March 22, 2010
Dr. Robert Clark-Chairman
The Commission met this week to review investment risk, longevity risk and inflation risk issues related to the State Retirement System.
Investment Risk: This was discussed using an employer/employee grid to compare NC’s retirement system to other systems. Thirty-five states have the same risk as NC with the employer basically taking the risk on the investment and the employee bearing no discernable risk. It has a Defined Benefit and the Defined Contribution plan that uses the pension trust to invest and the investment is expected to deliver the return for the employee. The remaining states, such as Georgia, Indiana and Oregon use a plan where no more than 50% of the balance can be invested in a benefit trust and both the employee and employer share investment risks.
In 2008 the NC’s retirement plan lost 20% of its value but it gained 15% in 2009 on the smaller amount. The goal of the funding balance for the retirement fund is 100%, but right now it is at 99.3%. The State has averaged over 7 % per year in gains over the past thirty years. NC is one a few states who sets its return assumption at 7.25% – this is below the benchmark set in most other states who will assume up to 8.5%. NC’s retirement system was underfunded up until the 1990’s, when they exceed their funding and were well above 100%. A question was raised why some of the states use shared employee/employer risk philosophy. The possible answer is that political leadership changes resulted in different investment philosophies. Another question was posed regarding the potential change to shared risk and the potential benefit to long-term workers over short-term employees. It was noted that employees should typically have a retirement plant that includes the state pension allotment, social security and a personal plan outside the state system thereby creating three prongs for personal investment.
Longevity Risk: This is simply the risk that the retiree will outlive his/her retirement benefits. A Defined Benefit plan provides an annual income lasting an employee’s lifetime with the state bearing the burden of estimating life expectancy of its workforce. But again the question remains, who should bear the risk – the employer or the employee? One way to distribute the risk between employee and employer is to have the employee bear the risk while working and the employer bear the risk once the employee retires. One way this can be achieved is to annuitize the Defined Benefit Plan upon retirement. It was noted that fifty percent of private pensions allow for a lump sum distribution of annuity at retirement. While NC allows a lump sum options, I believe the funds are reduced when the employee elects that payment. An exception to this process is the Law enforcement Group and its retired employees are able to move an annuity to the state’s Defined Benefit Plan. The State then uses these funds to pay out an increased monthly dividend to the retired law enforcement employee thereby allowing the retiree to consolidate retirement funds with some security of investment. Annuity products have the ability to protect retirees from longevity risks, but very few employees elect to convert their retirement funds into annuities. Part of the reason may be lack of financial literacy and an underdeveloped annuity market. The primary longevity risk for employers is that life expectancies will increase faster than predicted, though most experts believe this is unlikely. In the 1940’s life expectancy was 63.62 years and in 2004 it had risen (60 years later) to 77.8 years, while life expectancy at age 65 only increased 6 years since the 1940’s.
Inflation Risk: The two main issues to consider with inflation risk are the impact of inflation on retirement benefits and the cost of providing cost of living adjustments. This is one of the biggest and most hidden costs in retirement. The economic forecast is that inflation risk will only average 2.5% over the next 10-30 years. Employees however, should plan financially for an average 3% increase in their income. The problem with annuities for retirement are they are often fixed and do not take into account inflation. The employer can assume inflation risk by including an automatic cost of living adjustment in the designed benefit plan. The employer could also have the employee take the risk. The most common way for an employer to protect against inflation risk would be to purchase inflation-protected treasury bonds (push the risk to the Feds) or trade in inflation derivatives in the financial markets. You can set the retirement rate at the consumer price index and split the liability between the employee and the employer. The cost of living allotment can track inflation with a reduction in the retiree’s payment in the first five years and not cost the employer any more.
The schedule for the next meeting will be presentations from the main groups who represent members in the state employee retirement system to include the Office of State Personnel, the Community College System, the University System, and the Public Schools.
Senator Stevens and Representative Ross from Wake County serve as members of this Commission along with other government appointees from the across the State.
Next Meeting Dates: May 10, June 14, July 12.