The Florida Retirement System: Defined Benefit or Defined Contribution?

• David Denslow, Ph.D.

Suppose you are a young college graduate just beginning a career in state government. You’re one of the best and brightest, and in spite of the depressed job market in public service you are weighing offers from two states. For simplicity, both of them offer level pay that would cost the state $80,000 a year over your career in total compensation. The only important difference is that one state offers a defined contribution (DC) pension and the other a form of defined benefit (DB). The peculiarity of the DB plan is that if you leave the job early, it is portable as if it were DC.

Which would you choose? Your first impulse is to toss a coin. Who in their youth thinks about retirement? But being a far-sighted sort, you stop to reflect. If the mortality tables are still the same as today, when you retire at 65 your chances of surviving at least to each age are:

How then should you draw down your savings if you choose the DC state? Certainly you plan for age 85, but you face the “longevity risk” of making it to 90, 95, or even 100. You’re hoping that when you do hit 65, the long life survival odds will be better than today, so that 65 will be the new 50. But to be realistic, life will still be uncertain. Age of death will still have a random component.

Use your DC payout to buy an annuity?

Also, who knows whether the company with the best annuity, Lemon Brothers, will still be around when you’re old and gray?Not to worry. At retirement, you will use your DC funds to buy an annuity. Or if your health is poor, not. Good option to have. Checking out annuities, however, you see that they’re not all that great. Maybe it has occurred to the companies offering them that the people who buy annuities are the ones in fine health whose parents lived into their late nineties. Also, who knows whether the company with the best annuity, Lemon Brothers, will still be around when you’re old and gray? State B, the DB state, however, has high odds of being there for you. You start leaning toward state B.

But you have another thought: with the DC plan you can control your investments, following the standard plan of heavy in stocks (long-run inflation-adjusted return around 6.7% a year) at first and gradually shifting to bonds (long-run inflation-adjusted return around 3% a year, but safer, at least according to the conventional wisdom). The DB pension plan has the same investment mix for everyone. Thinking deeper, however, you realize that’s a score for DB. Its payments will go to beneficiaries currently arrayed across the age distribution, young and old. With that spread, it can stay invested in a portfolio that is riskier in the short run but has a higher long-term expected return. You vaguely recall that book you’ve been planning to read about stocks being the investment for the long term.

What's the right projected rate of return?

As you probe still more, the difference between DC and DB becomes even more subtle. Leading financial academics seem to agree that since pension obligations are virtually certain, sure to be paid, the projected rate of return on pension fund assets should be that on a totally secure asset, such as U.S. Treasury long-term bonds, now down to around 3%. That’s a terrible long-run return, which would imply that most public pension funds are hopelessly underfunded. (Actually, these finance wizards are willing to allow that Treasuries are more liquid than pension obligations, and permit a projected rate of return of 3.5% or even up to 5%.) But thinking more deeply than those noted academics, you realize that the obligation of the pension fund is not to the beneficiaries—they’re going to get what they have coming no matter what—but to the future taxpayers who are going to have to meet that obligation. The pension trustees are in fact responsible not to beneficiaries but to future taxpayers. If the pension fund has lousy returns on inadequate contributions, they’ll have to pay higher taxes. If it has great returns on the better contributions, they’ll get the joy of lower taxes. There’s a trade-off there somewhere.

Back to the future

You imagine being able to go back to your parents 25 years ago, giving them $100,000, and asking them to invest it for you. Would you want them to put your fortune in riskless Treasury securities? Probably not. You’re willing to take a bit of risk in exchange for a higher expected rate of return. It occurs to you that the same would be true of the future taxpayer. The future taxpayer would be willing to accept risk in exchange for a higher expected return over the long run, even the risk of paying higher taxes, with all the inefficiency that brings. (The main thing for the future taxpayer is not so much wealth risk as tax inefficiency risk. After all, there are ten taxpaying households for every one public employee, so the risk to taxpayer wealth is bearable, and the truly sophisticated may, if they wish and are currently adults, offset the risk in the state's pension portfolio by making their own portfolios safer. The true risk to them is the tax inefficiency risk.)

Being a political realist, you do realize that if the pension fund’s investments head south while you’re still working, your salary is likely to rise more slowly, perhaps even decline if things are really bad. (Thus the pension trustees are also partially responsible, given realistic assumptions about labor markets for government employees, responsible to them as well.) But the higher expected return also more than offsets that risk to you, especially since it would also affect your DC funds. Weighing it all, you choose the state that gives you, at the same cost of total compensation, a DB option. You have a slight twinge of conscience: Since the federal government places such an onerous burden on private sector DB plans that most companies have abandoned them, you’re getting an unfair advantage over your former classmates in the private sector. But such is life. And those select few of your classmates who match your talent are going to do just fine in the private sector anyway. So state B takes advantage of its ability to escape those federal laws. Good for it. Does the federal government pay higher interest on its bonds to avoid unfair competition with private corporations? No way.

Maybe there’s an advantage of a DC plan you haven’t thought of before: With a DC plan, you would be forced to learn to invest rationally, and that knowledge would spill over into your personal finances. On the other hand, you could just finally get around to reading that investment book, and maybe a couple of others. Next year. Too busy right now.

It's the politics, stupid

What these ideas boil down to is that Florida would be ahead in competing with other states for employees, and also in doing what’s best for its taxpayers and employees by sticking with a DB plan. Why, then, does it appear that lawmakers are going to switch the Florida Retirement System to DC? Mainly, I think, because they don’t trust future legislatures. Given the example of legislatures in other states—Florida’s has fallen short of perfection, but on balance hasn’t been all that bad either, especially compared to others—that’s probably wise. A DB plan offers too many irresistible temptations to shift the tax burden from present to future taxpayers, to engage in a sort of Ponzi scheme—not quite the right concept but with the right flavor to it—in which the state offers generous pensions and makes it seem cheaper to hire government employees than it actually is.

A standard way of doing this is by projecting a high rate of return on pension assets. The modal projected rate of return for Florida’s municipal pension funds is 8.5%, instead of the 6% it should be (in my humble opinion, nobody knows for sure). My 6% is higher than the 3.5% to 5% range preferred by financial academics but, as noted, I don’t think they understand that pension obligations are really to a “financial intermediary,” future taxpayers, who prefer a higher-return though riskier portfolio to one of nothing but bonds. The long-run return to stocks is too high to use as the projected return, however, since future taxpayers are owed compensation (in the form of extra expected return) for bearing the risk of tax inefficiency. It’s neither fair nor efficient for current taxpayers to shift the full burden of the risk to the future by using the expected rate of return as the projected rate of return. By not being efficient, I mean that doing so causes us to underestimate the true cost of hiring government employees.

Florida Retirement System projections are not all that bad

In short, the FRS is not all that far off, and is better run than retirement systems in most other states.What about the Florida Retirement System’s 7.75% projected rate of return? Is that too high? Well, yes, at least by my criterion. But that high return is partially offset by a high projected annual salary increase of 5.85%, which appears unlikely. But then, the FRS also assumes that in growing state there will be no payroll growth, zero percent. It’s all very complicated. In short, the FRS is not all that far off, and is better run than retirement systems in most other states. There have been abuses to be sure, perhaps the most serious ones being using pension fund surpluses as if they were general revenue and ratcheting benefits upward in good times.

Florida’s legislature seems better at responsible budgeting than most—admittedly not a high hurdle. Because of the terrible examples of a number of state and local governments, pension abuses and mismanagement are now much more likely to come to public notice than they used to be. Does that mean that future Florida legislatures can be trusted, under the threat of exposure, to manage a DB plan as it should be, giving our state a competitive edge in hiring good people? Or does political realism require that we tie future legislators to the mast? With their political experience, our lawmakers can answer that one better than I.