In the last post, we settled on 4.5% as an assumed rate of return when projecting the DC account balances. However I decided it was just as easy to perform the calculations at 4.00%, 4.50% and 5.00%, therefore giving some more options. Below you will see two charts. The first chart assumes and Entitlement Age of 65. For age at 5-year intervals from age 20 to age 65, a $1,200 contribution is projected using the stated rate of return to age 65. The "Yrs @ $20" represents the number of years someone could collect $20 per month beginning at age 65 from the projected value. The second chart is the same, but to an Entitlement Age of 60.
So what the first chart displays is that a firefighter age 45 that earns a $1,200 contribution will see that $1,200 contribution grow to $2,894 by age 65 if a 4.5% annual rate of return is earned. That $2,894 would be enough to pay the firefighter $20 per month for 17.3 years.
You will notice in some years there is an infinity sign. That is because the $1,200 contribution grows to such an amount that it would pay a $20 benefit forever. The reason is that the interest accrued is more than the $20 monthly benefit. For example, $6,980 would earn about $314 per year at 4.5%, which is more than the $240 that would be paid annually.
How we will use these figures to compare the $1,200 DC plan to a $20 DB plan (still by far the most popular DB plan here in NY State) will be discussed in the next post. But we will use the average life expectancy data to try and draw some conclusions.
In our last post we decided that we would compare the DB and DC plans at entitlement age. In order to make that comparison, we'll need to make some assumptions about the rate of return on the program investments and how long someone will generally live to collect monthly benefits.
First we'll look at the rate of return. Currently, 10-Year US Treasury is yielding about 2%. Interest rates on money market accounts seem to be around 2.25% on average. The stock markets are at all time highs! A LOSAP is generally invested in a blended portfolio, typically on the more conservative side, such as 30 to 40% equities and 60 to 70% fixed income. A survey of asset managers available online pegs the US equity market earning around 6.25% over the next 10 years. The same survey estimates US corporate bonds to return about 3.25% during that same period. Using these estimated returns, a 40/60 equity to bond ratio would result in an expected 4.5% rate of return. A 30/70 allocation would be around 4.20%, and a 50/50 ratio at 4.75%. Since 4.5% is right about in the middle for a 10-year period, we'll use a 4.5% assumed rate of future investment return.
Second, we need to make an assumption about how long someone will live to collect the monthly benefits. Typically, this is where an actuarial assumption would come into play. But in order to keep this from being too technical, it may be helpful to instead use the results of an annual study released by the Centers for Disease Control and Prevention (or CDC). The most recent study indicated that an average male at age 65 will live to age 83, or 18 years. A 60 year old is expected to live about 22 years, or to age 82. We will use these figures to perform our analysis for an "average" male.
The next step will be to make the actual projections, which we'll tackle next time.
Trying to compare the DB and DC plans is exactly like the old saying of trying to compare apples to oranges. Just like fruit, part of the decision making process in selecting which type of plan is better comes down to preference and taste - not something that can be analyzed. But, the analysis is worth doing.
One of the ways you can approach understanding the two types of plans are considering when all participants are considered "equal" - meaning, when is the benefit they all earn during any given year from the sponsor the same.
In a defined benefit plan, they are all equal at the entitlement age. If a DB plan has an entitlement age of 60, and pays a $20 monthly service award for each year of service credit earned, then all participants that earn 50 points in 2018 are paid the same $20 monthly benefit when they turn age 60. (For now I'm going to conveniently ignore the fact that some firefighters could be over age 60.) If a 20 year old, 30 year old, 40 year old and 50 year old firefighter all earn 50 points in 2018, they all will be paid the $20 at age 60 - so they are all treated the same at age 60. Some have to wait longer than others to start collecting the benefit, but ultimately the terms of the plan say everyone will get paid the $20 per month beginning at age 60.
In a defined contribution plan, all participants are equal at the time they are earned. So regardless of the entitlement age in a DC plan, every firefighter that earns service credit during a plan year receives the same contribution. Since programs do have an entitlement age and those contributions are not paid until each participant turns the entitlement age, then most certainly the amount each participant is actually paid will be different. The amount will depend on what rate of interest is earned on those contributions.
In summary, DB plan participants earn equivalent benefits at the entitlement age, while DC plan participants earn equivalent benefits at the time the benefits are earned. In order to compare the two plans, we have to decide at what point should the comparison be made - at the current age or at the entitlement age. In order to avoid heavy-duty actuarial math, we will make the comparison at entitlement age in a future post.
We fully expect the Governor to sign the bill to increase the defined contribution (DC) amount from $700 to $1,200 into law at some point before the end of the year. For the sake of many fire districts that would like to amend the program at the upcoming commissioner election in December, we hope it is sooner rather than later!
Although we would prefer to have had the contribution amount increased to $2,100, which was the original version of the bill, the $1,200 amount at least increases the contribution by close to 70%, and makes the DC plan a bit more competitive to the benefits that can be provided from the DB plan. But by how much?
Over the next few posts we'll take a look at that. There are many assumptions that go into the calculation, and any changes to those assumptions will create different results.
Sharing my thoughts and insights on LOSAP, and occasionally other topics.