Getting Public Workers the Retirement Income They Need

Retirement plans should move toward an investment approach that focuses on lifetime income rather than wealth accumulation.
January 18, 2016
By Richard Hiller  |  Contributor
Senior vice president for government and religious markets for TIAA-CREF

There are nearly 20 million public-sector workers across America, and providing for their future retirement security grows more complex with each budget cycle. States and municipalities want to do right by employees who have devoted their careers to public service, yet they also must contend with rising health-care costs, other public investment needs and the concerns of taxpayers.

The right approach to public-sector pensions should give workers the sustainable retirement income they've come to expect while giving governments and taxpayers greater cost certainty. Accomplishing this means embracing solutions that merge some of the best features from the defined-benefit and defined-contribution worlds.

It's clear that asking public-sector workers to plan for their own retirement by focusing on wealth accumulation has major drawbacks. Many Americans lack expertise in investment selection and asset allocation. In defined-benefit plans, investment experts employed by the plan remove this burden from workers. Defined-contribution plans try to do the same by offering target date funds (TDFs) that can put workers on an automatic path to accumulate assets early and reduce risk as retirement nears.

Yet even when they incorporate TDFs, defined-contribution plans oriented toward asset accumulation can leave workers exposed to certain risks that can jeopardize their income in retirement. Longer lives can leave retirees short on income in their final years. The possibility of low or negative returns early in retirement can erode savings over the long term. So can inflation. And as we age, we run the cognitive risk of being unable to make appropriate decisions about our financial well-being.

Given these risks, it is little wonder that 47 percent of government workers say that concerns about running out of money to cover monthly expenses in retirement keep them up at night. To allay these concerns, public-sector plans should maintain lifetime income as the core objective, offering a defined-contribution solution that helps workers generate retirement income that they can't outlive. With knowledge about a worker's likely income trajectory, length of employment, outside sources of retirement income (including Social Security) and other life factors, innovative retirement approaches can help put employees on the right path. Using an income-replacement ratio of 70 to 100 percent of pre-retirement income is a good rule of thumb.

An investment approach commonly used in defined-benefit plans known as liability-driven investing (LDI) makes this income-driven approach feasible for employers and employees in a defined-contribution environment. With an LDI approach, workers and employers contribute to retirement accounts, and then the individual is placed in an asset-allocation model (based on age, savings and other metrics) that is adjusted according to a methodology, chosen by the employer, that puts retirement income front and center. Predictable, income-producing assets that might be passed over in an accumulation-driven portfolio -- such as guaranteed annuities or U.S. Treasury Inflation-Protected Securities -- may become integral features of an income-driven portfolio. These products are designed to generate income and manage risk effectively throughout retirement.

As the retirement-income objectives that are set by the plan are met, individuals are placed in a more-conservative asset allocation model similar to a TDF approach. But LDI goes a step further than TDFs by helping to protect a worker's retirement contributions from market shifts and other risks, just as a defined-benefit pension plan does. And when delivered in a defined-contribution structure, the LDI approach moves employees between asset-allocation models based on their retirement readiness.

Liability-driven investing is already used in private-sector defined-contribution plans across different countries, including the United Kingdom, Germany, the Netherlands and South Africa. With fiscal pressures rising, more state and local governments in the United States might want to consider the same approach. An LDI strategy aims to deliver the sustainable retirement income public employees are accustomed to while providing them with the portability needed by today's mobile government employees. It also comes with the added benefit of providing greater budget predictability -- a sought-after feature for both public-sector employers and taxpayers.