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Making the Choice:Defined Benefit vs Defined Contribution
©Olivia S. MitchellThe Wharton School
Comments on Brown/Weisenbrenner
RRC meetings, August 2006
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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.
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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)
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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.
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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)
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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?
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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.
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Switch Patterns by Age: Yang 2004
0%
20%
40%
60%
80%
100%
a<30 a[30,39] a[40,49] a[50,59] a[60,65] Age
DC Switchers DB Choosers DB Defaulters
Inertia/ Disinterest
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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%
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Employer Costs: Yang 2004
Per Employee % of SalaryAll 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!
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Lessons for SS Reform?• 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.
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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).
