Have you ever made a decision in the past that, years and years later, you came to regret? I’m sure we all have. We work with teachers all over the country, but one conversation that continually happens with educators in Ohio is their frustration with the pension system that they’re under. In recent years the requirements to be able to retire with full benefits has changed, of course not in a good way. According to STRS’s website, which can be seen here, to be able to retire with full benefits you must achieve 35 years of service or age 65 with at least five years of service. For example, a teacher that starts at age 23, would become eligible for retirement with unreduced benefits at age 58. This leads to the questions: Is the STRS Defined Benefit Plan (Pension) the best option for me? Would I regret my decision to enroll in the defined benefit pension plan, later in life?
STRS Defined Contribution Plan
This is a plan available to teachers in the State of Ohio that acts more like a 401(k) plan, as opposed to the traditional pension plan. Let’s look at the specifics of the defined contribution plan vs. the defined benefit (pension) plan.
Teacher Contribution Amounts:
Contribution required by teacher for defined contribution plan: 14%
Contribution required by teacher for defined benefit plan: 14%
Therefore, we see as a teacher your contribution does not change – meaning it doesn’t cost you anything extra to participate in one plan over another
School District Contribution Amounts:
Contribution required by school district for defined contribution plan: 9.53%
Contribution required by school distribution for defined benefit plan: 14%
The school district is required to make a contribution into STRS. If you participate in the defined contribution plan, you’ll receive a 9.53% contribution (think of this like a 401(k) match) into your account.
How is my Retirement Benefit Determined?
The defined contribution plan will determine your benefit, meaning what you can annuitize into an income stream or roll over to your IRA, when you retire, based on the deposits you and your employer have made – which is 23.53% of your salary each year and the subsequent investment performance of those deposits. STRS gives you a host of investment options along with target date funds, that will invest your dollars based on your age and expected risk tolerance at that age. A list of investment options in the STRS plan can be found here. We will walk you through an example below, however consider if you had a 401(k) that forced you contribute 14% of your pay and gave you a match of 9.53%. It would be hard to image a scenario, where that person didn’t do well into retirement.
The defined benefit plan will determine your benefit by how many years you have provided service or your age + a minimum amount of service. Since this article is geared towards the new teacher, who must elect which plan is appropriate for them upon hiring, based on today’s STRS rules, you would need to work 35 years to reach your full unreduced benefit. The amount of contribution by you and your employer has no factor in how your benefit is calculated. Essentially, those contributions are your ticket into getting the pension. Should you leave employment and not stay in teaching, you will be refunded whatever you have put into STRS plus potential interest and a portion of your employer contributions (after 5 years).
Hypothetical Example
Let’s assume Susan is a new 23-year-old teacher having to make her decision around the defined contribution or defined benefit. Her starting salary will be $32,000 and she’ll average 2% raises over her career. How should she weight the options in front of her regarding these two different retirement plan options?
In the defined contribution plan, with an average annual rate of return of 7.22%, she’ll have approximately $1,418,112 at age 58, which using the 4% distribution rule, would create $56,724 worth of annual income and (and this is important) she owns an asset worth $1,418,122, meaning if she just lives on the interest, the principal is able to be passed to her children, other family or charities she cares about. You can see the annual growth projection of this here.
In the defined benefit plan, after working 35 years and contributing the same amount into the defined benefit plan, Susan would receive a monthly benefit of $4,093 which would annualize into $49,116. Additionally, if Susan was married and wanted to cover her spouse on this pension (so if she died before him, he would receive her pension still) she is going to get even less than $4,093. Finally, Susan does not own this pension, meaning that when she dies, if she had been paid out the money she had put in STRS (her contribution), there is no benefit left for her children, family or charities. You can see the STRS pension calculation we ran here.
One argument we hear from those opposed to the defined contribution plan is that, “you’re assuming you get a 7% rate of return, what if that doesn’t happen?” Valid question, however the alternative plan, the defined benefit pension is only able to provide a benefit to you because the money is invested into stocks, bonds, private investments and real estate. Meaning if the stock market for whatever reason had a 35-year window where it didn’t average 7%, we would argue the pension is in big trouble as well considering it is providing you a monthly pension, only because the money has been invested and presumably did some reasonable rate of return. As always, we encourage those skeptical to view the Prudential Asset Allocation Chart, which shows the returns of the market over the last thirty years.
Other Considerations
Some other items you may want to consider when determining which plan is correct for you are:
While you are 100% vested in your deposits in the defined contribution plan, your employer contributions are vested at 20% per year. This means that if you leave teaching after three years, you would receive 100% of your contributions (plus or minus the investment returns) and you would receive 60% of the employer contributions (plus or minus the investment returns).
Survivor Benefits: In the defined contribution plan, if you were to pass away, the amount of contributions you and your employer have made (assuming your vested in employer contributions) would be refunded to your beneficiaries. There is no monthly benefit available to them. This is why term life insurance while you’re young is so important.
Disability Benefits: There are no disability benefits in the defined contribution plan, so you would want to talk to your Financial Advisor about the possibility of obtaining a disability insurance policy. If you’re young and healthy these should be very affordable and easy to obtain.
Health Insurance: You will not be eligible for the STRS health insurance plan. Three main alternatives to consider are:
Would I be comfortable with a medical sharing plan in retirement? You can read more about these from the article we wrote last year.
Would I be eligible for Medicare at age 65 because my spouse is enrolled in Social Security?
Does my spouse have health insurance coverage in retirement for our family through their employer?
Additional Savings Options
For the educator, participating in either the defined benefit or defined contribution plan, we highly encourage them to stay away from the annuity salesmen & women that come to their benefit fairs. It is always sad for us to see how many teachers, many who are already getting a guaranteed pension because they enrolled in the defined benefit plan (pension) are being sold annuities which have much higher fee’s (if they are variable annuities) and/or much lower returns (if they are fixed or indexed annuities). Your retirement money is long term money and putting it in a low yielding investment vehicle that pays your advisor a high commission is not a great option. We strongly encourage teachers to consider opening a Roth IRA, to supplement their STRS plan. These dollars can be invested in mutual funds or ETFs, that have been vetted and approved by their trusted Financial Planner.
Conclusion
We are big believers in the Ohio STRS Defined Contribution plan because it allows you, the participant, to be able to save and invest for your future like you would in a 401(k), without the governmental control of a pension, which has consistently changed over time and not for the better. However, every situation is unique and it is our advice before electing either the defined benefit or defined contribution plan in STRS that you reach out to a Financial Planner who can understand your unique situation.