By Leon F. (Rocky) Joyner Jr.
American private sector workers are woefully ill prepared for their retirement years. The Center for Retirement Research of Boston College has estimated a retirement savings deficit of $5 to $8 trillion for American households in their peak earning and saving years (ages 32 to 64) to maintain their standard of living in retirement and remain robust contributors to the national economy. The calculation took into account all major sources of retirement income and assets, including Social Security, traditional pension plans, 401(k) plans, and personal savings. The alternatives to adequate retirement income are extended working careers or settling for a reduced living standard with greater reliance upon governmental support services.
The pension leg of the traditional three-legged stool model of Social Security, an employer sponsored retirement pension plan, and personal savings (including any employer sponsored 401(k) plan) is practically nonexistent today for private sector workers. Pension plans in the private sector are becoming increasingly rare. According to an Employee Benefits Research Institute March 2011 study, only 30 percent of full time employees working for medium and large companies are covered by a defined benefit plan. The number covered by small business is even lower.
Alternatively, coverage for public sector workers is extremely high with approximately 85 percent of employees covered by employer-sponsored retirement plans, the majority of which are defined benefit pension plans.
Recently, the National Conference on Public Employee Retirement Systems (NCPERS), under the leadership of executive director Hank Kim, began a process to consider how the strength and efficiency of the public sector pension model could be used to enable secure retirement for all American workers. Despite what you may read in the press and hear from some politicians, public sector pension plans continue to provide meaningful benefits and have many advantages. In particular, these plans can achieve low administrative costs and investment expenses through the economies of scale offered by their size. The pooling of assets also provides the opportunity for professional investment management that can provide better benefits for lower cost than a typical individually managed defined contribution plan while also providing lifetime income to participants. Public pensions are nearly universal in all states and as such can provide an easy platform for employers in the state to offer benefits without having to get into the plan sponsorship business while improving portability (employees can stay within the plan within multiple employers in the state). Utilizing the public pension model and focusing on retirement security for all, the Secure Choice Plan was created.
To this end, NCPERS established six guiding principles for designing the “Secure Choice Pension” (SCP). These principles are:
- Overriding Principle: A partnership among private sector workers and employers, and public sector plan sponsors, to build retirement savings
- Provide secure lifetime retirement income
- Provide flexibility, portability and simplicity
- Manage and share risk
- Leverage the investment power of public plans
- Augment (and not replace) existing retirement savings programs
In applying these principles, SCP embraced:
- Risk sharing among participating employers and workers
- Hybrid plan design approach
- Portability and simplicity
- Conservative funding requirements
- Transparent governance through a Board of Trustees
- Flexibility in sharing any potential underfunding due to
- Improvements in life expectancy
- Plan investment experience
- Employer withdrawals
From these base principles and design specifications, SCP was developed and stress tested. As noted earlier, SCP is intended to be the missing pension leg of the three-legged stool. SCP is NOT intended to replace either Social Security, employer sponsored 401(k) plans, or personal savings. An employee needs all of these components to build a secure retirement.
The Benefit Design
The SCP design is a very basic, career accumulation benefit. It does not include any subsidized early retirement benefits, credit for prior unfunded service or significant early career death or disability benefits. It is designed to provide about one-third of the income necessary for a secure retirement.
The basic elements of SCP are as follows:
- Retirement at age 65
- Notional account balance accumulating at 6 percent of salary each year
- Interest credited based on U.S. Treasury notes
- Minimal 3 percent career average interest rate credited to the notional account balance
- Immediate vesting
- Life annuity at retirement, no lump-sums permitted
The chart below shows that Social Security plus personal savings of 6 percent of salary (including 401(k) savings) with investment earnings of 5 percent annually is expected to replace about 55 percent of pay at retirement for a career worker. The benefit from SCP is expected to add an additional 29 percent totaling 84 percent. Even if the economic conditions result in application of the 3 percent minimum, the total combined replacement ratio is estimated to be 66 percent.
1 Calculated using 2011 Social Security bend points and assuming career earnings consistent with national average. For ages 35 and 45, the replacement ratio is prorated to reflect the fraction of a participant’s 35 years of covered earnings used in Social Security Primary Insurance Amount calculation which would be earned under their tenure with their current employer if they worked until age 65.
2 Calculated using assumed salary increases based on age, an average investment return of 5 percent per year, annual accruals to the account balance of 6 percent of salary, retirement of age 65, and annuity conversion based on PBGC annuity valuation assumptions.
3 Calculated using assumed salary increases based on age and an interest crediting rate of 5 percent per year to the notional account balance.Source: The Segal Company
To assure adequate long-term funding as well as protection from near term possibilities, SCP funding takes a “belt and suspenders” approach. Funding redundancy is built in with four layers of protection.
- Layer 1: Benefit Design
- Layer 2: Annual Contribution
- Layer 3: Dividend Reserve Fund
- Layer 4: Termination or Withdrawal of an Employer
Layer 1: Benefit Design
As noted earlier, the plan of benefits is designed to minimize the potential for underfunding. To achieve this goal, the plan design offers:
- No subsidized early retirement
- No past service liability at plan inception
- Conservative annuity conversion, including generationally projected mortality
- Possible reduction to the minimum level of benefits accrued if future experience is negative
- Limited potential gain-sharing from positive results
Layer 2: Annual Contribution
The required annual contribution will be a combination of two amounts. The first amount is the “Standard Funding Contribution.” This annual amount is the sum of the normal cost and a 15-year level dollar closed amortization of any unfunded accrued liability. The normal cost and accrued liability are based on 7 percent discount rate, appropriate salary scale, RP-2000 Combined Healthy Mortality blended 50/50 male/female projected generationally with Scale AA, five-year asset smoothing method, and entry age normal funding method. The Standard Contribution may never be less than the normal cost.
The second amount is referred to as the “Conservative Funding Calculation.” This calculation is the normal cost, plus a 20-year, level dollar closed amortization of any unfunded accrued liability as of the valuation date. The accrued liability is determined using the same assumptions and methods as the Standard Funding Contribution except that the discount rate assumption is equal to the annual crediting rate for the year (assumed to be 5 percent for modeling purposes) and the mortality assumption will be projected an additional 20 years. Assets in this calculation will be the lesser of actuarial value and market value.
The Annual Contribution is equal to 70 percent of the greater of these two amounts, plus 35 percent of the lesser amount. The 105 percent total sum provides an extra level of conservatism.
Layer 3: The Dividend Reserve Fund (DRF)
Based on plan experience, the SCP will create a DRF by reserving an amount, which is equal to 70 percent of assets in excess of 110 percent of the Conservative Funding Calculation accrued liability. This reserve is available, at the discretion of the trustees, to either grant a retiree dividend or allocate toward plan funding to provide relief for employers. The retiree dividends granted may be reduced to the minimum benefit guaranteed by the 3 percent career interest accumulation if subsequent experience does not support their continued payment.
Layer 4: Termination or Withdrawal of an Employer
In the event that the first three layers of protection fail to prevent an underfunded position and a participating employer should terminate when the plan is underfunded, then the trustees must implement a methodology for eliminating the underfunding. These four options are available for the trustees to allocate the underfunding:
- Assess the terminating employer a withdrawal amount, similar to the withdrawal liability assessed to terminating employers under ERISA multiemployer plans
- Establish an insurance pool using plan premiums to provide termination coverage
- Cover the liability from a dedicated reserve
- Limit future benefits to the amount that could be supported by assets at termination
Segal stress tested the SCP design by modeling a sample employer’s assets, accrued liabilities, and contributions under varying economic conditions. The sample employer assumes 25 employees with ages uniformly distributed over the working career and an average salary of $40,000.
The modeling assumed a 50/50 annuity and fixed income portfolio net of 0.5 percent for expenses. Stress Test 1 assumes all assumptions are met including 7 percent annual return. Stress Test 2 models investment returns from 1990 to 2000 and Stress Test 3 uses years 2000 to 2010.
All three tests provide very stable contribution rates the first six years. Predictably, Test 1 is stable for all years. In Test 2, the positive returns begin to reduce required contributions and create a DRF around year seven. Test 3 remains very stable through year 9. Year 10 shows the impact of 2008, but even this poor investment return scenario does not appear to be a catastrophic increase. Furthermore, even under Test 3, after 11 years of very difficult investment returns, the plan remains overfunded using a 7 percent discount rate assumption and assuming investment returns over the long term of 7 percent.
A summary of each stress test is shown below:
There has been much discussion about the looming retirement savings crisis. So much so that the national vision of retirement is becoming blurred. What does retirement mean? Will there be a generation that will never be able to stop working? The SCP concept moves the discussion from one of talk to one of walk. SCP may not be the only remedy but it is one that builds on existing retirement savings programs—Social Security, IRAs, and defined contribution arrangements—to provide meaningful additional income, which can be the difference between inadequate retirement income, and retirement security.
Leon F. (Rocky) Joyner Jr., ASA, MAAA, EA, FCA, is vice president and actuary with The Segal Company in Atlanta, Ga. He may be reached at email@example.com.