Academic journal article Journal of Risk and Insurance

Florida's Pension Election: From DB to DC and Back

Academic journal article Journal of Risk and Insurance

Florida's Pension Election: From DB to DC and Back

Article excerpt

During the year 2002, the State of Florida's 600,000 public employees were given the choice of converting their traditional defined benefit (DB) pension plan into an individual-account defined contribution (DC) plan with full control over asset allocation and investment decisions. To mitigate some of the risk and uncertainty in the decision, the State granted each employee electing the DC plan an additional option to switch back (i.e., change their mind once) at any point prior to retirement. This option has been labeled the 2nd election by the State and the cost of reentry is fixed at the accumulated benefit obligation of their pension entitlement, which is the present value of the life annuity. Our article presents some original analytic insights relating to the optimal time and financial value of this unique 2nd election. Although our model is deterministic in nature, we believe that it provides a number of intuitive insights that are quite robust. Our results can be contrasted with Lachance, Mitchell, and Smetters (2003). We estimate that the increase in retirement wealth that arises from having the 2nd election is equivalent to at most 30 percent in future value, and only when utilized optimally. Furthermore, for most State employees above the age of 45, the 2nd election has little economic value because the DB plan dominates the DC plan from day one. Of course, it remains to be seen what percent of Florida's 600,000 employees will elect to behave rationally with their newfound pension autonomy.

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THE FLORIDA PENSION ELECTION

During the year 2002, the State of Florida's 600,000 public employees were given the choice of converting their traditional defined benefit (DB) pension plan into an individual-account defined contribution (DC) plan with full control over asset allocation and investment decisions. This new Public Employee Optional Retirement Program (PEORP) has been the focus of intense scrutiny by local and national media because it is the largest such pension conversion in the history of the United States and is being viewed by some observers as a potential laboratory for Social Security reform.

Interestingly, to mitigate some of the risk associated with this decision, the State granted each employee electing the DC plan an option to switch back into the DB plan at any point prior to retirement. This option has been called the 2nd election by the State authorities and we will adopt this name. The cost of getting back into the DB plan is the accumulated benefit obligation (ABO) of their pension entitlement under the DB plan. The ABO is effectively the present value of that portion of the life annuity (pension) to be received at retirement, based on the number of years of service and salary at the time of computation. (1)

Our article presents some original analytic insights relating to the optimal time and financial value of this unique 2nd election. Although our article is structured in deterministic terms, we believe this framework is sufficient to capture the economic trade-offs. We will elaborate on this throughout the article. A follow-up paper by the authors is examining a more robust general framework for pension decisions.

We are careful to distinguish between the value of the 2nd election, which is the focus of this article, versus the more vague and controversial pension "funding cost" of providing the 2nd election to the employee. While the former is related to portfolio replication and dynamic hedging of guarantees, the latter depends on various actuarial standards of practice, assumptions, and cost methods that are beyond the scope (and interest) of this analysis. We refer the interested reader to the work by Haberman and Sung (1994) as well as O'Brien (1986) for stochastic models of pension plans that are focused on actuarial funding methods.

Most importantly, the conclusions from our, albeit simple, analysis differ from the results of Lachance, Mitchell, and Smetters (LMS) (2003) that were recently published in this journal. …

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