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A Closer Look at Different Kinds of Retirement Plans

Advanced Design Concepts: Guaranteed Return Plans

There are good ways to build Guaranteed Return plans, and bad ways to build Guaranteed Return plans.

An Uncommon Concept with Common Sense

A Guaranteed Return plan is technically a defined benefit retirement plan. The benefit being “defined” is a minimum guaranteed investment return on assets plus the potential to earn additional investment returns. By contrast, a pension plan is “defining” the benefit by a formula that uses years of service to calculate guaranteed income. A GR plan also provides a guaranteed minimum level of income (contributions multiplied by the guaranteed return on those contributions, calculated for a certain number of years of service, and then converted into annualized income payments). But with a GR plan the income to be received could be higher than that minimum since employers and employees usually share a portion of the investment returns above the guaranteed rate.

This kind of plan design is not common in the public sector yet, although the concept has been growing in recent years. Nebraska created a GR plan in 2002, and Kentucky and Kansas adopted GR plans in their states during the 2010s for different kinds of public employees. Louisiana’s lawmakers created GR plans around that time too, but the authorizing legislation was overturned on an unrelated technicality.

In practice, GR plans aren’t that hard to understand and actually make a lot of sense. With GR plans, both employees and employers make contributions into a common fund. The retirement system keeps track of who contributed what, creating notional accounts. But in practice the state is holding on to all of the money and invests it as a group. Every participant’s account gets credited with some minimum investment return each month or quarter. If the state is able to earn investment returns above that amount, a portion of the excess is shared with participants.

Example Guaranteed Return Design Plans

Both Kansas and Kentucky’s GR plans guarantee a 4% return on the employer and employee contributions made for each participant. In Kansas, a state retirement board decides each year how much of any excess returns over 4% to share with employees. Kentucky has set a fixed rate —three quarters of all returns above 4% go to employees. The state keeps the rest to create a reserve fund for paying out guaranteed rates in years where investment returns are lower than 4%.

Trade-offs for Guaranteed Return Plans

We know that employees really like having guarantees associated with their retirement income. It can be nerve wracking to have a DC account and worry about investment returns. So, one advantage a GR plan has over a DC plan is that there are some guaranteed investment returns. And that makes GR plans more like pensions.

We also know that a major downside of pensions is the lack of portability. Pensions are designed to provide the largest benefits later in someone’s career. If an employee leaves early he can only take his own contributions with him, leaving behind anything the employer contributed on his behalf, other than maybe some interest payments. But GR plans are totally portable. Because all employees have their own notional account, once they vest in the benefit, employees get to keep all of the contributions from their employer. This makes GR plans more like DC plans.

In many ways, GR plans blend the best parts of pensions and DC plans. The downsides are that the guarantee is often slightly less than an employee would get with a typical pension, and employees who want to manage their own retirement account can’t do that with a GR plan. These are trade-offs that try to strike a balance between competing objectives.

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