When my wife first joined the faculty at the University of Georgia in 2006, she was given a large stack of paperwork to fill out. Buried among the several documents was perhaps the most consequential one for our finances and this related to her retirement benefits. The form required her to choose between enrolling in the Teachers Retirement System of Georgia (“TRS”) pension plan or opening a 403(b)-type tax-deferred retirement account, called the Optional Retirement Plan (“ORP”). The pension plan would not “vest” for ten years, whereas the ORP was hers to keep or take with her from day one should she decide to leave UGA before retiring. Before receiving her first paycheck, she needed to decide which of these two retirement plans was right for her, and that choice would be permanent and irrevocable.
Being new to both teaching as a profession and living in the South, a ten-year vesting period seemed like quite a commitment to make with all the uncertainties involved. That, coupled with the fact that her husband happened to be a professional money manager, and very comfortable with managing her retirement accounts, made the choice relatively easy for her; she enrolled in the ORP.
But now that more than 15 years have passed, and she is still at UGA, it is time to review that early decision again. It’s far too late to make any changes of course, but a review of the key factors and considerations behind her decision might be helpful to the many thousands of new teachers and state employees who find themselves facing a similar decision each year. Let’s start with the basics-
How the TRS pension plan works
The Teachers Retirement System of Georgia provides a generous annual pension benefit equal to the average of your two highest earning years, times the number of working years (up to a maximum of 40 years), times 2%. For example, a retiree with 25 years of “service credit” is entitled to an annual payment equal to 50% (2% X 25 years) of the average of their best two earnings years. Someone ending their 25-year career earning $150K can expect a pension of ~ $75,000 per year for the rest of their lives. Even better, the annual pension amount is indexed to inflation, so their purchasing power remains constant. There is no denying the obvious attraction of a guaranteed stream of income at a significant fraction of pre-retirement earnings, for life. However, it is important to note that because of the 10-year vesting period, there is no pension benefit for anyone with fewer than 10 years of service credit.
How the ORP benefit plan works
The ORP system works like a traditional 403(b) or 401(k) plan. The employee contributes to their own ORP account (typically 6% is withheld from each paycheck) and the employer also contributes (about 9.24% of their gross income) to their account. The employee owns the account in their name and can see their balances at any time, but it also means that the employee is responsible for managing the investments inside the plan. Like a 403(b) plan, the ORP plan is “portable” and can be rolled over into an IRA at another institution after separation of service.
Is one plan “better” than the other plan?
In order to determine which plan might be the right choice, let’s run through an example to demonstrate the value of each plan at different points in time and under various scenarios. We’ll start with the following assumptions:
(1) A newly hired state employee, age 30, is deciding between enrolling in either the TRS or ORP retirement plans.
(2) Their starting salary is $100,000 and they expect to earn 3% raises each year.
(3) They plan to work for 30 years, retiring at age 60.
(4) They will be required to contribute 6% of their salary each year, regardless of the plan they choose.
(5) The ORP plan will be invested in a mix of 80% stocks and 20% bonds with the goal of generating a long-term average investment return of 8% per year.
(6) The employer will contribute 9.24% of their salary to the ORP plan. (The employer may contribute more than that to the TRS plan, but this is largely irrelevant to the employee because the amount of the employer contribution does not affect their personal benefit amount.)
(7) Based on Social Security life expectancy tables, life expectancy at age 60 is 21.8 years for males and 24.8 years for females.
(8) TRS pension benefits will be precisely adjusted for future inflation (Cost of Living Adjustments) to preserve purchasing power.
With these eight assumptions in mind, how do the two plans compare? And by what metric will we determine which plan is “superior”?
For this analysis, I am comparing the future values of each plan at age 60, with the number of working years as the main [unknown] variable. Why is this the right metric to use? The truth is, we don’t know the length of anyone’s career at the outset. If we did, this analysis would be much easier. Given that uncertainty, we need to re-calculate the future value of both plans each year, as well as any “break-even” point, at which point one plan becomes more valuable than the other plan. Only then can we determine which plan may be worth more at retirement age.
As stated above, the “base” scenario assumes average ORP investment returns 8% per year. For comparison, I will also show figures for a “low-return” scenario of 6%, and a “high-return” scenario of 10%.
[Geek’s note – In this simplified example, I’m assuming a constant return of 8% each year. In practice, market returns are volatile, and an average 8% return over 30 years does not mean earning 8% year in and year out. Investors do not earn the average return over time; instead, they receive the compound geometric return, which is always less and can be estimated by subtracting ½ the variance from the average return.]
Early in the employee’s career, there is really no comparison — the ORP plan wins by a mile. This is primarily because of the vesting clause that precludes any pension benefit from accruing to the employee for the first ten years. Employees who leave service before reaching the ten-year vesting period are entitled to a return of their own contributions, plus interest. However, any contributions made the employer are forfeited.
At the ten-year mark, just when the TRS plan has vested, the balances in the ORP plan have grown to $248,415. Should the employee quit at age 40, that balance is theirs to keep. This includes both their own contributions to the plan as well as their employer’s. Assuming they leave the plan invested, those balances will continue to grow at the assumed rate of 8% per year to more than $1,157,000 by age 60, even in the absence of any further contributions. In that same scenario (the employee quits at age 40, and begins drawing retirement benefits at age 60), the TRS plan would provide an annual benefit of $25,715. Taking an average of life expectancy between men and women at age 60, this payment stream would continue for 23.3 years and is worth about $599,000 (23.3 X $25,715) over their remaining lifespan, which is 48% less than the value of the ORP plan at the same age.
Note that the ORP plan is still worth substantially more to the employee, even after the moment of vesting. However, as we can see in the graph below, the advantage of the ORP plan over TRS erodes over time, as the number of working years increases (X-axis):
The breakeven point is not reached until age 53, or after 23 years of working and earning service credits. Beyond that point, the TRS plan is superior in terms of pure expected economic value.
I should stress here that ORP returns matter a great deal to the relative attractiveness of that plan. Under the “low” return scenario of 6%, the TRS advantage breakeven point occurs much earlier – at age 45, or after just 15 years of service. By age 60, the value of the TRS pension would dwarf the ORP plan balance: $3.2MM (TRS) vs $1.7MM (ORP).
The converse is also true – the higher the rate of ORP return, the smaller the TRS advantage becomes. At a 10% annual ORP return, the TRS advantage vanishes entirely, and the ORP plan is worth slightly more ($3.3MM vs. $3.2MM) at age 60. Although one could potentially earn that much over 30 years if nearly 100% of their portfolio were invested in equities, the high volatility of such a portfolio would be challenging for most.
One of the key takeaways from this analysis is that sufficiently high ORP returns are crucial to making it a competitive retirement plan for teachers. As an ORP participant, the proportion allocated to stock investments probably needs to be greater than 75% for at least the first couple of decades to achieve an average of 8% annual returns over their entire career.
Potential disadvantages of the TRS plan
Although the TRS plan becomes economically superior under moderate return assumptions after 23 years of service, there are still reasons to consider the ORP plan, even for teachers and state employees with expectations of a long career. Below are some potential disadvantages of this (and other) pension plans:
- If you die early, the pension payments end. There is no “asset” for spouses or children to inherit as there would be with the ORP or other traditional retirement account (IRA, 401(k), etc.). You can add a “spousal benefit” to the TRS plan, guaranteeing income for your spouse’s lifetime as well, but this insurance comes at the cost of a permanently reduced monthly benefit payment.
- There is no flexibility to the income stream with a pension plan. In a traditional (IRA) retirement account, you have wide control over the withdrawal rate. You can save taxes by withdrawing less in certain years, shielding your income from the highest marginal tax rates. You also have the option of a larger withdrawal in case of large expenses, such as travel or medical bills.
- There is no possibility of converting a pension payment into a Roth (after-tax) account. The ability to convert IRA balances partially or fully to a Roth account, particularly in lower earning years, is a powerful tax planning tool for reducing lifetime tax liability.
- Although unlikely, there is always the possibility of future benefit cuts if the TRS system were to become insolvent, or due to unexpected changes in state legislation.
For newly minted teachers and state employees, the choice between a pension plan or a traditional retirement account can be quite vexing, especially since the decision is both highly consequential and completely irrevocable. There are many uncertainties involved, including how market returns and teaching careers will unfold. One variable that is at least somewhat known is one’s comfort with making investment decisions and, by extension, one’s tolerance for investment risk. Very conservative investors who lose sleep over market volatility are unlikely to take the requisite risk in their ORP account to achieve competitive returns; these workers would probably be better off in a solid pension plan like the TRS.
But for more aggressive investors, especially those with some skill at building well-designed portfolios, the ORP might be the better choice. There are advantages to having control over the assets in a retirement account (and the income it produces), especially in the realm of tax and estate planning. With a solid investment plan in place, the economic value of the ORP can be competitive with the TRS plan as well.
Disclosure: The opinions expressed herein are those of Elevate Wealth Advisory (“EWA”) and are subject to change without notice. EWA reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. This should not be considered investment advice or an offer to sell any product. EWA is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about EWA, including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request.