Transcript The Effects of Portfolio Choice on Retirement Wealth Outcomes

Who Chooses Defined
Contribution Plans?
Jeffrey R. Brown
University of Illinois and NBER
Scott J. Weisbenner
University of Illinois and NBER
NBER RRC Conference
October 2006
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Why care who chooses Defined
Contribution (DC) plans?
 Numerous proposals to partially replace DB
benefits provided by Social Security with personal
retirement accounts
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In many proposals, participation in personal accounts is voluntary
Benefit offset – participants must give up DB to have PRA
 To assess welfare implications and timing of
expenditures of Social Security reform proposals it
is important to understand who would opt to
participate in personal accounts
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Existing Research
 Large literature on 401(k) participation
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The counterfactual is different
Consumption vs. saving as opposed to form of benefits
 Better to look at explicit DB vs. DC choice
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Employees at non-profit (Yang 2005)
Faculty at NC universities (Clark, et al 2005)
 Also interesting to observe decision when it is not
already on top of existing Social Security system
(and for broader cross-section of employees)
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Our Research Design
 Examine a sample of individuals that have to
make a one-time, irrevocable choice between
DB and DC plan
 This choice is important as:
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Combined employee & employer contributions
are at least 14.6% of wages for these individuals
Earnings from this employment are NOT
covered by Social Security
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Who is our sample?
 There are seven states whose public-sector
employees do not participate in Social Security

California, Colorado, ILLINOIS, Louisiana,
Massachusetts, Ohio, and Texas
 We have administrative data provided by the State
Universities Retirement System (SURS) of Illinois
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Established 1941, covers all faculty and support staff of
Illinois higher public education including universities
and community colleges
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Decision faced by
SURS-covered employees
 Within first six months of employment, are given
opportunity to make a one-time, irrevocable choice
among three retirement plans:
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Traditional DB plan: formula-based DB plan (or money
purchase when more generous)
Portable DB plan: somewhat less generous than
traditional DB if retire from the system, but much more
generous if take an early lump-sum distribution
Self-Managed Plan: self-directed DC plan
 If make no decision within 6 months, participants
are defaulted into the Traditional DB plan
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Our Focus in This Paper
 What choices do individuals make?
 What worker characteristics are correlated with
retirement plan choice?
 Next paper – why do individuals make their choices
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Brief Background on SURS
 Prior to 1998, all SURS employees’ covered by the
Traditional DB plan
 In 1997, Illinois legislature passed a law allowing
participating employees a choice of three plans
 These new choices adopted by most employers
sometime in 1998
 Rules changing for employees starting after 7/1/05
 Our sample is 45,000 new hires over period 19992004
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Basics on the three options
 Some similarities across the three plans
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All have 5 year vesting for employer contributions
All require employee contributions equal to 8% of salary
All require annuities at retirement if individual wants
retiree health care
 Important differences across three plans along:
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Rate of return
Amount of employer matching contributions
Handling of “refunds” for early termination
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Traditional DB Plan
 The default plan for those who do not choose
 Retirement annuity is the highest amount calculated
under two different formulas

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DB = 2.2% * Service * Final (4-year) Compensation
Money Purchase = annuitized value of account balance (using
generous Effective Rate of Interest)
 But benefit is subject to a maximum of 80% of final
average pay
 In recent years, most individuals have had higher
benefit under the money purchase formula
 Also receive spousal benefits at no additional cost
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Traditional DB Plan
 While this plan is quite generous for those
who retire from it, it is not as generous for
those who leave the system early
 Two choices if leave early:
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Leave money in SURS to grow under MP
formula
Take refund: only receive employee
contributions plus 4.5% interest – no employer
contributions
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Portable DB Plan
 Benefits calculated in same way as Traditional
 Except that one must pay for the survivor benefit
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Amounts to 7% to 13% reduction in benefits
 Big difference in treatment for those who leave the
system before retirement and take refund
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If leave within five years, receive own contributions (+
cumulative returns from an Effective Rate of Interest)
If leave with tenure of 5+ years, receive own
contributions plus a dollar-for-dollar employer match
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SMP (DC plan)
 Entirely participant-directed DC plan
 Participants choose from a variety of mutual funds
provided by TIAA-CREF and Fidelity
 Balance in account depends on asset returns and
vesting status
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If leave system in less than five years, lose employer contributions
If leave system with tenure of 5+ years, leave with employee and
employer contributions
Employer contributions are 6.6% of salary or 0.825-for-one match
 At retirement, must annuitize if want health
insurance – annuity rates inferior to SURS
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Some Comparisons
(for those hired before July 1 2005)
Refund match
Traditional
0%
Refund int rate
4.5%
Benefit if
retire from
system
Portable
100%
SMP
82.5%
ERI (8-10%) Actual returns
Max [DB
Max [DB
formula, Money formula, Money
Purchase] +
Purchase]
Survivor benefits
Annuitized
account
balance
MP interest
ERI (8-10%)
ERI (8-10%) Actual returns
Ben Max?
 80% FAC
 80% FAC
None
Annuity price
Subsidized
Subsidized
Market Rate
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Summary of Traditional Plan
 Traditional plan attractive for those with long
careers under SURS
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DB formula tends to be attractive for those starting at
older ages
Money purchase formula tends to provide higher benefits
for those that start at younger ages
 If leave service early under traditional, rational path
is to leave money in SURS to benefit from money
purchase option rather than taking refund
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Portable vs. SMP?
 Benefits of Portable:
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Portable “match” rate is higher (8% vs. 6.6%)
Portable “return” has averaged 8-10% nominal over past
20 years (and gains are implicitly locked in)
Portable annuity prices extremely attractive
DB formula provides a generous benefit “floor”
 Benefits of SMP
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Not subject to the benefit cap at retirement
Less subject to political risk – but there isn’t any!
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Portable vs. SMP
 For most employees in our sample, it would appear
that the Portable is better choice
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Access to DB formula or MP if retire under system
Higher match rate if refund from system
High Effective Rate of Interest
Would need SMP returns of 9-12% depending on time
horizon to come out ahead with SMP
Impairment clause of constitution minimizes political risk
 Two sets of simulations …
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Portable vs. SMP: Refunds
 Compare refund amounts if leave system
and take the money with you
 Assumes 5% real Portable Return
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SURS real rate over last 25 years is higher
But no guarantees about this rate
 Assumes 60/40 portfolio returns from
Shiller data over 1802 – 2004 with 30 b.p.
expenses
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Refunds: Portable 5% Real Return v.
Historical Returns on 60/40 Portfolio
Time Horizon
5
10
15
20
25
30
35
% times SMP beats
Portable
28.5
38.9
43.8
44.8
43.2
37.7
36.6
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Portable vs. SMP: At Retirement
 Then compare amounts if retire under the
system after working from given age …
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$40,000 with 4% growth in salary
8.5% ERI and 8.5% SMP return (nominal)
DB benefit discounted to retirement age using
1994 group mortality and 4.75% nominal interest
rate
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PV of Benefits at Ret. Age
(* means exceeds 80% benefit cap)
Start
Age
25
30
35
40
45
50
55
Portable DB
Formula
1,445
1,019
698
459
283
155
92
Portable M.P.
Option
2,277 (1,500)*
1,414 (1,235)*
859
504
280
141
85
SMP
2,077
1,291
784
460
256
129
78
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Portable v. SMP Summary
 Portable is the “Winner” under most (though not
all) plausible scenarios
 SMP better only if returns large enough to:
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Beat assumed interest rate under SURS, plus
Cover the contribution differential, plus
Cover the annuity pricing differential
 Even when benefits hit cap under Portable, you can
still take a refund to get higher amount
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Would lose ability to annuitize at favorable rates
Would lose access to retiree health insurance
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How Choices are Currently Framed
SMP
DC
DC or
DB?
Portable
DB
Portable
or not?
Traditional
Alternative Framing
Traditional
No
Value
Portability?
Portable
Yes
SURS
Or Self?
SMP
What Do People Choose?
 This project is focused on who chooses
which option
 Next phase is a survey – why do they choose
what they choose … (more on this later)
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Our Data
 45,000 observations from 1999 – 2004
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Ranges from 6600 to 8600 per year
52% university, 40% community college, 8% other
55% academic, rest is staff, police, etc.
57% female
59% married
Average age is 41
Of the cohort starting in 1999
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35% left prior to vesting
7% left with vesting (as of April 2006)
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Plan Choice, 1999-2004
SMP
15%
Portable DB
19%
Traditional DB
66%
Enrollment in SMP (DC plan)
100
90
80
70
60
50
40
30
20
10
0
Full Sample
Enrollment in SMP (DC plan)
100
90
80
70
60
50
40
30
20
10
0
Full Sample
University
Academic
Enrollment in SMP (DC plan)
100
90
80
70
60
50
40
30
20
10
0
Full Sample
University
Academic
University
Academic
$100K+
Enrollment in SMP (DC plan)
100
90
80
70
60
50
40
30
20
10
0
Full Sample
University
Academic
University
Academic
$100K+
Jeff
Enrollment in SMP (DC plan)
100
90
80
70
60
50
40
30
20
10
0
Full Sample
University
Academic
University
Academic
$100K+
Jeff
Scott
Enrollment in SMP (DC plan)
100
90
80
70
60
50
40
30
20
10
0
Full Sample
University
Academic
University
Academic
$100K+
Jeff
Scott
SURS
Enrollment in Portable DB Plan
50
40
30
20
10
0
Full Sample
University Academic University Academic
$100K+
SURS
The Default Option
 If no choice made in 6 months, defaulted into DB
 Vast majority of Traditional DB plan enrollment is
via the default
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From 1999-2004, 56% of participants default into the
Traditional DB plan vs. 10% that actively choose the
Traditional DB plan
Percent defaulting has grown over time
 Might it be rational to default?
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Plan to be here forever, want the Traditional, so no need
to spend time filling out paperwork
Plan to be here < 5 years, differences in returns are small
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Percent of 1999 & 2000 Cohorts, by Tenure in Plan,
that Defaulted into Traditional DB Plan
70
60
50
40
30
20
10
0
Left in < 5 Years
Left in 5+ Years
Still in System
Empirical Methods
1. Series of linear probability models
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SMP
Portable
Traditional
Any active choice
Choose traditional (given traditional)
Choose traditional (given active choice)
2. Multinomial logit of all four choices
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Empirical Findings
 Academics more likely to choose SMP
 University employees more likely to choose SMP
 Community college employees more likely to
actively choose traditional (unions?)
 Individuals who subsequently left with vested
benefits more likely to choose Portable
 Higher earners more likely to choose SMP or
Portable
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Empirical Findings
 Women more likely to make active choices
 Married individuals more likely to make active
choices
 Older employees more likely to choose traditional
 Younger workers more likely to default
 Evidence of strong “employer effects”
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Peer effects?
Benefit office effects?
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Next Steps
 Lots of information missing from administrative data
that is relevant for retirement plan choice
 2006/07 RRC project
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Focus groups
Survey of members
 We would appreciate your input on survey questions
and survey design
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Hypotheses: Why Choose DC?
 Failure to understand benefit rules
 Optimism about financial market returns
 Excessive optimism about own investment
prowess
 Value choice / control
 (Irrational?) concerns about political risk
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Some Questions …
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Sources of information used when selecting plans
How well can they describe differences across plans
Expectations of financial market returns
Confidence in investment ability
Assessment of political risk
Expectations about length of service under SURS
Social Security and pension coverage of spouse
Views about Social Security reform
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