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Pension Pals

By Cindy Long

 Brenda Brum  Dolores Townsend
Longtime friends and fellow retirees Brenda Brum (pictured top left) and Dolores Townsend (top right) have a lot in common. They both like antiquing and poking around flea markets. They both care for an elderly parent. They both taught at the same school. And they both feel fortunate to have avoided a financial decision that would have kept them working well past retirement age.

Brum and Townsend live in West Virginia, which until a few years ago had the worst-funded pension plan in the country. By the early 1990s, the plan was on the verge of collapse, with just 14 percent of the money needed to cover the pensions it owed teachers.

In 1990, then-Gov. Gaston Caperton signed legislation to pay off the pension liabilities over a 40-year period. But it also changed the plan from a defined benefit (DB) pension to a defined contribution (DC) 401(k)-type plan.

Effective July of 1991, West Virginia’s new teacher hires were placed into the DC plan. Educators hired before that date were given the choice of enrolling in the new 401(k)-type plan or staying with the pension. Lured by the possibility of huge investment returns instead of a lower, but steady, pension income, many made the switch to the DC plan.

But not Brum or Townsend—they opted to stick with the DB pension, and now they’re counting their blessings rather than the number of years to retirement.

“I have colleagues who changed to the DC plan and they have to keep on working,” says Townsend, who retired in 2009. “They’ve been ready to retire, but they lost all their 401(k) savings in the crash of 2008, and now they can’t afford to retire.”

Turns out they wouldn’t have been able to afford to retire before the crash either.

By 2008, according to a study done by West Virginia’s Consolidated Public Retirement Board, most teachers age 60 or older who participated in the 401(k) had $100,000 or less in their accounts—a fraction of what the pension would have provided them, and not nearly enough to retire on and remain self-sufficient.

“In West Virginia, people think $100,000 is a lot of money. Teacher salaries have always been so low, people have a distorted view about how much is enough to live on,” says Brum, who retired in 2011. “But most people live 18 to 20 years after they retire, and how can you stretch $100,000 over that time? The only option is not to live as long!”

According to West Virginia Education Association (WVEA) Executive Director David Haney, the DC plan “failed in every way, shape, and form.”

He gives an example of a woman who retired on the pension plan at age 60 after 30 years of service. Over those 30 years, she’d contributed $51,604 to her pension (despite common misperceptions that taxpayers fund pensions, they’re actually a shared responsibility with employee contributions and investment earnings doing most of the work). The plan’s benefit formula is 2 percent of final average salary times years of employment. The woman’s final salary was about $45,000 a year, so her pension is $2,261 a month. To earn the same amount in the DC plan, she would have had to amass $323,400 in her 401(k)—a hefty sum compared to $51,604, and a long shot given the market’s volatility.

401(k)s Weren’t Meant to Replace Pensions

Defined contribution 401(k) plans were never intended to be a pension replacement for employees. They were originally created as a perk for highly paid executives, and were called “salary reduction plans” before being renamed for the tax code that makes them possible. The thinking was that the more these executives were paid, the more they could afford to contribute from their paychecks, and the more they had for retirement—on top of the old stand-by pension and Social Security. Another perk was the portability of DC plans—convenient for executives climbing the corporate ladder from one company to another.

It all sounds pretty good when the markets are hot and delivering high returns, which is why so many working Americans clamored to get in on the 401(k) action starting in the 1980s. But what happens when the bottom falls out like it did in 2008?

People lose money. Lots of money. And moderately paid public employees, like teachers who’ve spent their careers serving the public, find themselves suddenly unable to retire after their 401(k)’s value has sunk.

Pensions Provide Secure—and Higher—Retirement Benefits

For years, David Haney and WVEA members lobbied the West Virginia government to return to a pension system that provided secure retirement benefits and was managed—and funded—properly. They pointed out the discrepancies between the DB and DC plans, showing why the pension plan offered a much better retirement benefit for employees and major cost savings for the state.

Finally, the retirement board’s actuary provided some facts that backed them up.

The actuary discovered that savings rates in the DC plan did, in fact, lag far behind monthly benefits that the DB plan would pay. The DC plan members, including new hires and those who made the switch in 1991, had an average of $33,944 in their accounts by June of 2005. Those over 60 had an average of just $23,193—a trifling amount to spread over the rest of their lives in retirement. Teacher participants in the DB plan, however, earning the average salary after 30 years of service, would receive an annual pension of $27,000—that is $27,000 each and every year of their retirement, whether they lived to be 68 or 108.

The government saw the red ink writing on the wall, and in 2008, West Virginia agreed to switch back to a DB plan.

Here’s why they made the switch and why other states should follow suit.

Defined Benefit Plan Investments Are Managed by Financial Experts

Over a 30-year period, according to a study by the National Institute for Retirement Security (NIRS) and consulting firm Milliman Inc., DB plans delivered an almost 25 percent greater return to participants than DC plans.

One reason for the higher returns is that DB plans’ investments are managed day to day by investment experts rather than individually by people with little investment knowledge, like those in West Virginia.

“The DC plan participants received absolutely no education on how to manage their investments,” says Haney.

“Do most classroom teachers, bus drivers, and cafeteria workers know what their risk tolerance is, or about their time horizons? Do they know the difference between fixed securities and equity securities, or max-cap versus mid-cap? Do they know whether they should invest internationally, in growth stocks, or derivatives?” asks Haney.

Defined Benefit Plans Lower Costs With Pooled Risks

DB plans are pooled and therefore have “built-in” savings that allow them to deliver retirement benefits at a lower cost to the employer as well as the employee.

First, they average risks over a large number of participants. Instead of requiring contributions substantial enough to provide retirement income through a person’s maximum life expectancy, which, with the miracle of modern medicine, could be upwards of age 90 or even 100, DB plans only need to fund benefits through the average life expectancy of the group. So when a pension member or their designated beneficiary dies prematurely, the assets that have been accumulated on their behalf are used to provide benefits to the remaining employees.

Also, with pooled funds, the management fees are lower than maintaining hundreds or thousands of individual accounts, which result in a 26 percent cost savings, according to the NIRS.

Defined Benefit Plans Don’t Age

Also, unlike defined contribution plans, pension assets can be diversified for optimal returns throughout an employee’s lifetime. People with 401(k) plans, on the other hand, are advised to move their investments into safer, lower-returning assets as they age and approach retirement. But because DB plans pool the risks of losses, they can maintain an investment mix that is diversified among stocks, bonds, and other investments, increasing the investment returns and lowering required contributions.

Defined Benefit Plans Boost the Economy

According to an analysis of 20 million 401(k) participants conducted by the Employee Benefit Research Institute and the Investment Company Institute, the median account balance of a worker in his or her 60s, making between $40,000 and $60,000 a year was $97,588 at the end of 2006. That amount would generate about $8,000 a year in retirement income.

“How can someone live on that amount?” asks Haney. “They’d struggle just to pay utilities and to put food on the table. They’d probably become wards of the state.”

In fact, research shows that when older Americans can’t be self-sufficient in retirement, taxpayers face higher public assistance costs.

But when they’re on a fixed income pension, retirees represent a vital, continuous source of spending. An NIRS study shows that public employee retirees pump $358 billion into local economies and help create 2.5 million jobs.

They can afford home maintenance, buy a new car, or, like Townsend, take a vacation.

“I don’t have to scrimp and save because I’m worried my retirement benefit will run out,” says Townsend. “When everything else fluctuates, like gas, groceries, and prescriptions, it’s nice to know my paycheck won’t, so I can plan for my expenses and then spend what’s left on a new pair of shoes or a ski trip with my nephews.”

Haney says the rest of the country can benefit from what West Virginia learned the hard way—that individual 401(k) accounts, which were only intended to supplement pensions, have proven to be an insufficient primary source of retirement income, that pensions are more economically efficient, and that they can provide the same retirement benefit at half the cost.

“Given the growing level of retirement insecurity, our nation should be looking at ways to ensure that all Americans have access to adequate and secure pensions,” he says. “Part of the American dream is that after a life of hard work, people should be able to retire with dignity and security.”

For a list of frequently asked questions on pensions, please click here


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