Working paper: Best practices in optional defined contribution plans

Executive Summary

Retirement plans serve a vital purpose for government employers. Public workers depend on these plans to build retirement security so they are prepared for their time after their working life. State and local governments use these plans to partner with employees in pursuing their individual retirement security goals. The most common retirement offering for public workers comes in the form of a defined benefit (DB) pension, but shifts in employee behavior suggest a need to modernize this approach for new hires. With changes in workforce mobility, government employers must expand their offerings beyond the traditional pension plan to appeal to a broader range of career paths. An increasingly popular and effective way to do this is by adding an optional defined contribution, or DC choice, plan that new workers can select at the beginning of their employment.

As public workers come to expect a shorter tenure or simply want more control over their retirement contributions, DC choice plans can be optimal over the commonly offered pension plan. An examination of how benefits accrue differently between these two options shows that one type of plan can work better than the other, depending on various factors like age of hire and years of service. The best way to accommodate all workforce situations is to allow each new worker to select the option that they believe best works for them. In the case of the New Mexico teacher plan, an educator hired at 25 is only better off after full retirement when compared to a DC plan. Before full retirement, that teacher will likely only get about 70% of the benefit they would have gotten in the DC plan.

Choice plans—plans that give the option to choose between a DB or a DC plan at the time of hiring—are beneficial not just for the employee but can also benefit the employer. With the proliferation of unfunded pension liabilities among U.S. governments, optional DC plans can serve as valuable risk mitigation solutions. For example, Utah saw significant improvements to its funded status after the implemented a DC choice system in 2012.

For those looking to implement or improve an optional DC plan to go alongside an existing pension, several key policy decisions are important to understand:

• Contribution rates must be adequate to achieve the committed retirement goals.
• There must be options for guaranteed retirement income.
• Proper benefit education must be provided to new members making the choice.
• The benefit selection period must be ample.
• The default option set must work for the particular workforce.

Each one of these policies can have an enormous ripple effect. For example, in Florida in 2018, the implementation of a DC default—steering new hires who did not indicate a preference between the two available options to the DC plan—had a notable impact on the enrollment rates between the system’s two options. When designing choice plans, policymakers must understand the crucial role that contributions play and how this role differs between DB and DC options. While both options aim to provide retirement security, pensions and DC plans diverge in how they approach contributions. DC plans work to save enough money in individual accounts, while pensions pool this money and make regular adjustments to contributions to address emerging funding shortfalls. With these core differences in mind, setting DC contribution rates to match the pension plan can lead to contributions misaligned with the DC’s primary objective and is not a wise idea. In the past, this approach created challenges for Florida’s public employee retirement plan, which was eventually addressed with a realignment of DC contribution rates. The Michigan State Employee Retirement System, MSERS, set the rate for its optional DC plan around best practices for retirement security, which, in this case, provided employees with an incentive to choose the DC option.

With thoughtful implementation of these policies, policymakers can expand on the options available to government workers, establishing a more robust retirement system that better achieves the goals of a public employer and better suits the individual public employee.

Full Working Paper: Best practices in optional defined contribution plans