Teaching note which retirement plan is best for Ann Smith?(Instructor's Note)

Gupta, Sanjay ; Moore, W. Kent

BACKGROUND

Ann Smith had just started a new position as a junior executive at Fowler Inc. five weeks ago. She was finally well settled into her new job and was now focused on sifting through all the details of the retirement plan options available to her through her employer. The plan choices available differed considerably in their characteristics and the variables that affected possible retirement income. Complicating the decision was the fact that the retirement income under the available choices was a function of how many years Ann will work with her current employer, at what age she decides to retire, how many years she spends in retirement, how risk averse she is, and what the expected return of investment is. Answers for these issues would result in big differences in the retirement benefits. Time was of the essence since a retirement plan had to be chosen within the first 60 days of employment. Otherwise it would result in a default selection of the ERS. Moreover, once a retirement plan was chosen it would be irrevocable.

Ann could not delay her retirement choice any longer. She had only three weeks left in the 60-day window allowed for making a decision. She and her husband Frank were in the process of gathering as much relevant information as possible. They would then put their heads together to make the best decision about this critical financial choice that would have a significant impact during their time in retirement.

CLASSROOM USAGE

This case provides an opportunity to examine one of life's important decisions--which retirement plan option works best for me? With increased life expectancies, it is not uncommon for people to spend 20 years or more in retirement. This combined with the fact that the selection of a retirement option plan is often irrevocable underscores the need to make a good choice.

The case is appropriate for assignment in both undergraduate and graduate accounting and finance classes. Several possible teaching approaches can be used to present this case. In its simplest form, by covering just the basic fundamentals, the case would be an introduction to retirement plan decisions in general while also serving as an exercise to enhance spreadsheet skills. In a more advanced setting, the requirements in the case can be used to motivate class discussion of the relevant individual variables, such as age, life-expectancy, time value of money, net present value, expected return on investment, and cost-of-living adjustments, that affect retirement plan choice.

An important objective of the case is to teach students to appreciate that any prediction of the future detailed enough to be useful for planning purposes will inevitably contain errors. On the other hand, any forecast oversimplified down to just a few details in order to avoid errors will be essentially useless for planning purposes. This is the fundamental paradox that renders detailed single point forecasts unworkable. The best approach to this is the consideration of multiple alternative scenarios, as demonstrated in this teaching note. These scenarios of the future should be customized to deal with the specific needs and circumstances of an individual, capturing a full range of plausible outcomes, with each individual scenario containing enough detail to be useful to decision-makers. After calculating projected retirement incomes under varying assumptions, students will be required to choose the "best" retirement plan option based on the scenario that seems most appropriate or most likely to occur.

The material in the case can be covered by asking students to do analysis individually or by employing a team learning approach. If small groups are already being used in the course, the case materials can be used effectively as a mini-test in which students are graded individually and in groups on case requirements. On an individual basis and prior to class, students can be assigned the basic requirements. During the class period, groups of 4-5 students can be formed and assigned additional (advanced) case requirements to work through during the class period. A lively discussion should ensue as student groups present and are asked to defend their solutions. The instructor can help guide the discussion and introduce the more advanced concepts as the discussion unfolds.

VARIABLES TO CONSIDER

Salary

Both retirement plan benefits are determined using salary as a variable. The Employee Retirement System determines retirement benefits by using the following formula:

Monthly ERS benefits = (2% * years of service) * highest 24 month average salary.

For the ERS plan, retirement benefits are determined by multiplying Ann's average salary for the highest two years, which is usually the last two years of employment, by 2% times the number of years of service. For the Optional Retirement Plan, contributions are first determined by multiplying the annual salary per year by the percentage of the combined employee and employer contributions. Retirement benefits are a function of the return on generated by the contributions. Ann has a starting salary of $60,000 per year.

Expected return on investment (ROI)

The retirement benefits under an ORP are a function of the returns generated by the investments chosen by the employee in the retirement plan. This may fluctuate greatly and provides no guaranteed minimum rate of return. Generally, the riskier the investments, the greater the expected return. Choosing a well-diversified portfolio and taking into account the number of years to retirement are keys to success. Retirement benefits under the ERS are not linked to ROI and provide a defined benefit to the employee. When making a retirement choice, it is important to consider a range of expected ROIs.

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 Ann has to make a mandatory contribution of 5%.

Number of expected years of work, number of years 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 an employee starts a job at an early age, earns 30 or 40 years of service by the time they are is 60 or 70 years of age, retires, and then, based on life expectancy, expects to live another 20 years or more in retirement. Since the benefits in the ERS system are fixed, the longer the surviving spouse lives, the greater the retirement benefits received. Under the 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 annuitized benefits.

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. 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.

Ann is currently 32 years old and, if she remains in good health, expects to work for 25 to 35 years. Given her life expectancy of 82 years, this means that she would retire between the ages of 57 and 67 and spend approximately 15 to 25 years in retirement. Frank, currently 33 years old, would be between the ages of 58 and 68 at the time of Ann's retirement. Given his life expectancy of 78 years, he would spend about 10 to 20 years in retirement.

THE DECISION

The retirement decision involves several variables and therefore it is impossible to have a single point forecast indicating an absolute decision. A more appropriate approach is to view this as a determination of a range of forecasts for the appropriate variables and arrive at a decision based on the forecasted benefits within that range.

Tables 1-3 present Ann and Frank's situation in which Ann has a starting salary of $60,000; is expected to work for approximately 30 years; have a combined (employer + employee) contribution of 15% in the ORP; and spend 10, 15, or 20 years in retirement based on her life expectancy. The monthly retirement benefits expected in the ERS plan are determined as (2% * years of service) * highest 24 month average salary. The salary is considered to be a real salary where the increases in annual salary are negated by inflation and therefore stays constant during the employment period. The discounting rate of 0% reflects that assumption. In Table 1, the monthly ERS retirement benefits are determined to be (2% * 30 years of service*$60,000)/12 = $3,000. The employee will therefore expect to receive a monthly annuity of $3,000/month for the 10 years (120 months) spent in retirement, for a total of $360,000. The present value of this future stream of benefits is then determined at a discount rate of 0%.

For the ORP, the monthly contribution of $750 is determined by multiplying the combined contribution rate of 15% by the monthly salary of $5,000 ($60,000/12). The retirement benefits are then determined as the future value of this stream of contributions under a range of expected ROIs ranging from a low of 2% to a high of 6%. For example, in Table 1, for an ROI of 2% and a 0% discounting rate, the amount $371,981 is computed as the future value of $750/month for 30 years (360 months) at a monthly ROI of 0.00167, i.e. 2%/12.

Table 1 indicates that, under the prescribed range of variables, the ORP is the more desirable plan regardless of the expected ROI. However, Table 2, in which the number of years in retirement changes from 10 to 15 years, with all other variables remaining constant, indicates that the ERS is the preferred choice for ROIs ranging from 2% to 4% and that the ORP is the preferred choice only at a ROI level of 6% and higher. Table 3, in which the number of years in retirement changes from 15 to 20 years, with all other variables remaining constant, results mirror Table 2 albeit with the spread between the ERS and ORP benefits being smaller at an ROI of 6%. This clearly indicates that, under the prescribed range of variables chosen for Tables 1-3, as the number of years spent in retirement increases, the ERS is the preferred choice.

An interesting observation is that in Table 2, both plans would yield similar retirement benefits at an ROI of 4.2%. However, in Table 3, when the number of years spent in retirement increase from 15 to 20 years, both plans would yield similar retirement benefits at an ROI of 5.75%.

Tables 4-6 use the same variables as Tables 1-3 with the exception that the salary has been changed from 60,000 to $80,000 to determine whether the retirement decision changes with a corresponding change in salary while keeping all other variables constant. The results mirror the results from Tables 1-3.

Tables 7-9 use the same variables as Tables 4-6 with the exception that the discounting rate has been changed from 0% to 1%. The discounting rate for the ERS monthly payments was set at 0% on the assumption that the inflation adjusted benefits mirror the inflation

rate. Inflation adjustments on defined benefit plans such as the ERS vary considerably across states. While some states, including Georgia where Ann is employed, provide an inflation adjustment equal to the Consumer Price Index (CPI), thereby negating the erosion of benefits due to inflation, others determine inflation adjustments on an ad-hoc basis. In states where the actual inflation exceeds the inflation adjustment, it can lead to an erosion of real retirement benefits. In this scenario, a 1% discounting rate reflects a situation where the actual inflation exceeds the inflation adjustment by 1%.

For the ORP, the monthly contribution of $1,000 is determined by multiplying the combined contribution rate of 15% by the monthly salary of $6,667 ($80,000/12). In Table 7, for an ROI of 6% and a 1% discounting rate, the amount $1,004,515 is computed as the future value of $1,000/month for 30 years (360 months) at a monthly ROI of 0.00417, i.e. (6%-1%)/12.

As stated above, Tables 7-9 use the same variables as Tables 4-6 with the exception that the discounting rate has been changed from 0% to 1%. In comparing Tables 4-6 with Tables 7-9, a shift occurs only in Table 8, where the ORP is now the preferred choice at an ROI of both 4% and 6%, whereas in Table 5 it was the preferred choice only at an ROI of 6%.

Tables 10-12 use the same variables as Tables 7-9 with the exception that the number of years of service has been changed from 30 years to 20 years to determine whether the retirement decision changes for employees who start their careers late and therefore have fewer years of employment before retirement. The years in retirement have been maintained at 10, 15, and 20 years. The results show that the decision choice would be different under several assumptions with each change being in favor of the ERS plan. This clearly indicates that the ERS is usually a better retirement option for employees with a shorter working career and greater years spent in retirement than the ORP unless the ROI generated by the investments in an ORP are higher than 6%.

OTHER VARIABLES TO CONSIDER

Portability

The ERS plan has limited portability. On termination prior to retirement, a vested employee can either withdraw or rollover their contributions to a tax-deferred account. An employee cannot, however, access employer contributions and earnings on those contributions if employment is terminated prior to retirement. In addition, a retiree's estate and/or heirs have no legal claim to any ERS assets. If, for example, an employee dies while employed, either a lump-sum death benefit or an annuity is paid to the surviving spouse. This annuity ceases upon the death of the surviving spouse even if the employee's contributions to the plan, and earnings on those contributions, exceed the cumulative amount received by the employee and/or the surviving spouse. With an ORP, however, employees do not lose any benefits even if employment is terminated prior to retirement. The balance in the ORP account, which includes employee and employer contributions plus any earnings on those contributions, can be rolled over to the employee's new plan administrator at the new job. In addition, an employee has the option of passing on all assets in the ORP to their estate or heirs.

Buy-in-provision

Employees choosing the ERS have the option of purchasing "credit" for previous public-sector employment without retirement benefits. Employees have the option of purchasing credit of up to 5 years with pre-tax dollars. The purchase price is determined as a function of the employee's age at buy-in, life expectancy, and current salary.

Sanjay Gupta, Valdosta State University

W. Kent Moore, Valdosta State University Table 1 Years in retirement 10 Years of service 30 Employer+Employee contribution to ORP plan 15% Salary $60,000 Discounting rate 0 ERS ORP ROI 2% $360,000 $371,981 ROI 3% $360,000 $437,053 ROI 4% $360,000 $516,842 ROI 6% $360,000 $753,386 Table 2 Years in retirement 15 Years of service 30 Employer+Employee contribution to ORP plan 15% Salary $60,000 Discounting rate 0 ERS ORP ROI 2% $540,000 $371,981 ROI 3% $540,000 $437,053 ROI 4% $540,000 $516,842 ROI 6% $540,000 $753,386 Table 3 Years in retirement 20 Years of service 30 Employer+Employee contribution to ORP plan 15% Salary $60,000 Discounting rate 0 ERS ORP ROI 2% $720,000 $371,981 ROI 3% $720,000 $437,053 ROI 4% $720,000 $516,842 ROI 6% $720,000 $753,386 Table 4 Years in retirement 10 Years of service 30 Employer+Employee contribution to ORP plan 15% Salary $80,000 Discounting rate 0 ERS ORP ROI 2% $480,000 $495,975 ROI 3% $480,000 $582,737 ROI 4% $480,000 $689,122 ROI 6% $480,000 $1,004,515 Table 5 Years in retirement 15 Years of service 30 Employer+Employee contribution to ORP plan 15% Salary $80,000 Discounting rate 0 ERS ORP ROI 2% $720,000 $495,975 ROI 3% $720,000 $582,737 ROI 4% $720,000 $689,122 ROI 6% $720,000 $1,004,515 Table 6 Years in retirement 20 Years of service 30 Employer+Employee contribution to ORP plan 15% Salary $80,000 Discounting rate 0 ERS ORP ROI 2% $960,000 $495,975 ROI 3% $960,000 $582,737 ROI 4% $960,000 $689,122 ROI 6% $960,000 $1,004,515 Table 7 Years in retirement 10 Years of service 30 Employer+Employee contribution to ORP plan 15% Salary $80,000 Discounting rate 1% ERS ORP ROI 2% $457,506 $495,975 ROI 3% $457,506 $582,737 ROI 4% $457,506 $689,122 ROI 6% $457,506 $1,004,515 Table 8 Years in retirement 15 Years of service 30 Employer+Employee contribution to ORP plan 15% Salary $80,000 Discounting rate 1% ERS ORP ROI 2% $670,312 $495,975 ROI 3% $670,312 $582,737 ROI 4% $670,312 $689,122 ROI 6% $670,312 $1,004,515 Table 9 Years in retirement 20 Years of service 30 Employer+Employee contribution to ORP plan 15% Salary $80,000 Discounting rate 1% ERS ORP ROI 2% $873,149 $495,975 ROI 3% $873,149 $582,737 ROI 4% $873,149 $689,122 ROI 6% $873,149 $1,004,515 Table 10 Years in retirement 10 Years of service 20 Employer+Employee contribution to ORP plan 15% Salary $80,000 Discounting rate 1% ERS ORP ROI 2% $305,042 $296,051 ROI 3% $305,042 $328,302 ROI 4% $305,042 $365,131 ROI 6% $305,042 $462,041 Table 11 Years in retirement 15 Years of service 20 Employer+Employee contribution to ORP plan 15% Salary $80,000 Discounting rate 1% ERS ORP ROI 2% $446,931 $296,051 ROI 3% $446,931 $328,302 ROI 4% $446,931 $365,131 ROI 6% $446,931 $462,041 Table 12 Years in retirement 20 Years of service 20 Employer+Employee contribution to ORP plan 15% Salary $80,000 Discounting rate 1% ERS ORP ROI 2% $582,172 $296,051 ROI 3% $582,172 $328,302 ROI 4% $582,172 $365,131 ROI 6% $582,172 $462,041