The New Finance of Longevity

Not All Hybrids Are Created Equal

For state and local employee plans, there is no universal answer to what is considered an ‘optimal plan structure’

A new publication from the National Institute On Retirement Security, authored by Dan Doonan Elizabeth Wiley, looks at current innovations with public-sector hybrid designs. Access the full report here.

Hybrid retirement plans for state and local employees are not new, but these plan designs have received increased attention in recent years as some jurisdictions have sought to modify workforce retirement benefits. A hybrid is not one particular plan design, but instead is an umbrella term capturing a wide range of different plan designs. Some hybrids are defined benefit (DB) pensions with risk-sharing provisions, while others blend attributes of DB and defined contribution (DC) plans. Each of these plan designs offers tradeoffs in terms of retirement benefits, risks, and costs.

The Hybrid Handbook – Not All Hybrids Are Created Equal provides a comprehensive overview of the many aspects of public sector hybrid retirement plan designs. The report finds that some shifts to hybrid designs were made without a proper evaluation of the long-term implications of the plan changes. In contrast, other hybrids are well-thought-out and more likely to provide retirement security to employees, enabling public employers to recruit and retain a qualified workforce.

Excerpts from the Hybrid Handbook

Evaluation Framework

There is no universal answer as to what is considered an optimal retirement plan structure, as this will vary based on the specific objectives of the plan sponsor, the characteristics of the population covered, the environment in which the sponsor operates, and legal and regulatory limitations. However, there is a general framework for designing and evaluating a retirement program. While this approach could be used to create a new plan for a sponsor without an existing program, it is presented in this report in the context of developing a structure for new hires within an existing system because this situation is more common than creating a new retirement system.

This process is typically driven by the sponsor – the state or local government that is offering the plan – but should engage and consider all stakeholders, including taxpayers and employees. The steps of this framework are as follows:

  • Identify the goals of the system
  • Consider the structural, political, legal, and regulatory limitations
  • Determine desired allocation of the risks of the system among the sponsor, active members, and retired members
  • Select structure and implement
  • Monitor and revise

The first step of the framework is to identify the goals of the system, which typically relate to the benefits and the risks of the plan. The benefits of the plan pertain to workforce management and retirement security, while the risks relate to the contributions necessary to fund the system along with workforce management and retirement security. While not exhaustive, this research identifies a number of items commonly considered for each of these categories.

Workforce management objectives relate to recruiting, retaining, and retiring workers as desired, and the effectiveness is determined by the level, pattern, transparency, and predictability of benefits offered.

Retirement security objectives include the adequacy of benefits, the accrual of benefits during a career, and the provision of ancillary death and disability benefits.

Assessing Key Goals of Various Types of Plans

To provide a general assessment of the various types of hybrid plans, the criteria listed below are used:

  • Adequacy and provision of lifetime income to those who retire from the plan
  • Purchasing power preservation in retirement
  • Adequacy of retirement income for those terminating before retirement
  • Funding predictability
  • Funding flexibility
  • Benefit predictability and transparency
  • Workforce management effectiveness

This table was developed to provide general insights and comparisons between various hybrid types. But in evaluating a specific structure, the characteristics may vary from the typical plan of that type based on its specific provisions.

Some hybrids are defined benefit (DB) pensions with risk-sharing provisions, while others blend attributes of DB and defined contribution (DC) plans. Each of these plan designs offers tradeoffs in terms of retirement benefits, risks, and costs...

Retirement Plan Benefit Structures

Having developed a general framework to use in developing or evaluating a plan structure, this section reviews the general types of retirement plan structures that currently exist, including traditional DB and DC plans and various hybrid plans. Traditional DB plans pool members for both investment and demographic risk, providing benefits determined by a formula. For state and local government plans, these formulas typically take the form of a multiplier earned per year of service times the number of years of service times a final average salary amount. With these plans, the employers typically bear the investment and longevity risk, with who bears inflation risk varying by plan. DB plans also tend to include ancillary benefits for death and disability.

Traditional DC plans develop individual accounts of assets for each member that are individually managed by the members. For state and local governments, these plans typically have contributions paid by both members and the employer as a percentage of salary. In this design, the employees bear investment, longevity, and inflation risk. There also typically are no benefits for death or disability other than the accumulated account balance.

Policy Objectives & Transition Costs: New Plans Versus New Tiers

There are factors to consider when considering a new plan or new tier. Important distinctions also emerge when considering a new tier. To achieve key objectives, it is necessary to be clear about the workforce goals of a new plan or tier. At times following the Great Recession, it often seemed as though these issues have taken a back seat to short-term cost concerns as public employers experienced large revenue drops that did not recover quickly. As a result, in many instances, structures for new tiers significantly reduced the value of the benefits from those of prior tiers. In some cases, these reforms were so extensive as to result in employees paying more in contributions than the value of their benefits.

This raises a moral question, and it also impacts the effectiveness of the retirement benefits as a tool to recruit and retain workers. If one of the objectives of offering the plan is to support workforce management, the value of the benefits, including what portion is financed by the member’s contributions must be considered. It is also important to delineate between the existing liabilities of the plan, which the vast majority of state and local systems currently have, and the risk of future liabilities exceeding expectations. Based on legal protections of benefits, changes to a system seldom impact accrued benefits, and in fact often do not impact liabilities for current members related to future periods. In these cases, reduction in the risk of new unfunded liabilities from a new tier is only gradually recognized as members under the new tier replace those under the current tier. While this gradual impact is sometimes given as a reason to not make changes since the short-term impact is limited, by thinking about the emerging liabilities separate from the existing, it is clear that this argument is not valid for the long-term condition of the system.

Read the full report here.