Which retirement plan is best for Ann Smith?

Gupta, Sanjay ; Moore, W. Kent

CASE SYNOPSIS

Ann Smith has recently accepted a new position as a junior executive with Fowler Inc., a company that manufactures construction equipment. Fowler Inc. offers two retirement plan options to their new employees, a defined benefit plan and a defined contribution plan. She has begun evaluating these two options, which differ considerably in their characteristics, to determine the ideal plan for her and her husband, Frank. Ann is grappling with several variables that affect the retirement choice, including how long she may work for her current employer, at what age she will decide to retire, how many years she might spend in retirement, how risk averse she is, and what the expected rate of return is. The importance of the retirement plan choice makes it critical that the Smiths consider all these variables carefully in order to make a well-informed and wise decision. Furthermore, the decision must be made within 60 days after employment begins. Which plan is best for Ann and her husband?

LIFE IN TRANSITION

It was an exciting day in the life of Ann Smith. She had just received her MBA degree from Florida Middle University. Her husband, Frank, and her parents were waiting outside the arena where the graduation ceremony was held to again congratulate her.

It seemed as though it had only been a few weeks since she had been accepted into the MBA program. Now it was all over and seemed like a blur. It would be great to have a few days to relax and not spend endless hours in the library, or on the computer, working on projects. Unfortunately, however, she did not have the luxury of time since she had accepted a position as a junior executive at Fowler Inc., a company that manufactured heavy construction equipment, and was starting in three weeks.

The move to a new city went smoothly and Ann and her husband Frank were excited about starting a new life. During the next two days, Fowler Inc. had scheduled an orientation for the new employees. This included a tour of the facilities, meetings with department managers, and an introduction of the company's retirement and health insurance options. While juggling all these meetings, Ann was also scrambling to take care of other minor issues like setting up her new office and helping Frank unpack. Work started on Monday of next week and there was still so much to do.

NEW EMPLOYEE ORIENTATION

The most substantive portion of the new employee orientation, the introduction of the company's retirement and health insurance options, was scheduled for Wednesday afternoon. By then, Ann was both physically and mentally exhausted from the flurry of activities over the last couple of days. Members of Med Cross presented the variety of health insurance options followed by a presentation by the Human Resources Director of the available retirement options. The two primary options were the Employee Retirement System (ERS) plan and the Optional Retirement Plan (ORP). Frankly, Ann had not even thought about retirement. She was only 32 and had so many other pressing issues on her mind at the moment.

The retirement session was well presented and contained very useful information. The Human Resources Director first presented the main features of the ERS retirement plan. Then, representatives from Fidelity, Vanguard, and Morgan Stanley, the three companies participating in the ORP plan, used formal PowerPoint presentations, video clips, and Q&A sessions to explain investment choices and historical fund performances. In the midst of all of this, several brochures and catalogs were distributed. Ann's folder looked like it was coming apart at the seams, not unlike what her mind felt like at that very moment. She had information overload and felt incapable of dealing with the complexities of choosing a retirement plan.

AVAILABLE RETIREMENT OPTIONS

Fowler Inc. offers two retirement plan options to their new employees, the Employees Retirement System (ERS) plan and the Optional Retirement Plan (ORP). The ERS is a defined benefit (DB) plan in which the retirement benefits are based on the number of years of service, using the following formula:

Monthly ERS benefits = (2% * years of service) * highest 24 month average salary. The employee makes a mandatory contribution of 5% and the employer contributes 10%. There is a vesting period of 10 years which means that if employment is terminated prior to 10 years, the employee can keep only his contributions and must forfeit the employer contributions.

The ORP is a defined contribution plan in which the employee also makes a mandatory contribution of 5%, while the employer contributes 10%. The employee is immediately vested into the plan without a vesting period. Retirement benefits are determined by the performance of the investments in which the employee chooses to invest the contributions. The employer provides the employee with three national companies, each with a variety of fund options, from which the employee can choose.

So the thorny decision facing Ann was multi-faceted. Should she choose the ERS plan or the ORP? If she chose the ORP, which company and funds should she select? To make matters worse, employees had only 60 days from the date of employment to make their retirement plan choice. Failure to make a choice within the 60-day window would result in a default selection of the ERS. Once a plan had been picked, the choice was irrevocable. Could life get any more difficult?

VARIABLES TO CONSIDER

Inflation Protection

The ERS plan offers some measure of protection after retirement against inflation. While this protection varies considerably across states, Georgia, the state in which Ann is employed, provides protection against inflation as measured by the Consumer Price Index (CPI). Historically, benefits have been adjusted 1.5% every 6-months. For employees expecting to live 10, 20, or even 30 years or more in retirement, this feature provides an incentive for employees to choose this plan.

Investment Risk

With the ERS plan, the employer bears the investment risk and guarantees a fixed monthly retirement income to the employee and the surviving spouse. In an ORP, however, the investment risk is completely borne by the employee. Retirement benefits are determined by the performance of the investments in which the employee chooses to invest the contributions. In Ann's case, her employer provides her with a choice of three national companies, each with a variety of fund options. Average annual returns can vary depending on the type of investment chosen. Nominal returns, over the past 30-years have been 11.24% for the S&P 500 Index, 9.2% for Corporate Bonds and 5.49% for T-Bills. Generally, the greater the investment risk, the greater the potential rate of return (http://www.thornburginvestments.com/literature/ generic_lit/TH1401_realreal.pdf)

Employer Contributions

For the Optional Retirement Plan, contributions are determined by multiplying the annual salary per year by the percentage of the combined employee and employer contributions. Clearly, all other factors being equal, larger contributions result in greater retirement benefits. Ann's employer, Fowler Inc., contributes 10% of the base salary whereas the employee makes a mandatory contribution of 5%.

Number of Expected Years of Work, Expected in Retirement, and Life Expectancy

Since the ERS plan offers defined benefits for the duration of time spent in retirement till death of the surviving spouse, it is usually the more beneficial retirement plan when the employee starts their job at an early age, earns 30 to 40 years of service by the time they are 60 to 70 years of age, retires, and then, based on life expectancy, expects to live another 20 years or more in retirement. Since the monthly benefits in the ERS plan are fixed, the longer the surviving spouse lives, the greater the retirement benefits received. Under an ORP plan, however, the employee accumulates a lump sum benefit at retirement and has the option to annuitize the amount and receive annual retirement benefits. In this plan, the greater the life expectancy and the greater the number of years spent in retirement, the less the annual benefits. One source of life expectancy data is the current life expectancy tables developed by the Center for Disease Control (CDC). This can be found at:

http://www.cdc.gov/nchs/data/nvsr/nvsr58/nvsr58_21.pdf

ANN AND FRANK'S BACKGROUND

Ann had just begun her first professional job and aside from a couple of thousand dollars in a money market account as an emergency fund, had very few assets. The good news was that she did not have any student loans or other debt. Ann's conservative middle-class parents taught her to spend money wisely. She considers herself to be moderately risk-averse, but wants to take full advantage of the compounding effect of money over time. She is currently 32 and realizes that at her age, with a career of 25 years or more, time is on her side. Her salary at Fowler Inc. is $60,000 per year. Frank, 33, is planning to return to school to get a master's degree in engineering.

Ann and Frank are both in good health with no apparent health problems. Based on the life expectancy charts cited earlier, Ann is expected to live to age 82 and Frank to age 78.

DECISION TIME

It has now been five weeks since Ann started her new job. Most of the trivial details had been taken care of, (employee ID, parking permit and email address), she had a functioning computer in her office, and work had been going smoothly. Ann's colleagues had been extremely supportive and she felt well accepted. Things had also mostly settled down on the home front and they were enjoying their new condo and evening walks in the wooded area right behind their backyard.

It was a Saturday afternoon and Ann and Frank were feeling relaxed for the first time in weeks. Ann was watching a particularly interesting episode on the Travel Channel and Frank had just finished a phone conversation with his mother. She sat down by Frank and they started talking about her new job and how much she liked it. The conversation then turned to their retirement plan choices and Frank asked Ann if she had decided which option she preferred. In the flurry of all the activity over the past few weeks, Ann had completely lost track of this critical decision. Now she realized that they could not put it off any longer. They had only three weeks left before the 60-day window for making their retirement plan choice expired. If a plan was not chosen prior to this deadline, she would be assigned to the ERS plan by default. Moreover, once a retirement plan was chosen, it was irrevocable. The magnitude of the decision finally dawned on Ann. She turned off the TV and gathered up all the catalogs, brochures, and literature she had received at the new faculty orientation. "Frank," she said, "I intend to read and learn all I can about our retirement options in the next few days. Then let's talk about the best possible choice for us."

ANALYSIS NEEDED

Ann was finally completed focused on the decision-making process. Frank certainly noticed that she was spending hours reading information and writing down comments to help structure her thoughts. Only three days later, Ann told Frank: "After a lot of thought about the retirement plan choice, I've decided that we must first identify the primary variables that would affect retirement income. Then maybe we can select the retirement plan that best fits our particular characteristics and circumstances. What do you think?" Frank agreed and added: "I also believe we need to consider multiple scenarios since there are many issues we can't know with certainty." "Good idea," said Ann, "and the use of tables would be a good way to organize our computations. Whew. This decision-making process is going to take more time than I thought."

Sanjay Gupta, Valdosta State University

W. Kent Moore, Valdosta State University