The Challenge of 401(k) Plans by 941aok

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									   The Impact of a DROP
          Program
on the Age of Retirement and
  Employer Pension Costs
           Samson Alva, Norma B. Coe, and Anthony Webb
           Center for Retirement Research at Boston College

Sixth International Longevity Risk and Capital Markets and Solutions Conference
                                Sydney, Australia
                              September 7-8, 2010
Defined Benefit Pension Plans
• Previous research shows that defined benefit (DB) pension plans
  incorporate age-related incentives that affect the age of retirement.


• For example – Friedberg and Webb (2005) estimate employees in DB
  plans retire two years earlier, on average, than those in DC plans.


• May disadvantage employees who would prefer to delay retirement


• May impose costs on employers if they result in premature loss of
  valued employees



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Deferred Retirement Option Program
(DROP)

• Some employers have responded by introducing a DROP.


• In the typical program we study:


      • Eligible employees (those who have 10 years’ service and who
        have attained their Normal Retirement Age) can elect to enter
        the DROP and remain in it for a maximum of four years.




                                                                        3
Deferred Retirement Option Program
(DROP) (cont’d)
• On entry, employees cease to accrue additional pension benefits or
  pay pension contributions.


• During DROP participation, pension benefits are credited to a notional
  interest-bearing account in the employee’s name.


• Balance on the account is paid to the employee in a lump sum on
  eventual retirement.




                                                                       4
Possible Effects

• Employees might enter the program at the age they would otherwise
  have retired.


• In that case, the program will be cost neutral, provided the interest
  rate on the DROP account equals the interest rate the employer can
  earn on the deferred pension benefits.


• We might then want to know who delays – are these workers more or
  less valuable to the employer than their putative replacements?




                                                                          5
Possible Effects (cont’d)


• Employees might retire at the same age as before, but spend the last
  few years of their career in the DROP.


• Will only do this if it is to their financial advantage (and to the financial
  disadvantage of their employer!)




                                                                              6
Questions We Examine

Using individual level data provided by a large public sector employer,
we estimate:


• Impact of the DROP on the age of retirement


• Cost of program to the employer


• Whether highly valued employees are particularly likely to be induced
by    the program to delay retirement




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Overview of Pension Plan Rules

  Hire date                                              Pre-1988                             Post-1988

  Employee type                               Police and fire Municipal             Police and fire Municipal

  Benefit accrual rate
    First 10 years                                     2.5                 2.5                 2.2                2.2
    11-20 years                                        2.5                 2.5                 2.2                2.0
    21+ years                                          2.5                 2.0                 2.0                2.0
  Normal retirement age                                 45                  55                  50                 60
  Early retirement age                                  40                  50                  40                 52
  Monthly early retirement                             0.5 %               0.5 %               0.5 %              0.5 %
  reduction



          Source: Samson Alva, Norma B. Coe, and Anthony Webb. 2010 forthcoming. “The Impact of a DROP Program on the Age of
          Retirement and Employer Pension Costs.” Working Paper. Chestnut Hill, MA: Center for Retirement Research at Boston
          College.



                                                                                                                           8
How Does the DROP Affect Pension
Wealth Accrual and the Incentive to
Retire?

Calculate expected present value of pension wealth by age assuming
DROP is unavailable. Then recalculate program assuming:
   a)     DROP is available
   b)     Employees makes optimal use of it

Assume 2.5% inflation, 1.1% real wage growth, 3.0% real interest rate,
population average mortality for the relevant birth cohort




                                                                         9
Pension Wealth Accrual
   Male Born in 1970 Commencing Employment in 2000 at $40,000 Starting Salary
              Real Discount Rate: 3%, Inflation: 2.5%, Real Wage Growth: 1.1%
      discounted to age 50, in thousands
                                           $400
          Wealth in year 2009 dollars,




                                           $300

                                           $200

                                           $100

                                             $0
                                                  30          40   50          60          70        80
                                                                         Age
                                           Municipal - early       Municipal - normal           Municipal - DROP
                                           Fire/ police - early    Fire/ police - normal        Fire/ police - DROP
      Source: Samson Alva, Norma B. Coe, and Anthony Webb. 2010 forthcoming. “The Impact of a DROP Program on the Age of
      Retirement and Employer Pension Costs.” Working Paper. Chestnut Hill, MA: Center for Retirement Research at Boston
      College.


                                                                                                                      10
Dataset
Large municipal employer


• 63,558 employees in pensionable occupations between 1990
  and 2008
                                     After sample attrition:

                 Occupatio                 No. of                  No. of person-
                 n                       employees                     years
                 Police                              9,179                        84,559
                 Fire                                2,986                        26,325
                 Municipal                         27,448                       200,943


        Source: Samson Alva, Norma B. Coe, and Anthony Webb. 2010 forthcoming. “The Impact of a DROP Program on the Age of
        Retirement and Employer Pension Costs.” Working Paper. Chestnut Hill, MA: Center for Retirement Research at Boston
        College.


                                                                                                                       11
Characteristics of Workers in City Pension
Plan

• Relative to the population, City employees are older and more likely
  to work in a blue collar job, have less education and longer tenure,
  and be members of a minority group.


• Fire and police officers are predominately male.




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Estimation Strategy

• Estimate probit model to calculate effect of DROP on retirement
  hazard


• Estimate counterfactual retirement age for DROP-eligible employees


• Compare pension wealth of DROP-eligible employees at actual vs.
  counterfactual retirement age


• Sum to arrive at overall cost



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Estimation Strategy (cont’d)
• Probit model – pooled person-year observations
                   P(Rt  1 | Xt )  ( XtB)
• LHS variable binary indicator for whether the individual left
  voluntarily at age t or continued to work for the employer


• Estimate on everyone, on fire, police, and municipal employees
  separately


• Control for education, occupation, ethnicity, salary, years of
  service


• Plus full set of age dummies

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Estimation Strategy – Pension-Related
Variables

• Difference between current and      • At early retirement age
  peak wealth/earnings
                                      • At normal retirement age
• Difference between current and
  peak pension wealth/earnings        • After normal retirement age
  squared
                                      • Pension wealth/earnings
• At peak pension wealth

• One, two, three, four, five, six,
  seven, or more years past peak



                                                                      1
Estimation Strategy – DROP-Related
Variables
• DROP eligibility interacted with:


   • Not-yet-attained peak pension wealth


   • At peak pension wealth


   • One, two, three, four, five, six, seven, or more years past peak


• Hypothesis – DROP will discourage retirement before peak and less
  than four years past peak. People incented to continue working will
  retire four or more years after the peak.


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Regression Results: Selected Pension-
Related Variables
                                                         All                    Fire                   Police                Municipal
Difference between current and                    -0.00534 ***             -0.00816 *                 -0.0108 ***               -0.00643 ***
peak wealth/earnings                            (0.000880)                (0.00490)                 (0.00198)                  (0.00130)
Squared difference between                      0.0000894 ***             0.000858 *               0.000151 ***               0.000294 ***
current and peak wealth/earnings              (0.0000271)               (0.000466)              (0.0000298)                  (0.000113)
                                                    0.0452 ***               0.0370 ***               0.0118 ***                  0.0485 ***
At peak pension wealth
                                                 (0.00392)                 (0.0111)                (0.00445)                  (0.00551)
                                                    0.0720 ***               0.0314 ***               0.0337 ***                   0.103 ***
 One year past peak
                                                 (0.00539)               (0.00958)                 (0.00602)                  (0.00960)
                                                    0.0462 ***             0.00733                    0.0247 ***                  0.0944 ***
 Two years past peak
                                                 (0.00500)               (0.00581)                 (0.00560)                    (0.0117)
                                                    0.0424 ***             0.00814                    0.0237 ***                  0.0642 ***
 Three years past peak
                                                 (0.00544)               (0.00643)                 (0.00602)                    (0.0118)
                                                    0.0572 ***               0.0159 *                 0.0362 ***                  0.0447 ***
 Four years past peak
                                                 (0.00695)               (0.00837)                 (0.00792)                    (0.0118)
                                                    0.0439 ***               0.0214 **                0.0195 ***                  0.0495 ***
 Five years past peak
                                                 (0.00736)                 (0.0105)                (0.00689)                    (0.0154)
            * Statistically significant at the 10 percent level; ** Statistically significant at the 5 percent level; *** Statistically significant at
            the     1 percent level.
            Source: Alva, Samson, Norma B. Coe, and Anthony Webb. 2010 forthcoming. “The Impact of a DROP Program on the Age of
            Retirement and Employer Pension Costs.” Working Paper. Chestnut Hill, MA: Center for Retirement Research at Boston
            College.



                                                                                                                                                  1
Regression Results: DROP Eligibility
Interacted with Pension-Related Variables
                                                     All                     Fire                     Police                  Municipal
Not yet attained peak pension                    -0.000419                   0.00558                 0.000172                     -0.0108 ***
wealth                                            (0.00161)                (0.00695)                 (0.00221)                  (0.00188)
At peak pension wealth                              -0.0163 ***              -0.0119 ***              -0.00131                    -0.0212 ***
                                                  (0.00110)                (0.00154)                 (0.00306)                  (0.00130)
One year past peak                                  -0.0157 ***              -0.0115 ***              -0.00937 ***                -0.0174 ***
                                                  (0.00125)                (0.00181)                 (0.00164)                  (0.00189)
Two years past peak                                 -0.0110 ***             -0.00443                  -0.00462                    -0.0196 ***
                                                  (0.00192)                (0.00454)                 (0.00293)                  (0.00215)
Three years past peak                             0.000840                  -0.00557                    0.0144 **                -0.00621
                                                  (0.00333)                (0.00399)                 (0.00682)                  (0.00466)
Four years past peak                                0.00842 *                0.00634                   -0.0115 ***                  0.0267 **
                                                  (0.00448)                (0.00885)                 (0.00169)                    (0.0104)
Five years past peak                                 0.0334 ***                0.0175                  0.00637                      0.0215 *
                                                  (0.00806)                  (0.0135)                (0.00680)                    (0.0120)
            *Statistically significant at the 10 percent level; ** Statistically significant at the 5 percent level; *** Statistically significant at the
             1 percent level.
            Source: Alva, Samson, Norma B. Coe, and Anthony Webb. 2010 forthcoming. “The Impact of a DROP Program on the Age of
            Retirement and Employer Pension Costs.” Working Paper. Chestnut Hill, MA: Center for Retirement Research at Boston
            College.



                                                                                                                                                     1
Estimating Counterfactual Retirement Age
• At 3% real interest rate and 1.1% real salary growth, program delays
  retirement by:
                        Police      0.952 years
                        Fire        0.183
                        Municipal   1.270


• But people stay in the program for a median of four years


• So people enter the program at substantially younger ages than those
 at    which they would otherwise have retired




                                                                         19
Calculate Mean Cost Per Participant


• At 3% real interest rate and 1.1% real salary growth, and STRIP
  interest     rates
                       Fire
                                     $38,700
                       Police        $24,300
                       Municipal     $29,700




                                                                    20
Costs are Actually HIGHER at Higher
Assumed Interest Rates
                             STRIP interest    8.25% nominal
                                 rate
          Fire                       $38,700         $60,100
          Police                     $24,300         $54,700
          Municipal                  $29,700         $35,900


• Why?


• Program accelerates payment to pension benefits.




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Are High Quality Workers Disproportionately
Likely to Delay as a Result of the Program?
• Performance assessments not available for most employees


• Infer performance from salary increase relative to average for age and
  year


• Interact eligibility with “high quality”


• Program disproportionately affects high quality fire officers, but high
  quality police officers are less affected.


• Why? Outside options?
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Conclusion


• Defined benefit pension plans incorporate strong age-
  related variations in pension wealth accrual.


• These variations in pension wealth accrual influence retirement
  behavior.


• DROP changes both incentives and behavior, and can be
  very expensive for the employer.




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