Deciding Between Michigan Pension Plus 2 or DC Defined Contribution Plan For School Employees

Recently I’ve done a deep dive into the details of the Michigan Pension Plus 2 retirement plan for school employees in the state of Michigan.  My oldest son recently needed to make a decision regarding this pension plan, so I’ve been learning the nuts and bolts with him.

For the past 6 weeks my oldest son has been working a 2nd job as a substitute custodian for his former school. Although this is currently a temporary part time position, there is the potential in the future that this will become a full time opportunity for him.  He has still been working his full time job at Walmart during this time, so he has been working 60+ hours per week.

School employees are required to choose between the Defined Contribution plan and the Pension Plus 2 plan.  This election is extremely important, as it must be done in the first 60 days of employment and IS IRREVERCIBLE.  This decision stays with you for your entire career in the Michigan School System. What if you don’t make a decision?  The Defined Contribution plan is chosen for you.  I don’t know about you, but I want the State to make the least amount of decisions on my behalf as possible.

My son did not receive this letter from the school system, all though I wish he did.  Here is an introductory letter that compares the 2 systems. Here’s another link to an overview of the system.

The Defined Contribution Plan:

We will cover this one first since it is the easiest to cover.  The defined contribution plan is effectively a 401K plan. There is no pension component.  The employer gives an initial contribution of 4%, regardless of your contribution, and then the employer matches the first 5% of wages. Your contributions are put into a 457 plan and the employer match is put into a 401K plan.  This makes accounting easier as your contributions and match are separate.  A 457 plan operates exactly the same as a 401K plan and has the same contribution maximum of $22,500.

The employer puts an initial 4% of wages into your 401K regardless of what you contribute.

The first 2% of wages (with 2% employer match) are labelled as “personal health fund” (no different than in the Pension Plus 2 program discussed below) and your contribution goes into the 457 and the match goes into the 401K..

the next 3% of wages (with employer match) are labelled “savings account”, and your contribution goes into the 457 and the match goes into the 401K.  Any additional employee deferral will also go into this 457 account.

The money you contribute into the 457 is always yours.  The 401K matching account vests over time.  After 2 years you keep 50% of the employer contributions, after 3 years you keep 75%, and after 4 years you keep all 100% of employee matching funds.

An employer putting effectively 9% of total wages into a 401K is a heck of a deal! Very few employers offer such a match.  My son’s primary employer is Walmart and they match 6%.  By saving 5% the employee is effectively putting 14% into a 401K. The 5% employee contribution is the default selected, however the employee can reduce this if they choose to or increase it up to 70%.

The Michigan Pension Plus 2 Plan:

The pension plus 2 plan has 3 components: The pension, savings, and health savings.  All 3 of these have a required percentage taken directly from your check:

Pension:  The pension contribution is 6.2%, the same percentage as Social Security.  The school system matches this 6.2% contribution into the system.

The pension plan vests after 10 SCHOOL YEARS of working a minimum of 1,040 hours.  It is important to note that the formula follows school years and NOT calendar years.

The Savings and Personal Health Fund is set up exactly like in the Defined Contribution plan, except they have a smaller match.

Personal Health Fund: The Personal Health Fund is the first 2% employee contribution and is matched 2% by the employer. Just like with the Defined Contribution plan, this is just a label.  Your 2% goes into your 457 plan while the match goes into the 401k plan.

Savings: the next 2% of wages (with a 1% employer match) are labelled “savings account”, and your contribution goes into the 457 and the match goes into the 401K.  Any additional employee deferral will also go into this 457 account.

So all in we are contributing a minimum of 10.2% of income and receiving a 9.2% total match, slightly more than in the defined contribution plan. The 4% employee contribution to the 457 plan is the default selected, however the employee can reduce this if they choose to or increase it up to 70%.

How The Michigan Pension Plus 2 Plan Math Works:

First and foremost, in order to be eligible to receive the pension you must be fully vested with 10 years.  If you do not fully vest your contributions will be returned with interest.  I’m sure the interest is at a very low percentage and of course the matching contributions are not vested.

You also need to be 60 years of age to draw a pension.

The pension is calculated based on years of service, the average wage of the highest consecutive 60 months of pay received, and a multiplication factor of 1.5%

Then the formula is simply A X B X C:

Example 1: someone who worked 10 years with the average yearly wage over the highest 60 consecutive months being $30,000 a year would have a pension that looked like this:

10 X $30,000 X .015 = $4,500 a year pension / 12 = $375 per month.

In an apples to apples comparison with a lump sum of money, assuming a 5% withdrawal rate, the value of the pension would be the yearly pension X 20, in this case the value of this pension would be $90,000.

Example 2: someone works for the school system for 40 years and has the highest 5 year average being $60,000 a year.

40 X $60,000 X .015 = $36,000 a year / 12 = $3,000 per month.

$36,000 X 20 = total value of $720,000.

The Pension Plus 2 Plan Is Beneficial To Older Workers:

When we look at how the math functions, understand that the pension portion is actually more valuable to older workers, here’s why.  If my son who is 20 years old works for 10 years and becomes fully vested, he must wait 30 more years before he can receive his pension, during which time the money he and his employer contributed to the system has stayed invested.  He will earn a pension for $375 per month at age 60.

Now another worker, Steve, starts working at the school the same day my son does and he is 50 years old.  Steve does 10 years and becomes fully vested.  He earned the same amount as my son did and his pension will be for $375 a month and on his 60th birthday he starts receiving it.

Here’s what is wrong.  If we assume they each earned $30,000 per year and the total yearly contribution of 12.4% is $3,720, and they would have an average annual return of 6%, we get the following numbers:

Steve’s contributions would be worth $50,802.  If this money were in a 401K and he took a standard 5% withdrawal, he would only get $2,540 per year or $211 per month.  The $375 a month pension is a way better deal.  Clearly the pension worked out well for him.

For my son on the other hand, we would have a different story.  He contributed the same amount, however his $50,802 has to sit an additional 30 years to vest.  Over 30 years that $50,802 will grow to $305,958.  Taking a 5% withdrawal he would get $15,297 per year or $1,275 per month.

These differences are stark, and they are even starker when you double the contribution numbers to account for the employer match.  Keep this in mind, if you are an older worker looking for a second act, spending 10 years in the school system is a great way to have a high ROI on retirement savings dollars.

Why Would A Young Worker Choose The Pension Plus 2 Plan:

The Pension Plus 2 Plan Forces Savings:

A school employee in the defined contribution plan can always drop their contribution to 0% and end up with nothing in retirement except the base 4% employer contribution. You can’t drop the Pension Plus 2 contribution, so this mechanism protects the employee from themselves.  I have a friend who works for a large corporation who for almost 2 decades has continually stated she will increase her 401K contribution…but it never happens.  It falls off of the to do list.  Life is always in the way and it’s easier to take money from our future self’s to subsidize our current self’s lifestyle.  This is also much more of an issue for people who have ADHD, like my son.  People with ADHD live in the immediate moment much more readily than the rest of us, which makes it very easy to neglect future versions of ourselves.

For A Long Term Employee It Will Work Out:

Let’s say my son stays in the school system for his entire career, starts at $30,000 per year in income and receives a 2% raise every year.  His final 5 year average will be $62,445.  His pension would be $37,467 per year and worth $750,000.   Had he invested the money instead and earned an average of 8% he would only have $605,000.  Had he earned 6% it would be only $375,000.  Accounting for the match he would have twice those amounts.

Taking this a step further if he invoked “pension spiking” and spent the final 5 years of his career as a superintendent instead of a custodian and earned $150,000 a year, his pension would be $90,000 a year with a value of $1.8 million.  Even if the job sucks, pension spiking makes sense!

 Diversification of Assets:

My oldest has already accumulated a large war chest in his 401K at Wal-Mart.  He has contributed 50% of his income to his Roth 401K for the 18 months he has worked there.  Assuming 8% annualized returns if after this calendar year he never contributes another dime he will have $900,000 at 60.   This doesn’t mean he will stop or should stop investing, just that it may make sense to have an additional form of income in retirement to balance his 401K paper stock investing.   I’m a strong believer in front loading retirement savings at the start of our careers, while living at home with no real expenses.  My oldest started investing in earnest right after turning 18.  My next oldest got his first job shortly after turning 14 and is also investing 50% of his income.

Defined Contribution Isn’t Limited:

The defined contribution plan is still a component of the Pension Plus 2 plan.  The individual contribution to the defined contribution plan has the same $22,500 ceiling for 401K contributions that all workers covered by a 401K plan have.  The only thing someone taking the Pension Plus 2 plan is missing out on is the 401K matching component.

Transfer of Risk:

We talked about IF we received an investment return of 6% or 8%, but those investment returns are not guaranteed.  There is risk in paper assets, even over several decades of time.  It’s entirely feasible that long term stock market returns that have averaged 7%+ for the last century will drop substantially.  This risk is one undertaken by the employee.  With a pension the employer, and in this case the state of Michigan, takes on the investment risk.

Investment return risk is part of the overall risk when planning for retirement, but longevity risk is a major concern as well.  Most people look at the average US life expectancy and plan to drop dead at that age, even if they live a healthy lifestyle. What happens when you plan to live to be 78 and end up living to be 98? or 108?  This can be a big problem when spending down paper assets, but if you have a pension, it will keep coming in like clockwork. With a 401K plan usually “The 4% rule” is seen as a safe withdrawal rate that will allow the money to last forever in every market condition (including retirements that started in the great depression, demonstrated by the Trinity study. But 401K withdrawals are not a “set it and forget it” option.  Will the average worker have the discipline to never deviate from the 4% rule?   If not, running out of money when it is needed most in extreme old age is a possibility.  A pension can act as a hedge against this.

Additional Upsides of Pensions:

Pensions in most states are lawsuit proof.  Say you have a civil judgement against you for millions of dollars.  They can’t take your pension.  They can’t garnish it and they certainly can’t take the face value of it. OJ Simpson owes tens of millions of dollars from his civil judgement from the deaths of Ron Goldman and Nicole Brown Simpson.  He receives an NFL Pension, a screen actor’s guild pensions that are not subject to garnishment.

The left doesn’t come for you: The pretend proletariat HATE millionaires.  They consistently use the phrase “Millionaires and Billionaires” as if someone with $1 million is remotely close to someone with 1,000 million dollars or 100,000 million dollars.  Having $1 million in retirement assets could provide around $3,300 a month in retirement income following the 4% rule.   Someone with $1 million net worth is vilified by the radical left, while a public worker with a $3,300 pension is seen as hero.

The Downside of Pensions:

To me, pensions have 1 significant downside, and that is that they disappear when you die. Sure they offer a reduced benefit survivor benefit for a spouse, but you can’t give the value to your child.  Remember how we were comparing the value of the pension to the value of an investment account? Apples to Apples if you have $750,000 in a retirement account and die, that $750,000 can be willed to your children.  The pension just goes *POOF* and ceases to exist.   This is why the pension should only be one building block building wealth, it should be at least equally weighted with 401K savings and real estate investing.  We also shouldn’t strive to leave behind money when we die.  We should be give away any money we plan to give away to our children and grandchildren while we are still living for tax efficiency and life usage efficiency for them.

Vesting risk:  Imagine this: You work for the school system for 9 years 364 days and you get cancelled.  This happens to people.  They did this to the FBI deputy director a few years back. Andrew McCabe would have been eligible for retirement at 50, but was fired 3 days prior to his 50th birthday, forcing him to wait until 57 to receive benefits.  This was undone at a later date after lawsuits, but still.  People can get fired just before vesting.

Who Should NOT Choose the Pension Plus 2 Option:

If you know for a fact there is no way you will hit 10 years of service…don’t choose this option.

If you believe the bureaucrats in charge of this fund will mismanage the fund and not follow through on the promised benefits, then do not join this plan.

If you are young (20s), extremely financially savvy and know you will invest a minimum of 10% into your Defined Contribution Plan, without deviation, then the Pension Plus Plan 2 is probably not the best option.

MI Pension Plus 2 Vs Defined Contribution Examples:

I ran all of these examples using my retirement calculation spreadsheet.

All amounts are for total yearly income, and the match has been factored in in all calculations.

Bold indicates which option is better in a given situation.

Example 1:

• Starting at 20 and working until 60
• Starting pay of $30,000 per year with 2% yearly increases
• Contributing 6.2% pension and 4% to 401K as default for Pension Plus 2
• Contributing 5% as default for Defined Contribution

In this scenario the Pension Plus 2 Plan is the best option for long term market returns equal to or less than 9%.  If the long term market returns for the next 40 years are greater than this, then the Defined Contribution plan is superior.

Example 2:

Same scenario as above, expect contributing 10% to the defined contribution plan to make the total employee contribution percentage the same.  This would require purposefully changing the defined contribution plan allocation from the default 5% to 10%.

A simple tweak makes a big change. Saving the same amount of money, which requires making a change at sign up, shifts the balance to making the most sense for the Defined Contribution Plan for market returns of 7% or above.

Example 3:

• Same Scenario, except we contribute the minimum possible.
• Zero employee contribution to 457/401K portion of Pension Plus 2 Plan, only 6.2% Pension contribution and 6.2% automatic match.
• Zero employee contribution to 457/401K portion of Defined Contribution Plan, only 4% automatic match.

This is my favorite example, because it comes back to the idea of the pension plan protecting you from you.  I know many people who have purposefully reduced their retirement account contribution for a temporary problem, say to have more cashflow to save up for Christmas presents in October and November, but then never switch it back.  The pension plan protects the employer from being able to fully negate saving for retirement.

Example 4:

• Start working at 40 and retire at 60.  Earning $45,000 per year with 2% yearly raises.
• Contributing 6.2% pension and 4% 401K as default for Pension Plus
• Contributing 5% as default for Direct Contribution Plan

No surprise here.  Pension plans greatly reward older workers.  If you don’t have much saved for retirement and are looking for a 2nd act, working in the school system could be a great opportunity.

Example 5:

• Work for 10 years from 20 to 30, then leave to do anything else.  Claim pension at 60.
• Contributing 6.2% pension and 4% 401K as default for Pension Plus
• Contributing 5% as default for Direct Contribution Plan

This scenario may be the most likely for young people.  Many get into teaching and decide long term it isn’t the right fit.  The pension isn’t even remotely competitive at any market return rate.

What Did We Choose?

I think its apparent that we went with the Pension Plus 2 plan.  It is really concerning that the default is to elect the defined contribution plan, which is very arguably a worse deal.  What’s more, it was not made clear the importance of making this decision and the timeline it needed to be completed in.  To be honest when the 1 page notice came in the mail giving the final reminder that he must set up an account and make an election, I almost threw it out.  I figured he would only be subbing for another week, and not a school employee again until needed again next school year.  Even after reading it and deciding to sign up for an account in order to make a decision, I figured it was a formality and assumed that the default was the pension plan, as the money was already being withheld from his paychecks for the pension plan.  Had we not taken action and made the selection he would have reverted to the defined contribution plan and never been able to change that “decision”.

Although its possible he will not work in the school system for 10 years or greater it is entirely possible that he will and the tradeoff is well worth it. Our son already has substantial investments through his 401K plan with Walmart.  He is about to hit his 2 year anniversary and has saved 50% of his paycheck into his Roth 401K since he started.  Because of this large investment base in his Roth 401K early on,  he will already end up with substantial retirement income, so he can afford to take a bit of a risk on if the Pension Plus 2 program doesn’t end up being the highest optimized option for overall return.

The Pension plan greatly reduces his ability in the future to NOT save for retirement when I may no longer have significant influence over his monetary decisions.  I like the idea that this locks in his savings rate to at least SOMETHING.  If he does go full time with the school system and drops Walmart to his part time job, we will still require a 50% savings rate while he is living at home.

What do you think about the Michigan Pension Plus 2 Plan Vs. Defined Contribution Plan?