A new research brief finds that most public defined benefit (DB) pension plans have effectively managed key retirement security risk – investment, adequacy, longevity and inflation risks.
During the last decade, managing investment risk has posed challenges while life expectancies have increased. Yet, the NIRS issue brief, Retirement Security Risk: What Role Can Annuities Play in Easing Risks in Public Pension Plans?, indicates that most public DB pension have successfully managed investment, adequacy, longevity and inflation risks appropriately as described below:
- Investment Risk: Public pension plans have demonstrated their ability to invest retirement assets and achieve target returns over their long time horizons. Pensions take advantage of the risk premium generated by equity investments in their diversified fund portfolios over time.
- Adequacy Risk: The fundamental principle underlying the appropriate and sustainable funding of retirement benefits is ensuring that sponsors pay the actuarial determined contribution (ADC). While a few states have failed to adequately pay their ADC, most states have paid 95 percent or more of the ADC.
- Longevity Risk: DB pensions protect retirees from out living their savings even thought retirees are living longer. Advised by professional actuaries, public pensions appear to anticipate changes in mortality experience successfully.
- Inflation Risk: Over time, the purchasing power of a fixed income stream diminishes even at low rates of inflation. Cost of living adjustments (COLAs) protect the purchasing power of retirees. State retirement systems manage inflation risk with limits on COLAs and using investment strategies designed to produce real rates of return.
In light of increasing life expectancy, market-based tools, such as annuities, may help manage longevity risk—for both individuals and plans themselves. Annuities are products offered by insurance companies in which a certain amount of money is paid up front in order to provide a regular income stream for the remainder of one’s life, or a set number of years. In the public sector, DB pensions remain the predominant retirement plan to help to attract and retain employees while enabling employees to retire with a monthly income.
Retirement Security Risk: What Role Can Annuities Play in Easing Risks in Public Pension Plans? considers the role that annuities might play in providing a secure retirement to public employees. It finds that:
1. Public DB pensions are highly cost efficient. They provide the same amount of monthly retirement income at a much lower cost than both a typical DC plan and a pension plan funded exclusively with fixed annuities purchased over a career. Because fixed annuity products deliver investment returns related to bond investments, it is difficult to generate a given level of monthly income from fixed annuities than from public DB pensions. Depending on the interest rate used in the pricing of the annuity, the cost of using fixed income annuities to fund DB pension benefits can be anywhere from 57 percent to over 175 percent more than the cost under a public pension’s diversified portfolio.
2. Public DB pension plans provide significant consumer protections in state law, while annuities have different consumer protections in state regulation and insurance law. Pension benefits of public employees and retirees are protected in various ways, including state constitutions, state laws, court decisions on contract law, and collective bargaining agreements. Consumer protections for insurance annuity contracts differ from those for public pension benefits. Under state guaranty funds, annuity protections have low coverage limits, lack prefunding, and can vary from state to state. In addition, state insurance laws generally provide insurance companies with tax credits for assessments they incur to support these funds, thus shifting the ultimate cost of protection against
insolvency to state taxpayers.
3. Longevity annuities focus on the insurance value and are less expensive than fixed income annuities. Longevity annuities start income payments at much older ages, typically in the 80s. This allows individuals to capture most of the insurance value of immediate annuities, but at a fraction of the cost. The relatively lower cost of longevity annuities may be attractive to some public plan sponsors who might seek to reduce their longevity risk exposure. Further analysis with actual participant data, and a clarification about the use of longevity annuities, would be helpful or plans considering their use.
