Did you just start working for the state (commonwealth) of Virginia? Then this is the post for you!
This analysis is primarily about faculty at state universities but if you recently opened a new-hire packet with acronyms like VRS, ORP, ORPHE, DCP, TIAA then I am here to help! I did this analysis more generally for another person in my first post here.
The plans we are reviewing are the from this website.
“Choosing Your Retirement Plan
• Optional Retirement Plan for Higher Education Plan 2 (ORPHE)
• VRS Hybrid Retirement Plan
Membership Date: On or after January 1, 2014”
Essentially these two plans are a comparison of “defined benefit” vs. “defined contribution” retirement plans. Defined Benefit = Pension & Defined Contribution = 401k/401a/403b type plans. Defined Benefit plans have a defined amount a retiree will receive regardless (maybe?) of market conditions, Defined Contribution plans have a defined amount you receive now, and it is up to you to invest wisely. An easy way to compare a big lump sum of money in a 401k account to a pension amount is something called the 4% rule.
The short version of the 4% rule is that it can be safely withdrawn from a principle of savings and effectively never run out. This is a pretty good way to compare the “lump sum value” or total account value of a 401k balance to a pension (or annuity) value because a pension also never “runs out” at least until you die or the company providing the pension goes bankrupt.
The 4% rule also works in reverse, so a $20,000/yr pension is worth about the same as a $500,000 lump sum in your 401k according to this rule (500,000 * .04 = 20,000). As always, I’ll post the spreadsheet at the end so you can change if you prefer. There is a ton of discussion about what rate to use for this calculation, but I prefer 4% for many reasons which are backed up by solid research.
So the spreadsheet is setup with key details in yellow and orange.
I’ve made the following assumptions:
- Starting Salary = 50k/yr
- Starting Age = 30
- Will Retire at age = 62
- Full Social Security Age = 67 (this is the age you can take pension, in most cases)
- Raises per year = 2%
- Returns Expected / yr = 8%
- Equal Total Contributions from Employee (9%) which are broken up differently between the plans. This makes for an easy comparison.
I’ll post the spreadsheet at the end so you can make changes, but I believe these are all very reasonable assumptions, the Voluntary contribution levels I chose for the two funds are meant to make for an easy comparison where both plans take 9% of your paycheck, HOWEVER, i strongly recommend you do everything you can to put away a LOT more. Especially if you are young, plow some money away now and you can always reduce contributions later. You should not think of these “deductions” to your 401a/403b/457 accounts as being deductions at all. IT IS YOUR MONEY just in another account. And you get to put it away tax deferred, which is awesome. If you are eligible for a 457, it is a retirement plan where you can take the money out at anytime, penalty free, if you leave your current job. Put as much money there as you can, it’s basically a tax deferred investment/savings account.
So what is the result for our hypothetical 30 year old? This graph explains it really well:
The plans end up providing almost the same level of income at retirement but during your working years the value of the ORP plan will vastly surpass the pension value. When you start working young the power of compounding really crushes the slower pension growth. The large sum saved in the ORP accounts (401/403/457) will also continue to grow in retirement while the pension is a fixed income. The reason you do still see some growth in the Hybrid plan after retirement is that your 5% in defined contribution portion of the Hybrid plan is still growing but it it is smaller than the 9%+8.5% match in the ORP account.
In addition to the actual dollar amounts calculated here, the ORP plan provides better flexibility if you ever leave your job and the ability to pass on the FULL account value to a child or spouse if you pass away. Where a pension amount will be reduced by 40-100% when the primary earner passes away, the 401/403/457 accounts belong fully to those who inherit it. The lump sum for our 30 year old in retirement is something between $1.2 and $1.7 Million dollars that belongs to them and any beneficiaries, where the pension does not.
I must recommend to any 30 year old that they strongly consider the ORP plan and invest wisely in simple low cost index funds. Here are your provider options.
- DCP VRS / ICMA-RC – lowest fee ($30/yr) with a great BlackRock Equity Index fund F (exp. ratio .01%, called the help-me-do-it “stock fund” here)
- The do-it-for-me Target Date Funds (exp. ratio .09%) at DCP are also solid if your retirement date is closer than 15 years these might work for you for a higher fee ratio.
- Fidelity – Middle Fee ($60/yr) but no good index funds, see your choices here. Do Not Recommend. Laughably high exp ratios >.57%!!!
- TIAA – highest fee ($66/yr) with several complex annuity offerings. I am suspicious of annuities because the person selling them almost always gets a “sales load” or fee to sell it to you. I read about them and don’t recommend over low-fee index funds. TIAA does offer one vanguard fund with a good expense ratio (.06%) but not as good as the DCP stock fund above. See the TIAA investment offerings here.
Wait, you say, not everybody is 30?!? Good news, the spreadsheet allows for easy adjustment (again I will post at the end for you to play with if so inclined) and I have generated the charts for starting at 40 and 50 also.
At 40 you can see we have a bit of pickle. The pension will provide MORE income at retirement but will be surpassed by the growing ORP accounts at about 71. We are looking very far into the future so by this time markets could be returning 10% or 5% annually. Also trying to target a specific year is essentially impossible because in a given year the market can be + or – 25%. I still think that due to the flexibility and inheritance considerations our 40 year old friend should stick with ORP.
At 50 we see the pension start to break away as the option that would provide clearly more income when retired. In my opinion this is the tipping point, if you are over 50 you can claim your pension MUCH sooner and so the years of compounding are much fewer. The hypothetical “overtaking” of the ORP income (red line) you see around 75 at this point is a wild guess. As predicted, the closer you are to your full social security retirement age the more likely a pension is right for you.
Now in addition to my math problem above there is a risk factor to consider with both types of retirement plan. Many arguments against the 401k self investment system usually involve a discussion of risk, with breathy articles like this one: 401(k)s are retirement robbery.
It’s hard to find a balanced view but my in opinion either system can work just fine if managed properly. However, I think the risks between trusting a market based self-directed approach (401a/401k) are probably somewhat similar to trusting that your company or organization will be in a position to pay your pension in 50 years, as we see in the news now, pensions are not sacrosanct. Your mileage my vary but I prefer the self directed approach for younger people. Specifically, Virginia’s pension system, the VRS is about 60-70% funded which isn’t the worst state but isn’t good. It hasn’t lost ground in recent years (article from 2012) but it hasn’t made up much ground either.
I hope the post was helpful for anybody starting in virginia with the complicated ORP vs VRS choice and for anybody who wants to understand the underlying difference between a pension and a 401k/403b type account!