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

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 ( ) 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 Defaulting given Expected Turnover: Yang 2004 Average % of Per Worker Salary No Turnover $2,7009% With Turnover$3,30013%

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

11 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.

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).