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August 2012, by David M. Stubbs and Nari Rhee
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The California legislature is currently considering SB 1234, a bill that would create the California Secure Choice Retirement Savings Trust—a state-sponsored retirement plan for private sector workers who lack access to a workplace plan. Although the plan would technically be a defined-contribution (DC) program based on an individual retirement account (IRA) platform, assets would be managed in a pooled fund and workers would be guaranteed a rate of return on their contributions, insured by private underwriters rather than the state. This Policy Brief broadly assesses the feasibility of such a plan by analyzing the private cost of guarantees, probable investment returns simulated through a hypothetical pension investment portfolio, and the long-term funded status of a hypothetical pension plan given conservative assumptions.
1. Experts agree that while government is in the best position to insure DC plans, the private financial market can also insure benefit guarantees—for a price. The question is how much insurance is optimal in terms of costs and benefits.
- Recent research based in finance theory finds that the private market cost for insuring a minimum rate-of-return guarantee rises steeply with the level of the guarantee, and is much higher than the cost that would be charged by government.
- While the market is unlikely to guarantee a high enough rate of return to provide adequate retirement income, private insurance can still be used to backstop a modest minimum guarantee— likely somewhere below the riskless rate—that insures against the worst outcomes but allows workers to capture higher investment returns.
- A pooled DC plan with nominal accounts rather than individual investment accounts that accumulates its own reserve fund and pools risks can incorporate features to help reduce insurance costs associated with the minimum guarantee. It can also strive to provide target level benefits in order to generate greater retirement income security for workers than is provided by a minimum guarantee alone.
2. Based on a hypothetical conservative portfolio split 50/50 between equities and bonds/treasuries, a publicly sponsored retirement plan is likely to generate an average annual real rate of return over the long term of 5 percent real (i.e., after inflation), with very little risk of the rate dropping below 2.3 percent over a 30-year period, or below 2.9 percent over a 50-year period.
- Looking retrospectively at overlapping periods between 1926 and 2010, the portfolio would never have earned an annual average real rate of return of less than 3.2 percent over 30 years, or less than 3.6 percent over 50 years.
- Random-draw simulations using bootstrapping and Monte Carlo methodologies yielded an average rate of return of 5.0 percent and 5.1 percent real, respectively, for 30- and 50-year investment horizons. Tenth percentile returns were at least 2.3 percent for 30 years and at least 2.9 percent for 50 years.
- Remaining uncertainty regarding long-term market performance can be managed in multiple ways, by carefully setting minimum benefits, periodically readjusting benefits, accumulating reserves, and—absent a government backstop—privately insuring benefits.
3. Results from a plan model based on conservative assumptions indicate that a hypothetical state-sponsored retirement plan with a modest minimum return guarantee would be fully funded or over-funded during its first 40 years of operation.
- The model assumes a minimum return guarantee of 3 percent nominal (essentially 1 percent real with 2 percent projected inflation), generous expense ratios, and very low discount rates. The low level of the guarantee reflects private insurance constraints and market interest rates, and would be higher if based on probable portfolio returns and a government backstop.
- Whether the hypothetical plan is publicly insured or privately insured at additional cost, the system stays solvent across a wide range of likely rate of return scenarios, from 2.5 percent real to 7.0 percent real, over its first 40 years.
- In the middle-range investment return scenario (5 percent real), the plan becomes substantially over-funded in relation to both accrued and future liabilities, with a funded ratio of 170 percent by the end of the 40 year period in the privately insured model. The surplus can be distributed plan retirees over time and/or used as a reserve fund in order to lower insurance costs.