With some actuarial studies estimating the state and local pension unfunded liability for existing retirement programs exceeds $1 trillion, many public (and private) plan sponsors are considering a migration from purely defined benefit programs to defined contribution programs over time, or blended programs that include both DB and DC components. Several states, including Utah and Rhode Island, have already taken steps to implement blended retirement plans that include both the legacy defined benefit components and new or expanded defined contribution components.
Since most defined benefit programs have been in place for many years, and the obligations under these DB programs are contractual, even those plan sponsors that wish to migrate to primarily defined contribution programs cannot fully do so for many years to come. Some jurisdictions, like Utah, have adopted blended programs, and there appears to be a philosophical decision that a blended program is a good combination for both the state and the employees.
Although not the purpose of this article, there does appear to be a growing conversation that a purely DC retirement system may result in a large portion of the population being ill-prepared for retirement, due to a combination of inadequate employee deferrals, insufficient employer matching contributions and the vagaries of the securities markets. During the recent meeting of the National Association of State Treasurers, several informal conversations included the need and desire to make sure the retirement programs around the country provided sufficient resources for citizens to retire. If the retirement plans are inadequate to maintain a reasonable standard of living, the care and well being of retired citizens simply gets shifted to other resources, which means additional burdens on the social systems of the country.
Maintaining and operating both defined benefit and defined contribution plans can itself present a daunting budget consideration for plan sponsors. In an ideal scenario, the economies of scale built over many years by the DB plans can be leveraged. The investment allocation, investment manager monitoring, custody relationships, securities lending, FX processing and transaction processing systems all have been developed over many years by the existing defined benefit programs. Ideally all of those systems can be utilized for the benefit of the much smaller (initially) and newer defined contribution programs.
These economies can be accomplished by unitizing the investment portfolios and making the same investment structures available to the defined contribution programs that are currently in use by the defined benefit programs. This can be done by unitizing the investment portfolios — in essence using mutual fund accounting principles and calculating a net asset value for each desired investment program, and making those same portfolios available to both plans.
The flow of contribution dollars into each plan, and the retirement benefit and other withdrawals from those same portfolios, can be handled just like shareholder transactions in any investment pool. The level of accounting detail inherent in net asset value accounting — treating principal, realized and unrealized gains and losses, income, and expenses — at the per unit level allows for extremely accurate and fair allocation of each line item, which flows down into fairness for all the underlying beneficiaries and participants.
While the concept of “unitizing” has not yet been applied to a state-level DB/DC plan, it has been utilized elsewhere in many state governments. For example, the California State Association of Counties Finance Corp. and the League of California Cities launched CalTRUST in 2005 as a vehicle for pooling assets for investment. By investing directly in one of three pooled accounts, local agencies can increase returns, lower administration costs, and improve compliance monitoring. Participants can set up separate subaccounts within the unitized structure, much as they would do in a defined contribution plan, move cash around, and have access to daily balances. This initiative now includes more than 145 California cities, counties, special districts, higher education agencies totaling more than $1.2 billion in investment assets.
This approach is far preferable to maintaining two completely separate investment programs and structures. Most investment managers have breakpoints in their fee structure, giving preferential rates as a percentage of the portfolio for larger accounts. If maintained separately the fee structure for each program would be higher. The same is true for custody fees, securities transaction processing fees and commissions, foreign exchange transaction fees, securities lending fees and spreads, consulting fees, and plan administration expenses.
Although these marginally larger fees may seem small when viewed as a percentage, each basis point in fees and expenses on $1 billion in plan assets is equal to $100,000 in additional expense. On a $20 billion retirement plan program, a size exceeded by a large number of state sponsored retirement programs, the additional expense is $2 million per $20 billion. That dollar amount can fund a number of other state or local budget priorities.
The expertise and accounting systems necessary to unitize portfolios and to handle the transfer agency aspects of posting and accounting for the movements into and out of the investment portfolios does carry an additional expense, but the additional expense in almost every conceivable scenario should be less than the significant savings and efficiencies that can be enjoyed by leveraging the existing investment infrastructure of the defined benefit program for the benefit of the next generation defined contribution successor, additional enhancement program.
Kip Meadows is founder and chief executive officer of Nottingham, a Rocky Mount, N.C.-based fund administration and accounting firm.