The Default Pension Option is Not in Our Stars But in the Plan

We noted yesterday that the task force charged with coming up with a pension system that would meet the requirements of the Committee of Two deal released its report. (The link is on yesterday's posting.) We now also have a guide to reading that report penned by the chair and vice chair of the Academic Senate:
http://senate.universityofcalifornia.edu/underreview/documents/ROTFReportGuide.pdf.pdf
It is recommended reading.

Basically, the guide and the proposal itself are the outgrowths of a Bad Deal reached by the Committee of Two. Here is the basic problem. By itself, the PEPRA cap, currently around $117,000 doesn't matter for employees whose earnings will always be below the cap in terms of their eventual pensions. But for faculty, even those who start below the cap are likely to end up above it if they have any kind of career at UC. The cap is not just a cap on the final pension. It is a cap on the earnings that are counted toward the pension. So even newly-hired folks who might never have reached the cap amount under the current 2013 pension tier will be adversely affected. It is unclear that either member of the Committee of Two understood the difference between a simple cap and the PEPRA cap and its implications. (We are being polite by saying "unclear.") The whole thing was political symbolism: CalPERS does it so why shouldn't UC?

Given the Bad Deal and another political constraint - that the new tier for new hires after starting July 1, 2016 "save money" - whatever emerged from the task force was bound to be inferior to the current pension system facing employees hired before July 1. That is, if you dump enough money into a pension plan of any structure - defined contribution (DC), defined benefit (DB), hybrid, cash balance, whatever - you can always make the new plan better than some other. But the task force was not free to dump enough money into the new system to make it better. It had to be worse.

So the task force was dealt a bad starting hand. What it came up was a choice model between two alternatives: Option A is a PEPRA-capped DB plan plus a DC supplement for earnings above the cap. Option B is a DC-only plan. A new hire can elect A or B upon hiring but the default option is A. That is, if the new employee does nothing, he or she ends up in A. The task force believed that making a lifetime choice at hiring was too severe a decision, so it includes a kind of buyer's remorse five years down the road. But that second choice is only for those in B to revert to A. (There is no A-to-B choice.) Those who move from B to A at the second choice point are not retroactively put in A. But they do vest in A. And they keep whatever money they accumulated in B up to that point.

Note: Five years is not a good period for a second choice for newly hired assistant professors. Presumably, they will want to know if they have tenure before possibly deciding to move from B to A. The decision on tenure is likely to take place in the 6th or 7th year. There has been some assurance that the second-choice point for faculty in the final version will be adjusted to match the tenure decision timing. But if there is to be a second choice point for faculty, it should definitely be done at tenure.

The general rule is that DB plans (such as A) tend to favor long-service, career employees. DC plans (such as B) tend to favor short-timers, i.e., employees who leave (and take their money with them) after a relatively short period. Note also that offering the B-to-A switch after 5 years (or tenure) really tilts the optimal initial decision as seen by the new hire. No one starting out knows for sure that he/she is going to have a long career. So it seems clear that for most new hires, faculty or otherwise, the optimum choice is to start in B with the knowledge you can switch later to A if you want to do so. Put another way, a knowledgeable typical new hire should go for B. But the key is "knowledgeable." The new hire has to understand the implications of the initial choice. He/she has to understand that B is better than A if it turns out he/she leaves early and that starting in A forever blocks a move to B.

But under the proposal, UC makes the default choice A. It knowingly picks a default option that is likely to be inferior for new hires. That approach seems odd. But if the default were to be made B instead, UC would be channeling more and more new hires away from the DB pension, gradually making it an orphan plan over time.

The Senate guide notes that there is some adverse selection cost to the DB plan of offering any choice at all. (That is, in principle the proposal of the task force could have been just A and the result would have been more funding for the DB plan.) But apart from the accounting issues, orphan plans become progressively problematic from a political standpoint. They gradually have fewer and fewer defenders. Presumably, for that reason, the task force did not choose just B, i.e., abandoning DB in the future. And presumably, for that reason, the default initial choice is A.

Given the default of A, however, UC is in the legally questionable position of shunting employees into what is likely to be an inferior option for many of them. When you start with a Bad Deal, you only have bad options. Maybe that is the ultimate lesson.