Making the Choice: Defined Benefit vs Defined Contribution

1. Making the Choice:Defined Benefit vs Defined Contribution Comments on Brown/Weisenbrenner RRC meetings, August 2006 ©Olivia S. Mitchell The Wharton School mitchelo@wharton.upenn.edu

2. Motivation: • Claim: usually workers either chose DC plan versus more salary. • Yet President’s Commission’s Personal Retirement Account proposal had  DB versus DC choice • So B/W contend Illinois case “better” for learning about DB versus DC choice under SS reform. Valid? I’ll come back to this.

3. The setting: • New hires in Illinois State ees (public sector) must decide on pension type: • Traditional Defined Benefit (DB): generous • Portable DB: less generous • Defined contribution (DC): invst choice, portable, employer match. • Traditional DB is default. No Social Security (very imp. diff from President’s Comission proposal)

4. Evidence: new hires (1999-2004) Overall: 85% ended up in DB • 56% default to DB +10% elected DB +19% elected ‘portable’ DB • 15% elected DC Surprise? No, early 2000’s not great time to be in stock market. % defaulting to DB rising over time. Only highly (?) paid academics in DC plan.

5. What’s the Puzzle? • Even though B/W feel the traditional DB plan is ‘head+shoulders’ better…. • DC plan is selected by professors “whom one would likely expect to be the most financially sophisticated.” • Maybe academics DO get it? • State DB plan very underfunded • Other public plans have gone bust (Cleveland, Bridgeport CT, Orange County)

6. Suggestions for further analysis: • What’s expected DB vs DC benefit, taking into account quit probability? • Test: are those who default to DB similar ex post, to DB choosers? • What’s IRR making ees indifferent between 3 plans? What risk aversion might make DB traditional and portable plans equivalent? (are estimates reasonable?) What do choices reveal about employees? • How much did State save when ees selected DC?

7. Related Studies: • Many on DC auto enrollment, contribution defaults • Three on DB/DC plan choice: • Papke 2004: Michigan correctional workers: 6% switched to DC • Brown et al. 2004: Australia Super Plan: 33% switched to DC • Yang 2004: Large east-coast university: 50% switched to DC Wide variation in choice patterns depending defaults in plan & asset allocation.

8. Switch Patterns by Age: Yang 2004 Inertia/ Disinterest

9. What are Worker Losses from Defaultinggiven Expected Turnover: Yang 2004 Average % of Per Worker Salary No Turnover $2,700 9% With Turnover $3,300 13%

10. Employer Costs: Yang 2004 Per Employee % of Salary • All Remain in DB $32,510 113% • All in DC w/ full match $34,280 119% • All in DC w/ actual match $32,790 114% Interesting that ER costs about equal!

11. B/W argue workers didn’t chose DC and were smart not to. NOTE: Illinois data only new hires, 1/3 part time, mostly out of system within 5 years. SO can’t extrapolate from their data to national SS, with mandated particip. & LT workers in DB plan. SS participants would still have SS real annuities, if elected PRAs. Those lacking SS may value inflation-indexed state annuity MUCH more than DC. Lessons for SS Reform?

12. Main lesson for PRA Default design critically important. • If traditional DB is default, many EEs will follow the path of least resistance. • PRAs could default to DC with sensible age-based asset mix (like Chile).