Many states are currently facing unfunded liabilities to their defined benefit pension programs. Pennsylvania, in particular is over $40 billion short of its obligations, alone about 1.5 times its entire yearly budget. Borrowing a concept from the private sector, and favored by Governor Corbett, is a plan to move all new state employees into a defined contribution 401k type program. While the move to defined contribution makes very good sense, it is important to recognize the problems with this approach and avoid them, doing the best we can for our state employees.
Defined contribution is subject to failure on two fronts. First are high costs that limit investment returns. Many plans offer overly expensive investment choices that, because of the high costs, often in the short term and pervasively in the long term, do not match the returns of simple passively managed low cost index funds. Then to make matters worse, responsibility to select the right mix of investment choices is dumped into the laps of ordinary workers (and some very smart workers also) who know little to nothing about the principles of sound investing, thus becoming their own worst enemy by allowing their emotions to make decisions that put them on a path to very poor results. The good news is that it doesn’t have to be this way and there is a superior model that all can strive to achieve.
The most surprising thing about this defined-contribution-done-right example is the source, that being the Federal Government, of all places! It’s indeed uncanny and hard to admit the Federal Government doing anything better than the private sector but the Thrift Savings Plan does just that. The TSP is administered by the Federal Retirement Thrift Investment Board, an independent agency of the Federal Government established in 1986. It now has over 4.5 million participants with $374billion in assets at the end of 2012.
What sets the TSP apart from most plans offered in the private sector is its strict adherence to low cost and simplicity. It currently offers only five investment choices plus target date collections of the five funds designed to produce the highest returns for the least amount of risk appropriate. The target date funds were added in August 2005 to address unprepared employees choosing poor fund mixes and then trading them on emotion to their detriment. The target date mixes are determined by scientific methods looking at past volatility and returns of the individual asset classes as well as how they tend to move relative to each other, combined with the participant’s individual time horizon.
While private sector 401k plans are dominated by actively managed funds that purport to be run by managers clever enough to beat the market, all TSP funds are passively managed index funds that won’t beat the market but guarantee capturing the generous returns the markets make available over time less very small expenses to do so. The dirty little secret is that attempts to beat the market most often end up trailing the market, mainly due to the expenses incurred in the pursuit. Study after study confirms this as presented in the writings of such investment heavyweights as John Bogle, founder of Pennsylvania based Vanguard Funds, who in a 2006 interview for Frontline noted:
“So our legislators and our federal employees get these great benefits through as close to a perfect retirement plan as you can have …… We don’t do that for our regular citizenry.”
Attempts to require private sector 401k plans to offer even one low cost index fund has been a struggle. The TSP, using only index funds, offers coverage of five distinct asset classes for an expense drain to the worker that is the lowest anywhere. Expenses compound in the negative as returns compound in the positive and can alone result in huge differences in account balances at retirement time. The actual numbers will seem untrue but they’re not. While many private 401k plans impose reported expenses to the investor in excess of 1%, or 100 basis points, the TSP reported 2012 expenses across all funds of an amazing 0.027% or 2.7 basis points! The actively traded fund manager hoping to beat the market must make up this difference just to break even because the expense of trying is passed through. In addition to reported expenses are those that are hidden but real nonetheless. A good article at Nerd Wallet lists 28 known potential hidden fees and shows by example how differences in expenses will drastically affect outcomes at retirement.
So when states look at defined contribution there are important choices within that choice that deserve attention. One approach that should certainly be considered and has yet to be attempted to my knowledge would be for a state to petition the Federal Government for voluntary participation and inclusion of its employees within the Thrift Savings Plan. So long as the TSP could accommodate unique matching and vesting criteria for each state’s employees, this expansion of the TSP into state governments should only benefit both states and their workers. In addition, a smoothly running structure that has been developed over time would save the expense to reinvent it.
In March I proposed this concept to one of the best investment advisors I know on his Saturday radio show, Financial Freedom, on WHP 580 in Harrisburg. Mr Tim Decker, host of the show, was fully supportive of the idea and the various legislative committees now considering pension reform would do well to seek input from Mr Decker. Our radio conversation can be heard here. Jump to 14:00.
Just yesterday morning on CNBC’s Squawk Box, Larry Fink, CEO of BlackRock, the largest investment management firm in the world, appeared with Congressman Paul Ryan. Both were singing the praises of the Federal Thrift Savings Plan, presenting it as the best model for individual retirement accounts. Significantly this is exactly what George W Bush suggested as the basis for voluntary private Social Security accounts. Will Pennsylvania and other states make the TSP their model for state employee pension reform?