plan also offers predictable budgets with a defined contribution structure, with costs defined as a percentage of payroll. Under existing plans, governments may plan for a pension fund to return 8%, for instance, and be forced to make up the shortfall by cutting budgets in other areas when the fund only returns 6%. Governments need to know what they can spend on critical areas such as schools, infrastructure, police, fire—they should minimize, to the extent possible, the uncertainty that comes with investment returns.
How do employees benefit from a hybrid plan?
Employees, like government plan sponsors, benefit from increased predictability of costs. The costs of the program are generally shared between employees and the employer, and employees always know how much of their salary is going into the plan each pay period.
The hybrid plan also recognizes the current realities of government employees’ career patterns by supporting job mobility. The portability of the DC component — the ability for employees who leave the system for another job to either keep their assets in the plan where they can continue to grow, or take their assets with them to a new job — is another significant benefit for employees.
Perhaps most important, with their risk-managed, long-term investment approach, hybrid plans go beyond a focus on accumulation to include a payout feature that helps ensure retirees will not outlive their savings.
Employees who were counting solely on 401(k)-type plans to fund their retirement found themselves in dire straits when their savings declined in value during the economic crisis. How does a hybrid plan minimize such risks?
Hybrid plans protect against risks, such as a steep decline in value, by including a guaranteed portion and a defined benefit.
Many 401(k) plans have an unlimited investment structure, so they can include a confusing number of investment choices and retail share class mutual funds that are very expensive. By contrast, hybrid plans offer a more controlled investment environment, resulting in lower costs and appropriate levels of diversification.
Hybrid plans can also offer attractive opportunities for individuals even if they are not sophisticated investors. The investment lineup may include customized lifecycle funds, which tailor investments to an investor’s target retirement date. Hybrids should also feature a comprehensive education and communication plan that's designed to help individuals make informed decisions and build retirement security.
A time for action
As we’ve seen, many state and local governments are seriously considering how to restructure their retirement plans to address the economic and demographic challenges they face. This provides an excellent opportunity for leadership to reaffirm their commitment to providing a safe and secure retirement for their employees, while still meeting their broad mandate to administer state and local programs that serve the entire population. Alternatives such as the hybrid plan model offer one way forward. As retirement models and structures continue to evolve we believe the focus should remain on treating all employees fairly, managing risk prudently and meeting the retirement needs of employees responsibly.
The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons.
Past performance does not guarantee future results.
TIAA-CREF was selected in February 2012 as the vendor to administer the defined contribution component of Rhode Island's new hybrid retirement program.
Please note that LifeCycle or Target Date funds are not guaranteed at any time, including at the target date. The target date is the approximate date when investors plan to start withdrawing their money.
Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income.
Please note that investments in securities carry various risks.