Retirement insurance: A Q&A with the Brookings Institution’s Matt Chingos about collective defined contribution plans
Matt Chingos, a Fellow at Brookings Institution’s Brown Center on Education Policy, is the co-author of a new report, “Improving Public Pensions: Balancing Competing Priorities.” In it, he and his co-authors make the case for a collective defined contribution plan. Public Sector Inc. editor Steve Eide recently spoke with Matt about the structure and advantages of collective defined contribution plans. Below is an edited transcript.
EIDE: What’s wrong with the 401k?
CHINGOS: A lot of folks are concerned that 401ks simply don’t provide adequate retirement security. Obviously, if you put a lot of money into them, they can. It’s not that they never provide adequate retirement security, but there’s concern that they expose employees to too much risk. To risk that they won’t save enough, or that the market will suffer a downturn right before they retire, or that they will outlive how much they’ve put aside. So people are kind of hesitant to move from a traditional defined benefit plan to a 401k, which is why we tried to find a middle road that took some of the advantages of the defined benefit and put them in the context of a defined contribution-like plan.
EIDE: What are the disadvantages of the defined benefit plan?
CHINGOS: For someone who enters a defined benefit plan as a young person, works a full career, 30 years, in that same job, they do pretty well in many states. They get adequate retirement security. But most folks do not follow that path, particularly these days. Most people don’t stay in the same job from when they finish college until they retire in their 50s or 60s. People move around. So what you have is people being treated in a way that I think is unfair. It’s not so much that I’m worried about the people who are in for one or two years. Maybe we don’t want to give them a big benefit, because we want to encourage longevity. But someone who teaches or is a police officer for only 20 years—I think 20 years is a pretty significant contribution to public service—receives a much much lower benefit than for someone who does the full 30 year career. It’s not that they get two-thirds the benefit, they get much less than that in many cases.
EIDE: What is a collective defined contribution plan and what are its chief advantages?
CHINGOS: The collective defined contribution plan has individual accounts, so it can’t be underfunded, by definition. You don’t have this worry that politicians are going to promise employees great benefits and then not put the money away and bankrupt the system. You get rid of that concern. But instead of having a regular defined contribution where everyone has just their account, and if they invest it badly, or if the market’s bad, they do badly and don’t have enough money at retirement, you make it collective. So it’s professionally managed, to provide a little more sophistication in the investment decisions—you don’t leave that to individuals who may not have that level of sophistication—and you do risk sharing. You pool risk across different employees and also across generations of employees. So let’s say you retire when the market is really good. You don’t get all of the benefit, all of the return, of having retired in a good market. Some of that gets set aside for people when the market is quite bad. You spread that risk out somewhat, so that everyone winds up closer to average. So sure, some people don’t do as well, but the people who are exposed to the most risk of not having enough money are helped, and everyone enjoys that, kind of like in an insurance policy.
EIDE: Would this guarantee a certain level of benefit to all employees?
CHINGOS: The specifics of an individual collective defined contribution plan would vary by context, and there are different ways to set it up. One way is to guarantee a certain rate of return, but that moves some of the risk back to the taxpayer and gets us back into a lot of the problems that we have today. It doesn’t necessarily need to guarantee a certain rate of return. What it could do is average the rate of return over a longer period of time. So the rate of return applied to any individual account isn’t the value of the assets at a given moment in time, it’s some average return over, say, 5 or 10 years.
EIDE: So it wouldn’t be a “defined benefit,” in the traditional sense of the term.
CHINGOS: No, the gains the account made would still be very much tied to the market. But, let’s say you retire in a year where the market is very good. If instead of being credited the value of the assets at that moment in time, you instead get the average rate of return, say, over the last 5-10 years, that average rate of return is going to be lower than the actual rate of return in that moment of time. But then if there’s a market downturn two years later, people who retired then will have that smoothed out over that longer period of time.
EIDE: Would contributions into the plan, for the employer and/or employee, be fixed or variable?
CHINGOS: We proposed a general framework for how to think about this, and an approach that we think is one that is worth taking a serious look at. We don’t have a specific plan saying you have to do it with a 9% employer contribution, or 12%, and have it fixed or variable over time. That really could be done in a way that was the most desirable by the people creating the plan for a particular set of circumstances.
EIDE: In the public finance policy world, we’re greatly concerned about this problem of “crowd out.” When the economy tanks, revenues collapse, as does the stock market, and governments that have a defined benefit plan have to increase their employer contribution at the exact moment when they have less funds available to do so.
CHINGOS: You certainly wouldn’t have that problem with a collective defined contribution. In general, contributions would be a fixed percentage of employee pay. Probably shared between employers and employees. How that balance is done would vary. Perhaps you want to have employees putting in more earlier on to get more gains, or more later on because they’re closer to retirement. But there’d be no reason that when the economy tanks, suddenly employers would have to put in more when they could least afford it. You wouldn’t have that problem that we have with a defined benefit plan.
EIDE: In the traditional defined contribution plan, the employee bears all the risk. In the defined benefit plan, the employer/taxpayer bears the risk. In the collective defined contribution plan, where do you locate the risk?
CHINGOS: I would say the employees still bear most of the risk, but it’s spread out over many employees in a way that individual employees don’t bear as much risk as they would under a pure 401k type plan.
EIDE: Why do you think pension reform is so important for public education reform?
CHINGOS: One reason is the underfunding issue, which is not limited to teachers, but is a broader issue. But, also, a number of people have been concerned for a long time about the incentives that are embedded in defined benefit pension systems, and about the fairness issue that I talked about earlier. The fact that someone who teaches for 30 years in one state does much much better than someone who teaches for 30 years but divided between two states-15 years and 15 years. Those teachers, I would say, have made equal contributions to the public good, but yet our system, in most places, has severe penalties for the person who divides his or her career. So I think there are some real issues there around recruiting and retaining the best employees and around simple issues of fairness.
EIDE: The collective defined contribution plan was originally proposed with private sector employers in mind. Why hasn’t it caught on more in the private sector?
CHINGOS: It’s a relatively new idea. The paper that we talk about in our report that proposed this idea came out just in the last year or two. I also think that people tend to stick with what they know. Private sector employees these days tend to get 401k-style plans, so when you move from one employer to another, you kind of know what that is. For a collective defined contribution plan to function well, it’s better if more than just one or two employers, are part of it. Of course, there is a chicken and egg problem there-to work better, you want more people to participate, but more people won’t want to participate until it works a little better.
EIDE: With all your focus on risk pooling, it sounds like what you’re trying to achieve is a health insurance model for retirement benefits.
CHINGOS: It does bear a lot of similarity to insurance. When people say they want retirement security, they want to be insured against the possibility that they’re going to be poor when they’re retired and elderly. In a lot of places, people have Social Security, but many public employees are not part of the Social Security system. All they have is their pension, so it’s important that they be protected from being impoverished as older people.