Should CalSTRS join UC in offering 401(k) option?

While public pensions are often said to be too generous, CalSTRS and other teacher pension systems face another kind of criticism. For short-term teachers, a 401(k)-style plan can be a better deal.

The California State Teachers Retirement System is designed as an incentive to keep teachers on the job. The back-loaded formula that sets pension amounts increases as teachers reach retirement age.

Before then, there can be a lengthy period in which teacher contributions to CalSTRS (10.25 percent of pay for most and 9.2 percent for newer members) could earn more in a 401(k)-style individual investment plan.

To counter criticism in papers such as “Negative Returns: How State Pensions Shortchange Teachers,” issued by the Urban Institute and others in September 2015, CalSTRS funded a study by the UC Berkeley labor center issued in February last year.

The two papers agree there is a “break-even point,” when teacher contributions in CalSTRS begin to earn benefits that exceed the value of the same amount of money invested in an idealized 401(k) plan.

But they disagree on the years of service needed to get to the “break-even point.” For teachers starting at age 25 under the new CalSTRS formula, the Urban Institute paper figures 24 years, the Berkeley paper 20 years.

The dueling papers are another round in the battle over whether public pensions, said by critics to be taking too much money from basic services, should be replaced by the 401(k) plans now common in the private sector.

The paper issued two years ago by Richard Johnson of the Urban Institute and Chad Adelman of Bellwether Education Partners was funded by the Laura and John Arnold Foundation, a major financial supporter of public pension reform.

The CalSTRS paper authors are Nari Rhee of the UC Berkeley Center for Labor Research and Education and William Fornia of Pension Trustee Advisors. Rhee also was an author of a study for California Secure Choice, a state-run plan for private-sector workers that may start in 2019.

The new program to provide a workplace retirement plan, for an estimated 7.5 million workers now without one, is backed by public pensions and unions to help close the retirement gap between government and private-sector workers.

Another blending of the battle lines, not yet studied by CalSTRS, was a decision by UC Regents last year to begin offering new University of California employees a choice between a pension and a 401(k) plan.

In the early returns, 35 percent of the 6,411 eligible UC new hires chose a 401(k)-style individual investment plan, instead of a pension, during the first 10 months of the new program called Savings Choice.

A UC guide seems to describe Savings Choice as potentially suitable for those who fall below the break-even point, when the value of the idealized 401(k) plan exceeds pension benefits.

“Consider Savings Choice if you: Want a portable retirement benefit you can roll over into an IRA or another employer’s retirement plan if you leave UC. Are comfortable choosing and managing your investments.

“Consider Pension Choice if you: Expect to work for UC for most of your career. Want predictable retirement income payments.”

What if, after making a choice, the employee’s circumstances or attitude changes? “Subject to IRS approval, UC may offer employees who initially choose Savings Choice a one-time future opportunity to switch to Pension Choice,” said the guide.

Urban Institute paper example of break-even point

UC Berkeley paper example of break-even point

Nationally, more than three-quarters of new teachers will earn less in pension benefits than they contribute to the pension plan, the Urban Institute paper estimates. Full-career teachers that move to another state with a different pension plan also can be losers.

Pensions for early exits are based on the lower salaries of teachers in the early stage of their career. If the same contributions were made to a 401(k) plan, the early contributions would be worth more than later contributions due to compound interest.

A teacher that exits early also can lose, said the Urban Institute paper, because their pensions are based on a salary that does not increase with inflation during the period between exiting and collecting a pension, which can be one or more decades.

In half of state plans, teachers must serve 25 years to reach the break-even point. Other employees gain pension benefits more quickly. The median break-even point for police and firefighters is 18 years of service.

The UC Berkeley paper, based not on national but on CalSTRS actuarial data, said one of seven current California teachers will accrue less in pension benefits than they would if their contributions went into a 401(k)-style defined contribution plan.

But the proportionate loss before the breaking point in CalSTRS compared to a defined contribution (see chart above) is dwarfed by the large and secure gain after teachers begin collecting their pension.

Although 40 percent of new teachers leave before vesting in a CalSTRS pension after five years of service, said the Berkeley paper, they represent only 6 percent of teaching positions.

Of the 14 percent of active teachers who will receive less in CalSTRS than with a hypothetical defined contribution plan, 6 percent are recent hires who will leave before vesting and 8 percent are teachers who vest but will leave before age 51.

The main reason the 8 percent who vest but leave receive a lower benefit, said the Berkeley paper, is that the salary that sets the pension does not increase with inflation. Teachers leaving CalSTRS can have their contributions refunded with interest.

So, what would it take for CalSTRS to consider a 401(k) option?

CalSTRS has been innovative with individual investment plans protected by a minimum guaranteed return based on the 30-year Treasury bond: Cash Balance for part-time and adjunct faculty, Defined Benefit Supplement for extra work and bonuses.

Teachers do not receive Social Security. The average initial pension replaces about 55 percent of final pay, said Michelle Mussuto, CalSTRS spokeswoman. The need for members to save voluntarily on their own is emphasized.

CalSTRS offers Pension2 as a way for members to invest in tax-deferred 403(b) and 457(b) plans. A redesigned CalSTRS website provides a way to compare the fees, performance, and services of 403(b) plans.

If CalSTRS were to look at a 401(k) option, one of the questions might be whether diverting a third of new member contributions would undermine the underfunded pension plan. Legislation in 2014 will more than double employer rates by 2020.

The political will to push legislation authorizing a 401(k) option might have to come from an organized segment of CalSTRS members, who would need the support or neutrality of powerful unions and the CalSTRS board.

UC was pushed into offering the 401(k) option. Gov. Brown wanted a cap on UC pensions like the one imposed in 2013 on state and most local pensions. To remain competitive in recruiting, a UC task force recommended a 401(k) supplement for capped pensions.

The task force said a stand-alone 401(k) option for all new hires “might provide a more competitive benefit to employees hired only for a fixed term or who may not expect to spend their career at the University.”

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at Posted 14 Aug 17

2 Responses to “Should CalSTRS join UC in offering 401(k) option?”

  1. Mike B Says:

    The state has a supplemental 401K & 457 plan as well – has had it for decades. It’s heavily promoted now because the revised pensions of a few years ago are significantly less than they used to be for new workers – so to get a similar payout new workers have to be fully invested, successfully, in the 401K/457 too. IIRC new hires, also, are in a 401K-like plan for the first year or 2; if they stick around, it’s then reinvested into the normal pension plan.

    One gotcha for old-timers is that if you stick around long enough to get the maximum pension, plus social security (are new teachers still non-social security?), the 401K could be a liability. Once mandatory-withdrawal time comes around, it punches up taxable income (both pension and social security are taxed already), so for practical purposes the mandatory withdrawals might simply be turned over as extra tax payments – figure 50% tax at least on them.

  2. spension Says:

    The first paper (Urban Institute) never mentions the words “longevity risk”. In a DB plan, pooling eliminates that risk. The second paper (UC Berkeley) notes the elimination of that risk. Who bears the risk? Not the employer, which is a typo in the UC Berkeley report. It is the cohort who dies early, not the employer.

    Odd choice above to display Figure 8, which has no coordinate values on the axis, for the UC Berkeley report, Figures 9, 10, and11.

    In DC plans, the pool size is 1/2 or 1… 1/2 if a married couple. The fluctuations in survival are huge… good chance you’ll run out of money in a DC plan by age 90, like 5% of folks or so of folks who live that long. In DB plans it is the people who die by 75 or so who pay for the long-lived. In DC plans the long-lived are just out of luck.

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