Trends in Pension PlansDecember 8, 2011

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Introduction

The Legislature has asked TRS to study the sustainability of its defined benefit plan, including examining the creation of a hybrid plan that includes defined benefit and defined contribution features.

Prior to a more detailed discussion on alternative structures, we thought the Board would benefit from an overview of the various types of retirement plans common in the U.S.

After defining the size and attributes of different retirement plans, we provide thoughts on recent trends impacting pension plans of all types.

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The 3-Legged Retirement Stool

Individuals have 3 general sources of retirement income1. Social Security (certain public sector employees, including TRS, are not eligible)2. Personal Savings3. Employer Sponsored Retirement Plans

Since legs 1 and 2 are out of the control of plan sponsors, we will focus our discussion on #3.

Retirement Income

Social Security Personal SavingsEmployer Sponsored Retirement

Plans

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Retirement Assets – Investment Company Institute

IC I Estim a te d To ta l U.S . Re tire m e nt Asse ts

3.6 3.5 4.6 5.7 5.0 6.3 6.5

5.1 4.6

5.7

6.85.6

6.8 7.02.82.5

3.3

4.1

3.4

4.5 4.7

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

20.0

2000 2002 2004 2006 2008 2010 2011:2H

US

$ T

rillio

ns

P ers onal S avings (A nnuit ies and IRA s ) DB P ens ion P lans DC P lans

11.710.5

13.7

16.6

14.0

17.6 18.2

See notes for disclosures regarding this exhibit.

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Defined Contribution

Definition: According to the Dept. of Labor, a retirement plan wherein individuals and employers contribute a portion of salary to an individual account that is managed by the employee.

– Category generally includes:1. 401(k) plans2. 403(b) plans3. Employee stock ownership 4. Profit-sharing plans

Pros: – Fully funded– Highly portable– Cost certainty

Cons: – Participants must be educated on investment decisions– Asset accumulation focus, not lifetime income in retirement – “Longevity risk” a key issue– Investment risk borne solely by participants– Costs generally higher than DB plans– Participant loans and early withdrawals inhibit savings

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Defined Contribution: Observations (Cont’d)

Other observations: – Started as supplementary vehicle for employees covered by DB plan, but have evolved into

primary retirement plan for many. – Plan features have evolved to adopt “DB-like” features: auto-enrollment, target date funds,

auto-escalation. – Many large plan sponsors have also moved away from higher cost mutual funds to lower cost

commingled funds or “unitized” separate accounts.– “Private label” funds are increasingly common for large DC plan sponsors.

Major fiduciary responsibilities: – Oversee line up of investment options – Determine plan design features– Maintain reasonable cost structure– Education and communication

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Defined Benefit

Definition: According to the Dept. of Labor, a defined benefit plan promises a specified monthly benefit at retirement. Often expressed as a set dollar amount, but the benefit level can be based on years of service, salary, and other factors.

– DB includes traditional defined benefit plans as well as cash balance plans.– Cash balance plan is a type of defined benefit plan in which members are assigned a

hypothetical account that accumulates in value based on a plan formula.  The trust assets funding the benefits continue to be invested collectively.

Pros: – Professional management of investments and asset allocation– Economies of scale– Pooling of mortality risk

Cons: – Funding uncertainty / contribution holidays– Contribution volatility– Risk fully on plan sponsor

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Defined Benefit: Observations (Cont’d)

Other observations: – Pension Protection Act of 2006. Reduces number of corporate DB plans open to new

employees. • Reduces asset smoothing period; penalizes underfunding; has led to the widespread

adoption of liability driven investing (LDI) and to the “freezing” of many pension plans. – Government and corporate accounting differ significantly and these accounting requirements

have resulted in a divergence of DB investment strategy.– Increased contributions to DB plans often come after stock market or economic downturns,

times when plan sponsors are less able to deal with higher contributions.

Major fiduciary responsibilities: – Set asset allocation – Oversee investment managers– Maintain reasonable cost structure

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A More Detailed Look: Public DBs Almost 25% of Retirement Assets

See notes for disclosures regarding this exhibit.

IC I Estim a te d To ta l U .S . Re tire m e nt Asse ts

1.0 1.0 1.3 1.5 1.4 1.6 1.62.6 2.5 3.3 4.2 3.6

4.7 4.92.0 1.72.1

2.52.0

2.4 2.53.1 2.9

3.6

4.33.6

4.4 4.5

1.1 0.9

1.1

1.3

1.2

1.5 1.5

1.71.6

2.2

2.8

2.2

3.0 3.2

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

20.0

2000 2002 2004 2006 2008 2010 2011:2H

US

$ T

rillio

ns

A nnuit ies IRA s

P rivate DB P lans Federal, S tate, and Loc al P ens ion P lans

O ther DC P lans 401(k ) P lans

11.7 10.5

13.7

16.6

14.0

17.6 18.2

See notes for disclosures regarding this exhibit.

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Some Critical Differences in Retirement Plans

DB and DC plans differ in many ways, but their ultimate objective remains to provide retirement income to participants.

In our opinion, several issues have provided a headwind to DC plans relative to DB plans in accomplishing this goal:

1. Cost2. Performance3. Accumulation vs. Income

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Cost Comparison

DC plan costs have come under increased scrutiny based on lawsuits by participants. While this likely has lowered aggregate costs, the increased administrative complexity of DC plans that requires accounting for and administering individual accounts will remain.

Adm in istra tive Ex p e n se s By Type O f P la n , 2009

0.43%

0.95%

0.00%

0.40%

0.80%

1.20%

Defiend B enefit (public p lans )

Defined Contribut ion(public & private plans )

Source: Munnell, Aubry, Hurwitz and Quinby (2011)

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Performance Comparison

When comparing aggregate performance of DB plans versus DC plans, the DB plan appears to be a winner.

This could be due to a number of factors: lower cost structure for DB, professional management of asset allocation for DB, or others.

M e dia n Ra te s O f Re tu rn For P riva te S e cto r De fine d Be ne fit And 401(k) P la ns, (1988-2004)

10.7%

9.7%

9.2%

9.6%

10.0%

10.4%

10.8%

Defined B enefit 401(k )

Source: Munnell et al (2006) based on Dept. of Labor Form 5500.

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Trends and Observations

The next 10 slides contain information on important trends or current issues we believe to be influencing the debate on retirement plan offerings.

1. Contribution levels and state budgets2. Pension Protection Act of 20063. LDI4. The Big Freeze5. Financial economics6. GASB vs FASB7. State use of DC plans8. Participant choice9. Hybrids10. “DB-ization” of DC Plans

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Contribution Levels and State Budgets

Research by Alicia Munnell, Jean-Pierre Aubry and Laura Quinby shows that pension contributions account for a significant portion of budgets in some states.

In periods of fiscal challenge, these costs are naturally questioned.

Source: The Impact of Public Pensions on State and Local Budgets, Munnell, Aubry and Quinby

P e n sion Co ntrib u tio n a s a P e rce n t o f S ta te a nd Lo ca l Bud g e ts

13

29

6

1 0 1

0

5

10

15

20

25

30

35

1-2 3-4 5-6 7-8 9-10 11-12

Pension Contribution as a % of Non-Capital Budget

No.

of S

tate

s

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The Pension Protection Act (PPA) of 2006

This legislation had a significant impact on corporate retirement plans. Increased pension funding targets; variable PBGC premiums Funding shortfalls to be addressed over shorter time periods

Along with FASB, PPA results in corporate pension plan contributions having a significant impact on financial statements. Size of pension contributions also have significant variability in size. Corporate CFOs dislike the uncertainty this creates for financial statements

Most corporations shift their investment strategy to one that more closely tracks changes in their liabilities (with the goal of reducing contribution volatility). Many corporations also close DB pension plans to new employees or freeze benefit accruals. New and often more generous DC plans are generally rolled out along with these changes to

DB plan offerings.

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Liability Driven Investing

The need to manage volatility of pension contributions has led to increasing use of LDI as a strategy to better track changes in pension plan liabilities.

– LDI is essentially a hedging strategy that seeks an asset portfolio that behaves like plan liabilities.

According to a survey conducted by SEI in 2010, 50% of corporate plans sponsors employed a form of LDI, up from 20% in 2007.

LDI has generally not been adopted by public pension plans due to differences in accounting standards

Factors preventing more widespread use of LDI include: Low level of interest rates make long duration bonds less attractive investments Pensions that are underfunded generally need to maintain some equity exposure to try and

close the funding gap

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The Big Freeze

While data shows that corporate DB plans have not gone away, they have experienced some fundamental change.

According the Aon Hewitt 2011 Hot Topics in Retirement survey, among corporations offering DB plans: 32% of plans are closed to new entrants but still allow legacy employees to accumulate

benefits 27% of plans are frozen, where benefits no longer accrue to any participant in the plan (this is

up from 24% in 2010) 41% remain open

94% of new corporate employees are offered a DC plan while only 28% of new employees are offered a DB plan. While DB plans may not be the retirement vehicle of the future, they are still significant

corporate liabilities and will remain so until underfunding improves.

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Financial Economics

This is a term that is generally used to refer to a group of academics, practitioners, and politicians that believe public pensions should use a long-term Treasury bond to discount their liabilities.

– They claim that these pension benefits are essentially government backed promises, often constitutionally guaranteed, and therefore the discount rate applied should reflect the riskiness of the promise.

– Professor Joshua Rauh of the Kellogg School of Management at Northwestern University is a vocal member of this group.

• His research arrived at an aggregate unfunded level of $3.2 trillion for public pensions using U.S. Treasuries as a discount rate rather than standard actuarial return on asset assumptions.

– Given the very low level of interest rates, this approach results in a much larger anticipated liability then when using conventional methods for estimating liabilities.

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GASB and FASB

The accounting rules employed by corporations and public entities differ significantly.

The Governmental Accounting Standard Board (GASB) is currently considering changes to its accounting rules that may bring it closer to the Financial Accounting Standards Board (FASB) that rules over corporate financial statements.

GASB has issued proposed rules for discounting pension liabilities. This proposal is currently subject to a comment period, but the main features of the proposal include: Maintain an asset-return based discount rate for funded liabilities Introduces the use of a high quality municipal bond yield as the discount rate for all unfunded

liabilities Shorten the period allowed for amortizing unfunded liabilities

GASB will also require changes in how financial statements disclosure pension costs and liabilities: Unfunded liabilities will be displayed on balances sheets, similar to FASB Annual pension costs will have to be disclosed on operating statements, even if the plan

sponsor does not make the required annual contribution Funding and accounting diverge, as is the case with FASB

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State Use of DC Plans

While many states are evaluating the viability of DC plans or other alternatives, there has not been a tremendous amount of activity. Looking at the past 10 years:

Only 2 states, Michigan and Alaska, require all new hires to participate solely in a DC plan.

2 states, Oregon and Indiana, adopted a hybrid approach and require employees to participate in both DC and DB plans.

6 other states retained DB plans but offered DC plans as an option and let employees choose.

Please note the study cited looks at 401(k) type plans and not 457 plans, which are commonly offered as a supplementary retirement offering.

Source: A Role for Defined Contribution Plans in the Public Sector, 2011, Munnell, Aubry, Hurwitz and Quinby

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Participant Choice

The Center for Retirement Research at Boston College produced earlier research that looked at the frequency in which DC plans were selected when public employees were offered a choice between DB and DC.

The portability and other features of DC plans appears to appeal to a smaller portion of the population.

State Percent Does plan have default into DB?

Colorado PERA 12% Yes

Florida RS 21% Yes

Montana PERS 10% No

Ohio STRS 19% Yes

Ohio PERS 6% Yes

South Carolina 18% No

Source: Why Have Some States Introduced Defined Contribution Plans? Munnell et al (2008), Olleman (2007)

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Hybrid Plans

Hybrid Plans combine elements of both DB and DC plans. Typically it comes in the form of a lower DB benefit along with a DC plan that a participant controls.

Governor Brown recently introduced a proposal for a hybrid pension system for California. Proposals such as these generally offer cost savings because of a lower contribution rate from the state or employers.

DB and DC plans are perhaps the most different in who bears investment risk. The hybrid plans generally bridge this gulf by having both employees and plan sponsors bear some investment risk.

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DB-ization of DC Plans

DB plans have several features that have increasingly been adopted in DC plans. These features are meant to address the cost and performance dynamic illustrated earlier, but also to increase savings levels.

These new features include: – More use of low cost index funds– Auto-enrollment and auto-increase features to boost savings– Low-cost managed accounts for professional advice

Many DC plan sponsors are also now considering types of annuities that can be offered in plans. This is part of a broader shift in the DC world to pay closer attention to retirement income issues and not simply the accumulation of assets.

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Summary

Preparing Americans for an adequate retirement is a complicated business.

The retirement plan landscape has changed considerably during the past 10 years as severe equity market declines and decreased state tax revenue created serious challenges.

While the discussion can become highly political, there are pros and cons to each approach.

Hybrid plans combine features of both plan types and may be a solution for the challenges facing some states.

There will be a more in depth discussion of many of these issues at the February Board Retreat

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Notes

Disclosures, footnotes and references from ICI data:– Annuities include all fixed and variable reserves at life insurance companies less annuities held by IRAs,

403(b) plans, 457 plans, and private pension funds (including 401(k) plans). – Federal pension plans include U.S. Treasury security holdings of the civil service retirement and disability

fund, the military retirement fund, the judicial retirement funds, the Railroad Retirement Board, and the foreign service retirement and disability fund. These plans also include securities held in the National Railroad Retirement Investment Trust and the Federal Employees Retirement System (FERS) Thrift Savings Plan (TSP).

– Other DC plans include 403(b) plans, 457 plans, and private employer-sponsored DC plans without 401(k) features.

– IRA data for 2008 onward is estimated. 2006 and 2007 IRA data is preliminary. Sources: Investment Company Institute, Federal Reserve Board, Department of Labor, National Association of

Government Defined Contribution Administrators, American Council of Life Insurers, and the Internal Revenue Service Statistics of Income Division.