The average age of a Maine resident is the highest in the country and the proportion of Maine’s population over the age of 65 is fifth highest, according to a report published last fall by the Brookings Institute. Accordingly, understanding the retirement income situation for older Mainers is a key public policy issue. This article will explore the basics of retirement plans, and will provide an overview of what the retirement picture looks like for future retirees and what challenges lie ahead.
Benefit or Contribution
There are two principal types of retirement plans: “defined benefit” and “defined contribution.”
A “defined benefit” plan is a traditional pension system where an employer provides a fixed benefit to its retired workers for as long as they live. Typically, the employer and employee both contribute to this type of retirement plan. The amount of the benefit is “defined” by a pre-determined formula, usually having two variables: salary and years of service. For example, an employer pays a retiree 2% of his final annual salary (or often the average of the last three years of employment) for each year of service up to 30 years. The federal Social Security program is a defined benefit system, as is the Maine State Retirement System, a pension program for all state and many local government workers in Maine.
A “defined contribution” retirement plan, by contrast, is one where the employer and employee jointly make tax-deferred contributions to a retirement account for the employee. The amount of employer contribution is usually contingent on two variables: salary and amount of contribution by the employee. For example, an employer might annually contribute 1% of a worker’s salary into a retirement plan for each 1% the worker contributes, up to some maximum level (typically around 5%). The most common defined benefit contribution systems are the “401K (private sector)/401A (public sector)” and “457” plans which are known by their section in the IRS code. The Individual Retirement Account (IRA) is also a tax-deferred retirement savings plan, similar to the 401 and 457, except that most IRAs do not have an employer contribution and may not be payroll deductions.
Originally, most government employees were excluded from Social Security. Since 1991, only governmental employees covered by traditional defined benefit pensions (e.g., Maine State Retirement) are excepted from Social Security; all others must enroll. Nationwide, 96% of all workers and approximately 70% of state and local government workers are now in the Social Security system. In Maine approximately 52% of government workers are covered by Social Security.
Trends – National
The traditional “defined benefit” pensions are on the way out in the United States, especially the private sector ones. According to the Employee Benefit Research Group (EBRG), the number of American families that had at least one member enrolled in a traditional pension plan plummeted by 40% from 1992 to 2004 such that now only one out of four American families is enrolled in such a plan. Correspondingly, EBRG reports that participation in defined contribution plans has increased in the same period by 38% so that just over half of all families are now covered by a defined contribution plan.
In other words, retirement plan coverage has remained constant since the early 1990s, at around 75% of all families. However, where enrollment in the two types of plans was roughly equal in 1992, participation in 401-style plans increased to double that of traditional “defined benefit” pensions by 2004 (excluding Social Security participation).
Trends – Maine
In Maine, the type of retirement plan one has varies by employment sector – the starkest differences are between state government workers and the private sector. Local government employees cannot be generalized because, unlike state employees, participation in MSRS is voluntary for the municipality and its employees.
The Maine Department of Labor surveyed over 1,200 Maine businesses in 2004 regarding benefits. Its report indicates that two-thirds of Maine businesses offer some form of retirement benefit to full-time employees and almost half offer some form of benefit to part-time employees.
Of those businesses that offer a benefit to full-time employees, 86% offer a defined contribution plan and 14% offer a defined benefit plan other than Social Security. Similar figures from 2001 show that Maine is following the national trend in the private sector away from defined benefit pensions.
These trends vary somewhat by the field of the private sector employer. For example, traditional pension plans were most frequently offered by manufacturing and financial services firms and least frequently by hospitality, professional, construction and information services.
On the public sector side, the major defined benefit program is the Maine State Retirement System (MSRS). MSRS administers defined benefit programs for state workers (non-university), K-12 teachers, and some other governmental organizations (counties, municipalities, state authorities, utility districts, etc.) who choose to participate.
As of June 2006, there were approximately 52,000 active workers making contributions to the MSRS system. Those 52,000 workers can be broken down into three broad categories: state workers (14,500), teachers (28,100), others (9,400). State employees and teachers are obligated to join MSRS. Accordingly, 100% of state employees and teachers are covered by a defined benefit plan.
The “others” category includes state, county, municipal, and quasi-governmental employees whose employer has elected to participate in MSRS (these employers are called “Participating Local Districts” or “PLDs”). There are approximately 267 PLDs in the MSRS.
A municipal employee enrolls in MSRS if his municipality has joined MSRS as a PLD and if he chooses to participate in the MSRS plan. Some municipalities offer a choice of MSRS or a “defined contribution” plan and other municipalities offer both. Those municipalities that don’t participate in MSRS must participate in Social Security, and may or may not also offer a “defined contribution” plan. MSRS will soon be unveiling a “defined contribution” plan in addition to its regular “defined benefit” plan.
A summary of data received from Maine Revenue Services regarding 8,800 of the 9,400 “Other” government employees in various PLDs is shown in the accompanying table.
This table reflects only “active” employers that are still allowing new employees to join MSRS. There are another 600 or so current employees covered by MSRS who work for employers who do not allow new employees to join MSRS. Based upon the above numbers, one would assume that approximately two-thirds of this additional 600 are purely municipal. Accordingly, there are approximately 5,500 “purely municipal” employees and another 1,000 municipally-related employees in utility districts, school districts and housing authorities.
A challenge is getting an accurate number of full-time, “purely” municipal employees in Maine. Most estimates are in the 10,000 to 15,000 range. If this range is accurate, the percentage of full-time, municipal employees enrolled in MSRS is somewhere between 33% and 50%.
Size is the most obvious characteristic for which types of municipal governments offer defined benefits. The eight largest city participants and two largest town participants account for 3,000 of the 5,500 city and town employees covered by MSRS. In other words, 2% of municipal governments account for 55% of municipal employees in this defined benefit program. (NOTE: The authors do not know what percentage of total full-time municipal employees are employed by these 10 municipalities. It is clearly much more than 2%.)
One may safely generalize that many of Maine’s private sector employers predominantly offer “defined contribution” plans as opposed to company-sponsored “defined benefit” plans, and since Social Security is mandatory for the private sector, they also provide that “defined benefit” plan.
In the governmental arena, all Maine state employees and teachers are enrolled in a “defined benefit” plan – Maine State Retirement System – and some also have “defined contribution” plans. Maine’s municipalities are not so easily categorized. Additionally, those communities, with employees, who don’t participate in MSRS must participate in Social Security, whether or not they have a “defined contribution” plan.
Risks and Rewards
Defined benefit and defined contribution plans each have positive and negative elements for both the worker and the employer. Understanding the positives and negatives is essentially a review of how the risks and rewards under each system are allocated.
Defined Benefit. From the employer’s perspective, offering employees a defined benefit plan is attractive for two primary reasons. First, it promotes stability and longevity in employment. A consistent issue for most employers is retaining good employees. Since defined benefit plans are calculated with a years-of-service factor, employees are given an incentive to stay with one employer.
The second reason a defined benefit plan can be attractive to employers relates to the risk-reward calculation. In defined benefit plans, the employer manages the retirement fund. The weekly employee and employer contributions are pooled by the employer and then invested, generally by a professional investor. The pooled employee/employer contributions available for investment can be quite large. Thus, if the investments provide returns in excess of what is needed to cover the benefits promised to the retirees, employers can gain a windfall from their retirement program.
During periods of strong stock markets, the employers benefit in that the retirement fund grows faster than the actuarial liability associated with paying out the retirement benefits. During very strong markets, employers might earn “windfalls” from their pension plans.
In Maine, investment returns for the Maine State Retirement System have been quite healthy (7.5% in 05-06 on top of 11% in 04-05).
There are two major risks associated with defined benefit systems. First, there is the obvious flip-side to the windfall phenomenon. When investment returns are poor and fail to meet the built-in assumptions underlying the system, the employer is responsible for the shortfall. The employer can’t just go back to the employees and ask them to either contribute more or accept fewer benefits.
The other risk that employers face is retirees living longer than the actuaries expected. That is, if the pension system assumes that retirees live an average of 10 years the employer bears the cost if the retirees live an average of 12 years.
From the employee’s perspective, a defined benefit system provides a sense of security from knowing that one will receive a sufficient pension that will provide a comfortable retirement for that person’s entire lifetime. This security is also accompanied by the lack of stress from not being responsible to manage one’s own retirement fund.
The primary downside to a defined benefit plan is that an employee does not own the retirement fund assets. If an employer does not manage the plan’s assets very well, it could spell trouble for the employees come retirement time. There is a federal pension guarantee system that sometimes steps in and bails out companies or forces them to liquidate other assets to honor their pension promises. However, this is a very frightening prospect for employees who don’t have the federal government-backed Social Security system to rely upon. The other downside to employees is that they sacrifice the opportunity to personally profit from the high returns produced by bull markets; those benefits accrue to the employer only.
Defined Contribution. The defined contribution system is one where the employee manages his own retirement savings. The typical vehicles for this are 401, 403(b) or 457-type plans where the employee chooses from a range of investment vehicles.
This plan is appealing to employers because there is no relationship between the employer and the employee after retirement. The employer thereby avoids any of the actuarial risks such as long-lived retirees or downturns in the market. The employer is only on the hook for its annual contributions to both the 401 plan and Social Security. Thus, any opportunity to rely on investment acumen to cover the employer’s contribution to its pension obligations is lost, as is any windfall opportunity.
Employees, particularly younger employees, are attracted to defined contribution plans for two reasons. One is that younger workers are more confident (maybe overconfident) that they can make wise investment decisions. Plus, young workers have never experienced an extended period of poor market returns. In addition, young workers are changing jobs more frequently and are attracted to the portability of 401s. According to a recent Bureau of Labor Statistics study, the average American worker will hold ten jobs between the ages of 18 and 38.
The defined contribution plan is also attractive for its “rollover” features. The employee owns the retirement fund and can either continue contributing to the fund in the next job (if the employer offers a 401/457) or let it ride until retirement age. Typically, employers’ contributions are subject to a “vesting” period which means that at the end of an initial employment period the employee gains ownership of the employer’s contribution to the 401 or 457 plan. The employee always has ownership of his contribution. A normal vesting period is three years.
A downside to defined contribution plans is that the only guaranteed benefit is what’s in the fund. If the individual employee either makes poor investment decisions, or fails to save enough (by not contributing much), the employee suffers the harm.
The Better Deal?
A natural question is: Which is the better deal as an employee?
Most financial planners will tell you the best deal is having both – a defined benefit and a defined contribution plan. Most defined benefit plans, however, cannot be relied on entirely for a comfortable retirement income (especially Social Security).
There are approximately 25,000 retirees currently receiving retirement benefits through MSRS. For those who have 30 or more years of service (approximately 6,000 retirees), the average final salary of this group was $38,000 and the average annual benefit is $29,000.
By comparison, a defined contribution employee who retired in 2006 with a salary of $40,000 after 30 years of service with a 401K account balance of $285,000. would get $29,000 per year for 15 years under a typical annuity plan.
Thus, from the retiree’s perspective, if one lives longer than 15 years, the defined benefit plan could be said to be preferable. If the retiree lives less than 15 years, the defined contribution plan is preferable (because the unused balance would remain in the estate of the deceased).
Excluded from this comparative analysis is Social Security. Approximately half of all MSRS enrollees are not covered by Social Security while all workers in a defined contribution plan are covered. Giving a more accurate answer to the question “which is the better deal” would require an accounting of Social Security. Accurately accounting for the impact of Social Security would be tricky.