Public sector retirement programs tend to focus on only a few benefit design elements. This is true for defined benefit pension plans, defined contribution plans, and the myriad of hybrid retirement plans that exist.
For traditional defined benefit pension plans, these common elements include a benefit accrual formula based on salary, years of service, and a benefit multiplier.
Defined contribution plans typically just focus on variations of employer and employee contribution amounts.
Retirement plan characteristics can also involve eligibility, participation, and vesting rules, as well as the rules for when benefits can be paid (e.g., normal and early retirement dates) and in what form (e.g., annuity, lump sum, periodic payments).
But are these elements enough to adequately address the many other factors that can greatly impact an individual’s ability to secure a financially secure retirement?
The Society of Actuaries 2011 report, Managing Post-Retirement Risks—A Guide to Retirement Planning, effectively listed the major retirement risks and factors that can impact an individual’s ability to have a financially secure retirement. These factors included:
- Longevity risk—outliving your retirement assets
- Investment risk—market losses can reduce retirement savings
- Interest rate risk—impacts market returns and annuity payouts
- Inflation risk—devalues fixed incomes
- Employment patterns and the effect on employer plan accruals—switching or losing jobs can create gaps in benefit accrual
- Business (employer) continuity and strength—the employer or company sponsoring the plan or annuity could go out of business
- Health care cost risk—including availability/local access to affordable caregivers and facilities
- Housing costs and needs—e.g., rent, property, taxes, and insurance
- Public policy risk—e.g., the funding of programs like Social Security and Medicare
- Marital and dependent status—including care for aging parents
- Homeownership—significantly affects net assets.
- Other unforeseen expenses
If one looks at the traditional defined benefit and defined contribution plan designs offered by governments today, it does not take long to conclude that many of these retirement security risks are either completely ignored or only partially or incidentally addressed in the typical retirement plan elements.
For example, a specific blind spot for defined benefit plans is their inability to account for worker mobility. The pension benefits in these plans can take 20-plus years to vest in and thus no longer serve today’s increasingly mobile workforce. For defined contribution plans, the most significant examples of risk are the management of investment and longevity risk of a retiree potentially outliving their savings.
The traditional definition of retirement benefit adequacy is a target retirement income is 70-90 percent of pre-retirement income. But this definition is also in need of examination because it ignores the reality and variability of actual expenses individuals may face in retirement, like growing health care and housing costs.
In these days of rapid-fire public pension reform and redesign efforts, overly simplistic proposals often fall short of addressing these broader measures of retirement risk for individuals. Policymakers are often too caught up in political battles and pension reforms rarely result in a significantly better public retirement plan that adequately meets the needs of employers and employees.
With all this in mind, is it necessary or appropriate to try and design retirement programs to address each and all these additional risk factors?
One might answer this question by looking at the venerable and sometimes misunderstood Pareto Principle, more commonly known as the 80/20 rule that states 80 percent of results come from approximately 20 percent of inputs or causes. Traditional retirement design would seem to say, “We are covering 80 percent of retirement income needs by including the major risks that make up about 20 percent of the variables that can be addressed, so it is not efficient or effective to try to do more.”
It is time to challenge and test this type of thinking. It should not be okay for retirement programs to accept that 20 percent of retirees’ needs are not going to be met. Even a cursory assessment of traditional defined benefit and defined contribution designs would conclude that many retirement security risk factors are not being adequately addressed.
A better way to think about public retirement plans could be to use another application of the same rule, a concept commonly known as Pareto Efficiency or optimality. Pareto Efficiency asks, can we address more retirement risk factors in the design of a retirement program without having undue negative impacts or costs? How can leading-edge plan-based technologies, big data, individual advice and financial planning services, investment management strategies, lifetime income solutions, and benefit portability features be more completely and efficiently included?
If policymakers ask those questions as they look to create the next generation of retirement solutions, it will become apparent that there are still unused tools, both new and old, that could help produce better retirement outcomes.
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