Defined Benefit vs. Defined Contribution

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corysold
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Defined Benefit vs. Defined Contribution

Post by corysold »

My wife is a teacher in IL. The TRS pensions system just underwent some changes. One of the changes involves an optional entry in a defined contribution plan vs the current defined benefit plan.

As of now, my wife has taught 12 years. The DB plan gives 2.2% of highest 4 of last 10 years of salary per year up to 34. That is my wifes goal. The current salary for 34 years at her education level is ~$105,000. So, assuming no changes in the future, that pension would be ~$78,000/yr, or 75% of her final salary 30 years from now.

The change is that they want 5% of teachers to join an optional defined contribution plan. The teacher would be frozen in their current DB plan and start a DC plan in 2015. So my wife would have 13 years in the DB plan, equating to a 28.6% of final salary pension, plus whatever is in the DC plan. The language from the website is below:

"On July 1, 2015, all members that have joined the DC plan would have their creditable service frozen on that date for purposes of determining a DB pension. To determine a member’s eligibility for a DB pension after the member switches to the DC plan, TRS would use the member’s service credit accumulated under both the DB plan and the DC plan at retirement.

Active members in the DC plan pay an 8.4 percent salary contribution. The state’s contribution would be determined annually.

Upon retirement, members would receive a DB annuity, plus equal payments from an accumulated DC retirement account until those funds are exhausted."

I'm not sure which is the better option. She pays 8.4% of salary either way. My thought is the full DB plan has less investment risk, but more risk of losing benefits in the future. The DC plan puts the investment risk on us, but the earning should be more secure (I think anyway).

As of now, this is our only retirement funds, though we recently opened 2 IRA's we plan on trying to fully fund every year as backup. We are currently 33 and 34, so this is problem 30 years in the future.

Are there any principles that suggest one type of plan is better than the other? Is any part of a pension guaranteed, specifically whatever contribution principle my wife has to this point and in the future, which is currently ~$45,000? Thanks!
cherijoh
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Re: Defined Benefit vs. Defined Contribution

Post by cherijoh »

Without more details on the defined contribution plan your wife would be buying a pig in the poke. The only thing that is defined is your wife's contribution:
Active members in the DC plan pay an 8.4 percent salary contribution. The state’s contribution would be determined annually.

Upon retirement, members would receive a DB annuity, plus equal payments from an accumulated DC retirement account until those funds are exhausted."


My current employer had a DC pension plan that they have since frozen; they now add a direct contribution to our 401K. But the DC plan was well defined - my employer paid 4% of each employee's salary into the plan as "compensation" credit. In addition, there are earnings credits (which still accrue) that are tied to the 10-year Treasury rate. While I do not know the exact amount I will get, I do know exactly how it is calculated.

Typically the main benefit of a DC plan vs. a DB plan is that if you leave the job, you can roll the balance of the account into an IRA so that it continues to grow. Someone who stops working before retirement in a DB plan gets their benefit frozen and then it subsequently gets eaten up by inflation. At least that is how it works with DB pensions where the employee doesn't contribute. Someone more familiar with teachers pensions will be able to give you better advice.
Valuethinker
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Re: Defined Benefit vs. Defined Contribution

Post by Valuethinker »

It's normally better to stay in the DB scheme *if* you plan to continue and finish your career with the employer. If you foresee leaving, then the DC scheme may be better.

So start your analysis with that bias. Usually to get to the same benefit level, by buying an SPIA at retirement, you need a far larger pot of money than you are likely to build up in a DC scheme. Particularly as it appears that, in the future, the State could flex down its contribution to the DC scheme?

A complication is Illinois' fiscal position. I don't know whether the problem includes teachers' pension funds, or just state employees? But as I understand it Illinois is one of the highest risk states in this regard (check that, don't take my word for it). That makes the crystal ball cloudy. However we can predict with some certainty that a resolution will be made, and pension plan members will have to take some pain in that resolution-- whether through reduced benefits or higher contributions (probably both).

The same economic forces that have imperilled private sector DB schemes (airlines, steel, auto etc.) in the last 2 decades are present for public sector schemes as well, it's just been possible to ignore that for longer.
Grt2bOutdoors
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Re: Defined Benefit vs. Defined Contribution

Post by Grt2bOutdoors »

Look up Brooks Hamilton on the web. He designs 401k plans and was interviewed on several Frontline PBS specials concerning retirement security.
He's quoted as saying if you want a retirement of 60% final pay including Social Security, one needs to save 15 to 18% of salary for 40 years without a break in saving. Your wife contributes 8.4% now and is in a defined benefit plan. Now she's being asked to move into a defined contribution plan, where your 8.4% plus some unknown amount may or may not be added - see it could be ZERO if the state decides it can make better use of the money like meeting its defined benefit obligation or paving roads, or giving tax rebates to taxpayers. No, I would not volunteer to get my neck taken off, let them either freeze the whole DB plan or even if they cut benefits, you will likely get 50-60% of the DB plan plus Social Security, still even with what a Brooks Hamiton suggestion for a decent retirement plan would be. Moving into an undefined contribution plan is like taking a walk on a gangplank that spans a deep chasm in the DARK! No way, would I voluntarily do it and chances are there aren't going to be ALOT or ANY takers for this with current members of the TRS.
"One should invest based on their need, ability and willingness to take risk - Larry Swedroe" Asking Portfolio Questions
Topic Author
corysold
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Re: Defined Benefit vs. Defined Contribution

Post by corysold »

The new law (which is going to court soon), in theory shores up the pension system, adding extra payments in future years with a goal of 100% funding by 2044. Of course, that is all speculation that A: The courts don't overturn the law and B: The state actually holds up their end of the bargain this time.

I don't know enough about pensions and their laws to know how much, if any, of what has been put in is guaranteed and whether a DB plan is more certain than a DC plan, or if both rely on the state for payments in retirement.

Essentially, we don't want to be relying on this pension, only to have it disappear 10 years before retirement. We've started secondary savings, but knowing which way to go as far as DB or DC would help, but not having more information on the states actual contribution level to a DC probably makes that cloudy.
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midareff
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Re: Defined Benefit vs. Defined Contribution

Post by midareff »

Looking at this simplistically .......................... Why would they offer you a "richer retirement" deal than the one you already have? One of the things you must consider is how well funded is the DB retirement plan you are presently in, and legislative changes already made or too be made to remediate any foreseen funding problems.

A couple of years ago Florida (my state) instituted a 3% employee contribution to it's DB plan (employer contribution was 3% as well) and modified the 3% annual cola. Folks who did not have 30 years of service were cola frozen at .1% per year of service (ie. 15 years of service = 1.5% annual cola) with further accruals stopped as of that July 1. They are legislatively attempting to raise the contribution to 4%, last I heard. As luck would have it I was already retired and avoided both cut backs. Fortunately the state is a top 5 or 6 best funded and has implemented plans to keep it that way but the 7.75% appreciation rate used to forecast funding still seems overly optimistic.

The core points being... how well funded is the system and at what rate did they forecast investment appreciation, and is it obtainable? Without a commitment from the employer as to their contribution a DC plan is not more than a mandated personal investment, AFAIK, and that may not be a bad thing either as save you must, and 8.4% is just a start.
Topic Author
corysold
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Re: Defined Benefit vs. Defined Contribution

Post by corysold »

midareff wrote:Looking at this simplistically .......................... Why would they offer you a "richer retirement" deal than the one you already have? One of the things you must consider is how well funded is the DB retirement plan you are presently in, and legislative changes already made or too be made to remediate any foreseen funding problems.

A couple of years ago Florida (my state) instituted a 3% employee contribution to it's DB plan (employer contribution was 3% as well) and modified the 3% annual cola. Folks who did not have 30 years of service were cola frozen at .1% per year of service (ie. 15 years of service = 1.5% annual cola) with further accruals stopped as of that July 1. They are legislatively attempting to raise the contribution to 4%, last I heard. As luck would have it I was already retired and avoided both cut backs. Fortunately the state is a top 5 or 6 best funded and has implemented plans to keep it that way but the 7.75% appreciation rate used to forecast funding still seems overly optimistic.

The core points being... how well funded is the system and at what rate did they forecast investment appreciation, and is it obtainable? Without a commitment from the employer as to their contribution a DC plan is not more than a mandated personal investment, AFAIK, and that may not be a bad thing either as save you must, and 8.4% is just a start.
Thanks. I understand the DC is a "worse" plan and likely wouldn't give the same return as the DB plan.

It seems my question is, which is the greater risk at this point?

Without knowing pension law, what is the worst that can happen on the DB plan? A reduction in benefits to 50% max? A total wipeout of everything, including contributions she's made? The DB plan is currently 41% funded, among the, if not the, worst in nation. New funding laws hope to change that, but who knows.

So would the DC, while not as good of plan, offer more long term security? She has to pay the 8.4% one way or the other, so is a simple 8.4%, even if the state paid nothing, for the next 22 years better than the risk of losing everything, or mostly everything, if the DB pension gets wiped out?

Maybe a better question is, while the DB is the superior plan financially assuming both are as expected, which would be better in a worst case scenario? If I better know my risks for each, I could then make a more informed decision based on our situation.
Grt2bOutdoors
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Re: Defined Benefit vs. Defined Contribution

Post by Grt2bOutdoors »

corysold wrote:
midareff wrote:Looking at this simplistically .......................... Why would they offer you a "richer retirement" deal than the one you already have? One of the things you must consider is how well funded is the DB retirement plan you are presently in, and legislative changes already made or too be made to remediate any foreseen funding problems.

A couple of years ago Florida (my state) instituted a 3% employee contribution to it's DB plan (employer contribution was 3% as well) and modified the 3% annual cola. Folks who did not have 30 years of service were cola frozen at .1% per year of service (ie. 15 years of service = 1.5% annual cola) with further accruals stopped as of that July 1. They are legislatively attempting to raise the contribution to 4%, last I heard. As luck would have it I was already retired and avoided both cut backs. Fortunately the state is a top 5 or 6 best funded and has implemented plans to keep it that way but the 7.75% appreciation rate used to forecast funding still seems overly optimistic.

The core points being... how well funded is the system and at what rate did they forecast investment appreciation, and is it obtainable? Without a commitment from the employer as to their contribution a DC plan is not more than a mandated personal investment, AFAIK, and that may not be a bad thing either as save you must, and 8.4% is just a start.
Thanks. I understand the DC is a "worse" plan and likely wouldn't give the same return as the DB plan.

It seems my question is, which is the greater risk at this point?

Without knowing pension law, what is the worst that can happen on the DB plan? A reduction in benefits to 50% max? A total wipeout of everything, including contributions she's made? The DB plan is currently 41% funded, among the, if not the, worst in nation. New funding laws hope to change that, but who knows.

So would the DC, while not as good of plan, offer more long term security? She has to pay the 8.4% one way or the other, so is a simple 8.4%, even if the state paid nothing, for the next 22 years better than the risk of losing everything, or mostly everything, if the DB pension gets wiped out?

Maybe a better question is, while the DB is the superior plan financially assuming both are as expected, which would be better in a worst case scenario? If I better know my risks for each, I could then make a more informed decision based on our situation.
The worse right now is they cut benefits to level of funding, that is - 41% of current projected benefit obligation that is owed. If they continue paying out 2.44 dollars for every dollar funded (1/.41) - the fund will completely run out of money sometime in the next 25 years or so - just in time for your wife to retire and zero money from which to pay her from. That is the worse case scenario. If you figure on a dollar doubling every 12 years under Rule of 72, you need to earn a 6% annual return for that to occur. If your wife is putting in 8.4% of salary and money accumulates at that rate - she may wind up with about 30% of final salary, plus Social Security and maybe 40% of earned pension benefit - so figure maybe 50% of final pay in retirement under mid to worse case scenario. Now you see why folks are scared of saving for retirement? It's a daunting challenge to accumulate enough assets to match a defined benefit plan's collective pool of assets for which you don't have to manage and the risk is on the employer instead of yourself.
"One should invest based on their need, ability and willingness to take risk - Larry Swedroe" Asking Portfolio Questions
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ps56k
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Re: Defined Benefit vs. Defined Contribution

Post by ps56k »

corysold wrote:The new law (which is going to court soon), in theory shores up the pension system, adding extra payments in future years with a goal of 100% funding by 2044..
Wonder what state you are in - we are in Illinois...
and it's just peachy here with TRS and the lack of state funding since, oh - 1970 !!
cowboysFan
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Re: Defined Benefit vs. Defined Contribution

Post by cowboysFan »

It really depends on what laws you think the Illinois legislature passes between now and when your wife possibly collects her last retirement check, as well as how those laws and the Illinois constitution will be interpreted by the courts. Basically, no one knows the answer and even if they did, any discussion of it would be about politics and hence prohibited.
viking112347
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Re: Defined Benefit vs. Defined Contribution

Post by viking112347 »

Also realize that Illinois teachers don't participate in Social Security.

http://trs.illinois.gov/press/reform/ss_why.htm
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