Thursday, May 19, 2011

Making Sense of Pension Reform: Defined Benefit versus Self-Managed Plans

NOTE: If there are any inaccuracies, please report them in the comments.

There is misunderstanding on the part of those with Self-Managed Plans (SMPs) that the proposed pension reform places them in a better position than Defined Benefit (DB) plan members. True, the biggest hit will happen to those in Defined Benefit (DB) plans. The lower impact of the proposed "reforms" (on SMPs) occurs because DB plans (traditional, portable) are much more generous. Nevertheless, keep this in mind: if you are in a DB plan, you KEEP ALL PAST EARNINGS: employee AND employer contributions plus interest (averaged 8.5% in past 15 years). The effective rates below:

9–1–97 thru 8–31–98 9%
9–1–98 thru 8–31–99 9.5%
9–1–99 thru 8–31–02 10%
9–1–02 thru 8–31–03 9%
9–1–03 thru 6–30–05 8%
7–1–05 thru 6–30–09 8.5%
7–1–09 thru 6–30–10 8%
7–1–10 thru 6–30–12 7.5%

Source: SURS

This money doesn't disappear if the legislature effectively forces DB members into 401(k) style SMP plans. Here are the advantages of DB over SMP:

1. Under SMP stock investment plans, it would be hard to match the 8.5% over those years. Example: employee hired in January 1998. The Dow Jones ("stock market" average) was 6450. Thirteen years later end of 2011, the stock market was at 11,577. That is an 80% increase. HOWEVER, if that employee had earned 8.5%/year (on average) his/her money would have doubled after 8.5 years and tripled after 13 years. In other words, SMP stock market investments would have had to TRIPLE to match the DB plan -- that is equivalent to a stock market average of 20,000 at end of 2011 rather than 11,577. 


How did DB outperform the stock market? This is controversial: first, keep in mind that the pension contributions are invested in a mix of stocks and bonds. Critics, however, believe that the pension board has goosed the numbers to please legislators: the higher expected rate of return, the less legislators must contribute! The truth is probably in the middle.

2. DB is more generous because the politicians are attacking it. Numbers aside, they are like the bank robber who was asked "why did you steal from the bank?" Answer: "Because that is where they keep the money!" Why?

3. Employers contribute 9.1% versus 7.1% for SMP employees (7.5% before expenses removed).

4. Cost of living: this is a HUGE factor -- when I ran financial plans for clients back in the 1980s, they grossly underestimated how much the cost of living (inflation) would erode the real value of their retirement savings. Yet the State protects DB recipients against inflation. SMP recipients are on their own -- each year their retirement fund is worth less.

5. SMPs are favored under the new Madigan/Cullerton bill in the legislature: state contribution "only" drops to 6% (although it may be 5.6% after expenses removed). Wonder why? Tens of billions of dollars in IOUs go POOF! when we are all on SMPs.

"What is to be done?" Note the usual caveat that you should seek advice from a licensed broker, estate planner, laywer, etc. before making any financial decisions. What would I do if I were a DB employee faced with a 7.3% increase in my pension payroll deduction? I'd hang tight until the courts have ruled. I don't expect much of the judiciary since the New Deal Court Revolution rendered government contracts something that could be changed at the whim of those in power. But who knows? Keep in mind you are still ahead of people who chose SMP over the years expecting to "beat the market" (and being handicapped with a lower state contribution!).

I joke that current retirees are "LGRs": the Last Generation of Retirees. It has nothing to do with partisan or class warfare but, rather, generational warfare -- and a "war" that isn't even declared but simply happened due the confluence of past events and current demographics.

On the generational front, there is positive news: if your parents left you or your spouse a trust fund/inheritance, you may still be able to retire and send the kids to private college. The rest of you are screwed. But I must end on a happy note. . .

There is another State of Illinois plan to raise retirement money (scroll down):

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