Some Public Pensions May Soon Run Out of Money

We have expressed previously the belief that, sooner rather than later, states, cities and other public sector employers will be forced to migrate to 401k (or similar) defined contribution retirement systems. Private sector employers have made this shift over the last 25 years and now public sector employers are facing an onrush of issues that makes a similar transition in government virtually inevitable:

• accounting rule changes that will force governments to be more realistic about their pension plans and retiree health benefits
• disgruntled taxpayers bitter that public employees earn more and have better pensions and benefits than they do
• falling tax revenues
• rising retirement costs that are diverting huge sums of public money away from important public services
• high profile public pension abuses - both in public pension management and benefits

On top of all this, now comes an important academic study by Northwestern University finance professor Joshua Rauh showing that several large state pension plans can expect to be bone-dry out of money within a decade. In aggregate, state funds will run out of money in 2028:

Based on September 2009 asset values, if state pension fund asset returns have an average return of 8% going forward (the states’ typical assumption), states in aggregate will run out of funds in 2028. If average returns are 10% through 2045, the funds in aggregate will be roughly sufficient to cover liabilities to existing workers under the states’ actuarial assumptions. If average returns are only 6%, state funds in aggregate will run out in 2024. This analysis assumes that state inflation forecasts, which average 3%, are met. If inflation is greater holding the investment outcomes fixed, then even under the higher asset returns the funds will run out sooner, as many state systems provide inflation-linked cost of living adjustments (COLAs) to beneficiaries.

Illinois pensions are in the worst shape - expected to be broke in 2018. Next come Connecticut, New Jersey, and Indiana in 2019 followed by Hawaii, Louisiana and Oklahoma in 2020. A small number of state pensions (Florida, New York, Alaska, Nevada, and North Carolina) are in relatively good shape and are not expected to run out of money.

Once pension funds run dry, states will be forced to pay benefits (which in most cases are constitutionally guaranteed) on a pay-as-you-go basis. This means the full amount of the benefits will be paid from current tax revenue without the advantage of investment earnings. For many of the states, this could mean one-third or more of the state tax revenue would be devoted just to paying public employee pensions.

The information in following table summarizes the anticipated cashflow status of each state's pension. ¹

State Pension Plan	Runs Out of Money In Year:	Annual Pay-as-you-Go Pension Benefits After Pension Funds Depleted ($ Billions)	Pay-as-you-Go Benefits as % of States Projected Tax Revenue
ILLINOIS	2018	13.6	32%
CONNECTICUT	2019	4.9	27%
INDIANA	2019	3.6	17%
NEW JERSEY	2019	14.4	34%
HAWAII	2020	1.7	24%
LOUISIANA	2020	4.3	27%
OKLAHOMA	2020	3.7	30%
COLORADO	2022	7.8	54%
KANSAS	2022	2.5	23%
KENTUCKY	2022	5.3	35%
NEW Hampshire	2022	1.0	30%
ALABAMA	2023	5.5	39%
MICHIGAN	2023	7.8	20%
MINNESOTA	2023	7.3	25%
MISSISSIPPI	2023	3.9	37%
MARYLAND	2024	6.0	24%
PENNSYLVANIA	2024	13.8	27%
SOUTH CAROLINA	2024	4.7	34%
WEST VIRGINIA	2024	1.3	16%
MISSOURI	2025	6.9	38%
MAINE	2026	1.7	28%
MASSACHUSETTS	2026	6.6	18%
NEW	2026	3.9	40%
MONTANA	2027	1.1	25%
RHODE ISLAND	2027	2.4	50%
VERMONT	2028	0.5	11%
ARIZONA	2029	7.3	29%
ARKANSAS	2030	3.1	21%
CALIFORNIA	2030	68.1	30%
OHIO	2030	28.0	55%
WYOMING	2030	1.0	25%
SOUTH DAKOTA	2031	1.0	38%
NEBRASKA	2032	1.2	15%
VIRGINIA	2033	8.6	22%
WASHINGTON	2033	8.0	21%
DELAWARE	2035	1.0	15%
IOWA	2035	3.0	20%
TENNESSEE	2035	4.2	16%
UTAH	2036	3.5	26%
TEXAS	2037	30.4	29%
WISCONSIN	2038	9.7	27%
OREGON	2039	6.0	33%
NORTH DAKOTA	2041	0.5	9%
IDAHO	2043	1.7	16%
GEORGIA	2047	9.8	17%
ALASKA	No Runout	8.4
FLORIDA	No Runout	35.8
NEVADA	No Runout	6.1
NEW YORK	No Runout	65.4
NORTH CAROLINA	No Runout	22.8
Mean	2028	15.6
Median	2026	9.3
Standard Deviation	7.0	19.3

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Notes:

1. Data from Rauh, Joshua D., Are State Public Pensions Sustainable? Why the Federal Government Should Worry About State Pension Liabilities (May 15, 2010). Available at SSRN: http://ssrn.com/abstract=1596679 [↩]

A Number to Remember: 15.7

Retirement and 401k planning can be incredibly complex. Or not.

We are big fans of keeping things simple whenever possible with easy to understand rules of thumb. That's why we were pleased to see a new report from Hewitt Associates that includes some well researched guideposts for retirement planning. Based on analysis of the retirement needs of 2.1 million employees at 84 large companies, the study finds that for employees who currently contribute to their employers retirement plan:

• on average will need to accumulate a retirement resources equal to 15.7 times times their pay at retirement to maintain pre-retirement living standards (e.g. $785k for a $50k salary)
• Social Security will provide, on average, retirement resources equal to 4.7 times pay
• other retirement savings - such as 401k's and DB pensions - will need to provide the remaining 11 time pay
• only about 18% of these employees are presently expected to satisfy 100% of their needs at retirement
• on average, workers who rely solely on a defined contribution plan to fund their retirement are projected to meet just 74% of their needs in retirement

Next time you ponder the question: How Much Should I be Saving for Retirement?, keep in mind the 15.7 factor. It's a well-researched yet simple way to target the retirement nestegg you need to work towards accumulating.

Inertia and My 401k

in·er·tia [in-ur-shuh, ih-nur-] –noun

1. inertness, esp. with regard to effort, motion, action, and the like; inactivity; sluggishness.
2. Physics. the property of matter by which it retains its state of rest or its velocity along a straight line so long as it is not acted upon by an external force.
3. Medicine/Medical. lack of activity, esp. as applied to a uterus during childbirth when its contractions have decreased or stopped.

As 401k participants everywhere ponder "What should I do with my 401k in this current market" they may want to give some thought to the beneficial aspects of inertia.

Synonymous with "inactivity" and "sluggishness", inertia is typically viewed as a negative characteristic in the 401k world. Indeed, the push by government and the 401k industry to make 401k's a truly workable retirement solution has centered on introducing policies specifically designed to counter what we can call "bad" inertia. Examples:

Examples of "Bad" 401k Inertia
Inertia causes workers to fail to enroll in 401k plans, often missing out on company match	Response: automatic enrollment
Inertia keeps workers from increasing contributions as wages rise	Response: automatic contribution arrangement
Inertia at the root of workers opting for low-yield investment options such as money market accounts	Response: automatically place 401k participants in qualified default investment alternatives

But there apparently is a bright side to 401k inertia as well. Some commentators credit employee inaction in the face of the historic market collapse of 2008-09 as the primary reason behind the remarkable recovery of 401k account balances that has occurred in the past year. Relatively few 401k participants reacted to the market turmoil by reducing their 401k contributions or moving account balances from riskier asset classes that were hardest hit into "safer" investments. Doing so, of course, would have been the classic panicked behavior expected of amateur investors: selling at exactly the wrong time.

For whatever reasons, workers by and large stood pat with their 401k's and were rewarded nicely. By the end of 2009, just 9 months after the market bottomed (DJIA @ 6,443 in March 2009) Fidelity and Vanguard both were reporting that most 401k participants had account balances higher than they did at the market's peak in October 2007.

"I think the good news is inertia took over and most people did nothing. During the rebound from April (2009) on, the inertia value of the 401k is very good."
- Jane Bryant Quinn as quoted in Employee Benefit News (4/1/2010)

"What to do with my 401k in this current market?" Consider setting a long-term course with regular 401k contributions, a solid 401k investment portfolio strategy and letting inertia take over from there.

Another Report Paints Bleak Outlook for Public Pension Plans

We have been watching closely the emerging public pension plan funding problems and have suggested that the public sector may soon become the next big area for 401k growth.

A just released study from the Center for Retirement Research at Boston College paints a dire picture for the future of public defined benefit pension plans. The study is significant not only for its message, but also because the messenger (CRR) has historically been a staunch supporter of DB plans as the most efficient and effective means to provide retirement security to American workers.

In April 2008, just months before the financial meltdown, a CRR review of state and local pension funding status at that time was titled "The Miracle of Funding by State and Local Pension Plans".

The current study analyzes current and near-term projected future funding levels for the same 126 large state and local pensions using the plans' own valuation data and methodologies - but now finds that the miracle has vanished. (It should be noted that there is significant debate and mounting concerns among governmental accounting experts that these valuation methods are too lenient and that the true public pension funding deficit is far worse than is being disclosed by the plans. The CRR report does not specifically address these concerns.)

But even setting aside this issue, the CRR report offers a very pessimistic outlook for public DB plans and no substantive or practical ideas to solve the problem:

"The conclusion that emerges from this update is that while states and localities were on a path toward full funding of their pension liabilities, they were seriously knocked off track by the financial crisis. The first glimpse of the dimension of the damage is becoming evident with the actuarial valuations for 2009. (Since three-quarters of plans have a fiscal year ending June 30, the 2008 valuations were closed before the crisis hit.) Between 2008 and 2009, the ratio of assets to liabilities for our sample of 126 plans dropped from 84 percent to 78 percent. But this decline is only the beginning of the bad news that will emerge as the losses are spread over the next several years. The ultimate outcome will depend on the performance of the stock market, but under our most likely scenario, funding ratios will decline to 72 percent by 2013.

The key question is what should be done. A major increase in contributions is not realistic at this time. States and localities may have only limited ability to increase employee contributions, because some state courts have ruled that the public employer is prohibited from modifying the plan for existing employees. Higher contributions from new employees will take a long time to have any substantial effect. Thus, if funding levels are to be restored quickly, the money must come primarily from tax revenues. But the recession has decimated tax revenues and increased the demand for state and local services. Thus, finding additional taxes to make up for market losses will be extremely difficult (emphasis added). One small step that would be viewed as a commitment to responsible funding would be for states and localities to at least pay their full ARC. Otherwise, the only option is to wait for the market and the economy to recover."

We, too, believe that finding additional tax dollars for public pension funding will be "extremely difficult" or, more accurately, near impossible in the next several years. The pressure will be extreme for state and local governments to mimic what has already taken place in the private sector and shift workers to a 401k-style retirement system.

ROBS (Rollovers as Business Start-up)

ROBS (Rollovers as Business Start-up) is the acronym used to describe a somewhat questionable technique used for starting a business with 401k rollover. The ROBS technique is controversial both because the IRS tends to frown on the practice and because of the extreme risk involved in taking one's retirement nest egg to start up a business.

Still, with bank financing for new businesses at a virtual standstill, ROBS has been heavily marketed as a legitimate financing plan particularly as a funding method to start a franchise operation. Several firms are marketing their services to walk entrepreneurs through the ROBS process - for substantial fees.

An IRS memorandum critical of the funding method describes the steps involved in a typical ROBS transaction:

• An individual establishes a shell corporation sponsoring an associated and purportedly qualified retirement plan. At this point, the corporation has no employees, assets or business operations, and may not even have a contribution to capital to create shareholder equity.
• The plan document provides that all participants may invest the entirety of their account balances in employer stock.
• The individual becomes the only employee of the shell corporation and the only participant in the plan. Note that at this point. there is still no ownership or shareholder equity interest.
• The individual then executes a rollover or direct trustee-to-trustee transfer of available funds from a prior qualified plan or personal IRA into the newly created qualified plan. These available funds might be any assets previously accumulated under the individual's prior employer's qualified plan, or under a conduit IRA which itself was created from these amounts. Note that at this point, because assets have been moved from one tax-exempt accumulation vehicle to another, all assessable income or excise taxes otherwise applicable to the
  distribution have been avoided. ¹
• The sole participant in the plan then directs investment of his or her account balance into a purchase of employer stock. The employer stock is valued to reflect the amount of plan assets that the taxpayer wishes to access.
• The individual then uses the transferred funds to purchase a franchise or begin some other form of business enterprise. Note that all otherwise assessable taxes on a distribution from the prior tax-deferred accumulation account are avoided.
• After the business is established, the plan may be amended to prohibit further investments in employer stock. This amendment may be unnecessary, because all stock is fully allocated. As a result, only the original individual benefits from this investment option. Future employees and plan participants will not be
  entitled to invest in employer stock.
• A portion of the proceeds of the stock transaction may be remitted back to the promoter, in the form of a professional fee. This may be either a direct payment from plan to promoter, or an indirect payment, where gross proceeds are transferred to the individual and some amount of his gross wealth is then returned to promoter.

The IRS makes it very clear in this memo that they cast a wary eye on ROBS and detail numerous potential violations that could be triggered by these transactions. ROBS are considered technically legal, but fraught with dangerous pitfalls that could potentially cost you not only your retirement savings, but also extremely stiff IRS penalties and fees.

It goes without saying, then, that the legal, tax, and personal finance implications of using ROBS makes it absolutely essential for anyone contemplating this technique to have competent legal and financial advisors at their disposal.

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Notes:

1. Distributions from tax-deferred accumulation accounts would generally be taxed under IRC § 72, which specifies treatment for various forms of annuity or non-annuity payments. In general, a single sum distribution would be taxed as ordinary income, at the individual's effective tax rate. Of particular concern here, the distribution would generally also be subject to the 10% "premature distribution" penalty provided by IRC § 72(t), unless the individual was at least 59-1/2 years old on the transaction date, or met one of the other limited statutory exceptions. ROBS transactions effectively avoid all § 72 concerns. [↩]

Auto Annuity?

A few years ago government 401k regulations were modified to permit and encourage automatic enrollment of employees into 401k retirement plans. An employer that sponsors a 401k and that chooses to use automatic enrollment enrolls its employees in the plan automatically, by salary reduction, without requiring them to take any initiative or action in order to participate. Employees have to formally elect not to participate if they don't want to be in the 401k.

Automatic enrollment generally is considered to be a successful tactic for countering employee inertia. Many employees - especially younger and low-moderate income workers - who in the past tended not to bother signing up are now being enrolled in the company 401k plan by default.

Now government agencies now are testing the waters to see if the inclusion by default concept should be considered for employees starting their retirement. The concern here is that, having accumulated a 401k nest egg during their working years, new retirees often tend to withdraw their 401k assets in a lump sum and may not fully understand the importance of making the money last throughout retirement.

In response, policymakers are seeking input on the notion of "automatically annuitizing" 401k balances at retirement to provide a lifetime income stream. Under this concept, all or part of a workers 401k balance at retirement could be turned into an annuity that pays a monthly benefit for life.

A recent request for information (RFI) put out by the Department of Labor seeks input from the public and industry experts on numerous questions about 401k "lifetime income options". Several of the questions included in the RFI reveal there is a significant interest in the auto-annuity idea:

"11. Various "behavioral" strategies for encouraging greater use of lifetime income have been implemented or suggested based on evidence or assumptions concerning common participant behavior patterns and motivations. These strategies have included the use of default or automatic arrangements (similar to automatic enrollment in 401(k) plans) and a focus on other ways in which choices are structured or presented to participants, including efforts to mitigate "all or nothing" choices by offering lifetime income on a partial, gradual, or trial basis and exploring different ways to explain its advantages and disadvantages. To what extent are these or other behavioral strategies being used or viewed as promising means of encouraging more lifetime income? Can or should the 401(k) rules, other plan qualification rules, or ERISA rules be modified, or their application clarified, to facilitate the use of behavioral strategies in this context?

12. How should participants determine what portion (if any) of their account balance to annuitize? Should that portion be based on basic or necessary expenses in retirement?

13. Should some form of lifetime income distribution option be required for defined contribution plans (in addition to money purchase pension plans)? If so, should that option be the default distribution option, and should it apply to the entire account balance? To what extent would such a requirement encourage or discourage plan sponsorship?"¹

Clearly, government policymakers recognize that the move away from traditional defined benefit (DB) pensions that provide monthly pension benefits for life is permanent and won't be reversed. Their challenge now is to find ways to tweak and strengthen the 401k system so that it becomes a viable means of providing long-term retirement security to American workers.

There are numerous practical challenges in the way of auto-annuitizing including the big problem of inadequate average 401k account balances. Still, the concept seems to be gaining momentum and is likely to be seriously considered and debated in the coming months.

The complete lifetime income options RFI can be found on the Department of Labor's website. The questions asked in the RFI provide insights into the direction that 401k planning policy may be headed in the Obama administration. You can also publicly comment on the RFI at Regulations.gov. ²

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Notes:

1. US Department of Labor Request for Information Regarding Lifetime Income Options for Participants and Beneficiaries in Retirement Plans - 2/2/2010 [↩]
2. Search for "RIN 1210-AB33" to bring up current comments on the proposal as well as links to submit your comments. [↩]

Older Workers Fare Better Through Crisis

There's no doubt that the financial crisis of 2008-09 has shaken up retirement planning like no other event in memory. Public defined benefit pensions, a mainstay of government employment, are teetering. Hundreds of companies have pulled the plug on matching contributions to 401k plans and are only now starting to reinstate them. And everywhere, workers - especially the oldest baby boomers - have been forced to rethink and remake retirement plans.

But a just released study from Boston College's Center for Retirement Research reaches a surprising conclusion: Even taking into account the massive losses brought about by the financial crisis, when viewed from a career-spanning perspective, early baby-boomers (those closest to retirement) have fared quite well in terms of financial market returns. The study looks at 401k investment returns over the careers of three hypothetical retirement savers:

• Early Boomers (age 50 in 1999)
• Late Boomers (age 40 in 1999)
• Gen Xers (age 30 in 1999)

The early boomer turned 60 in 2009 and was preparing for retirement just as markets hit bottom in March of that year. These workers - and their decimated retirement nest eggs - were the subject of countless stories highlighting the shortcomings of the 401k. How was it possible for someone to work and save diligently over an entire career only to have the rug pulled out from beneath them on the doorstep of retirement?

But as devastating as the crisis has been, it is amazing to realize that even at the lowest point (March 2009) the career-long rate of return for an early boomer 401k saver was +7.9%! This is because these workers were old enough to benefit fully from the historic run-up in the stock market that occurred between 1982 and 2000. Late Boomers and Gen Xers, on the other hand, had to deal with precipitous market declines in 2000 and 2008 without the benefit of the 80's market boom.

None of this is to suggest that early boomers' retirement plans weren't tragically impacted by the 2008-09 financial crisis. They certainly were and, unlike younger generations, they do not have time to recoup losses. Moreover, percentages and rates of return mask the more fundamental problem that, by every measure, workers across all age cohorts have not (and are not) adequately saving for retirement. A healthy rate of return on a pint-sized nest-egg is not a formula for retirement success.

"As jarring as the financial collapse may have been for the Early Boomers, the market has actually treated them well over their lifetime. Hypothetical workers investing either all in equities or in half equities and half bonds have enjoyed fairly high returns compared with long-run averages. This agreeable outcome is the result of these workers having substantial assets during the long bull market that began in 1982 and ended in 2000.

Moreover, the market has treated Early Boomers a lot better than the subsequent cohorts. Late Boomers and Gen Xers never benefited fully from the 1982-2000 bull market and were hard hit by two market collapses. The Late Boomers are the most vulnerable, as they would need substantial returns in the future to end up with the same ratio of assets to income at age 60 currently enjoyed by Early Boomers."¹

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Notes:

1. Returns on 401k Assets by Cohort, Center for Retirement Research at Boston College, March 2010. [↩]

Reasons Why State & Local Governments Will Shift to DC Retirement Plans

The public sector retirement landscape is dominated by expensive defined benefit (DB) pensions that provide government workers guaranteed income for life when they retire. A few states - Alaska and Michigan - require new hires to enroll in 401k-style defined contribution (DC) plans similar to the 401k's that predominate in the private sector. But economic conditions, budget constraints and other factors are forcing more state and local governments to consider switching from DB to DC retirement plans.

Here are our top reasons why we think the transition to DC retirement plans will spread in the public sector:

1. Public sector pay no longer lags the private sector - There was a time when government employees were paid much less than private sector workers of similar status. The pay differential was offset largely by good pensions, benefits and job security that public sector employment offered. But times have changed and there is now mounting evidence that public sector pay and benefits are well in excess of the private sector. An article in USA Today reported that, in 2008, "Overall, total compensation for state and local workers was $39.25 an hour — $11.90 more than in private business. In 2007, the gap in wages and benefits was $11.31...A full-time government worker receives benefits worth an average of $27,830 per year. A private worker's benefits are worth $16,598."

   As the public-private pay gap widens and becomes more publicized, taxpayers will press for reforms to bring pay and benefits in line with private sector compensation.

2. State & local budgets are distressed like never before - A recent article in Bloomberg noted:
   

   "The biggest financial crisis since the Great Depression is squeezing municipalities across the country. Since Vallejo, California, successfully petitioned for bankruptcy protection in May 2008, California’s towns, Detroit’s schools and Pennsylvania’s capital city of Harrisburg have all talked about Chapter 9...(municipalities are) talking about it more than they have since 1994, when Orange County, California, suffered through the country’s biggest municipal bankruptcy. Bondholders have to worry if it’s more than just talk. "

   The facts are:

   • government revenues have fallen precipitously in the recession
   • government costs - especially for pensions and healthcare - are rising at unprecedented rates
   • pension and retiree healthcare funds are not well funded and contribution deferral is no longer an option

   This adds up to mounting fiscal pressures to restructure public pensions.

3. Most taxpayers will never have DB pensions, so why should they have to pay for public workers to have them? - The phrase "public servant" may be out of step with today's reality. As already noted, average pay for public servants surpasses the average wage for their taxpayer-bosses. When it comes to pensions, the differences are even more striking: 90% of public sector employees have defined benefit pensions while only 20% of the private sector workforce get this benefit. Growing awareness of this inequity will pressure sponsoring governments to move towards 401k-type retirement plans.
4. Pension spiking and other abuses are fueling public anger - Defined benefit pensions are formula based and give extra weight to the last few years of a person's employment. In many cases, employees are allowed to boost their income in the last few years by cashing out accrued leave balances or by other means. This results in larger pensions - sometimes 25% larger - payable for life. Pension-spiking practices have been the subject of numerous news accounts in California and have helped fuel citizens' anger over public pensions.
5. The other shoe is dropping: Anyone know what OPEB stands for? - Expensive defined benefit pensions are only part of state and local governments retirement problem. These governments have also promised millions of workers that they will get health care and, sometimes, related benefits like life and dental insurance in retirement. Government financial reports refer to these promises by the acronym OPEB - other post-employment retirement benefits. No one knows how big the nation's total OPEB liability is. A November 2009 GAO survey of the 50 state and 39 large local governments tallied an unfunded liability for these 89 governments alone in excess of $530 billion. Other observers place the total OPEB liability for all state and local governments at $1 trillion or more. Whatever the actual number, there is no disagreement that it is huge and growing. The public is generally unaware of this issue, but they soon will become painfully aware of it as OPEB costs result in higher taxes and reduced public service levels - and more pressure to change the status quo.
6. Assumptions and numbers used by DB pensions are overly optimistic - Assumed annual 8% investment returns, "smoothing" losses over long periods, perpetual 30-year amortization schedules, and on and on. Public pension funding is complex and based on myriad arcane assumptions. These assumptions are sometimes modified - usually with an end goal of keeping employer contributions low and making things look better than they really are. Actuarial valuations for public pensions are not done according to the same standards that private sector valuations are required to follow. Indeed there is ongoing debate in the actuarial profession over whether it is appropriate and realistic to use fixed, non-market based earnings assumptions (typically 8%) for government pensions. According to one public pension actuary, changing standards to be more like the private sector (a distinct possibility) would be the death knell for public DB pensions:
   

   "The use of market-value rates to discount public pension plan liabilities would create greater contribution requirements and spur the replacement of public defined benefit plans with 401(k) plans...State and local (governments) would all have 401(k)s if we had to make contributions like that to provide for market volatility.”

7. Fixing Medicare and social security are more important than fixing state & local government pensions. - There are about 20 million state and local government workers, the vast majority of whom are covered by defined benefit pensions. Social security and Medicare, of course, are national retirement programs that affect at least ten time as many people and have their own serious funding issues as noted in the most recent annual reports of the two systems:
   

   "The financial condition of the Social Security and Medicare programs remains challenging...The drawdown of Social Security and HI Trust Fund reserves and the general revenue transfers into SMI will result in mounting pressure on the Federal budget. In fact, pressure is already evident. For the third consecutive year, a "Medicare funding warning" is being triggered, signaling that non-dedicated sources of revenues—primarily general revenues—will soon account for more than 45 percent of Medicare's outlays. A Presidential proposal will be needed in response to the latest warning. The financial challenges facing Social Security and especially Medicare need to be addressed soon. If action is taken sooner rather than later, more options will be available, with more time to phase in changes and for those affected to plan for changes."

   In coming years, the Social Security & Medicare funding crisis will compete with the state & local retirement funding crisis for taxpayer dollars. Our bet will be that the federal programs affecting nearly all workers will overwhelm concerns about public employee pensions.

8. Strong protections for existing DB benefits allow little flexibility - Reasonable people might suggest one fix for the public pension problem is to scale back benefits some degree for current retirees and/or currently active employees. The problem here is that state constitutions and statutes prohibit this. The Illinois Constitution, as an example, provides an explicit guarantee that makes it nearly impossible to modify benefits levels downward - even in a severe fiscal crisis:
   

   "membership in any pension or retirement system of the State, any unit of local government or school district, or any agency or instrumentality thereof, shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”

   Most other states have comparable constitutional, statutory, and/or common law pension guarantees. This makes changing pension benefit structure for new employees the only available avenue for relief.

Combined, these factors are certain to shake up the public sector pension world in the next few years. Formidable legal and political obstacles including will make changes difficult. But maintaining the status quo is simply no longer an option.

Existing State “401k” Plans: Michigan, Alaska & Washington DC

We suggested in an earlier post that it was just a matter of time before many state and local governments would find it necessary to abandon their expensive defined benefit employee pensions and replace them with 401k-type defined contribution retirement plans. In the private sector this transition has taken place over the last 25 years. Government budgets are under intense pressure (largely due to rising pension costs) and it seems highly unlikely that they will be able to successfully raise taxes - not to increase services - to pay into pension plans.

A few states have already made the switch to "401k" style defined contribution plans and many more are actively considering the move. The National Conference of State Legislatures published an overview report of state DC retirement plans in September 2009. According to this report, just two states (Alaska and Michigan) and the District of Columbia had defined contribution plans as primary retirement systems for new employees. ¹ Below is a summary of the 401k-type defined contribution plans ² offered by these governments:

State	Year Adopted	Primary or Optional Primary	Details
District of Columbia	1987	Primary for new hires after October 1, 1987	The District government's primary retirement plan for eligible employees first hired on or after October 1, 1987, is a "defined contribution" plan, with benefits based on 100% employer-provided contributions plus earnings over the course of the participant's working years. The District funds this plan; there is no employee contribution. The current employer-paid contribution is 5% of the base salary (5 .5% for Corrections Officers). Employees must have one year of continuous service to participate, and they are fully vested in the Defined Contribution Pension Plan after five years of continuous service.
Michigan	1996	Primary for new state employees hired on or after March 31, 1997.	Mandatory employer contribution of 4 percent of each employee's annual compensation to a personal Defined Contribution Account. Employer match of employee voluntary contributions up to an additional 3 percent of compensation. If an employee contributes 3 percent, the employer will match the 3 percent employee contribution to total 10 percent of employee's compensation. Employees may contribute additional voluntary amounts to their Defined Contribution Account or other tax-sheltered plans to the extent permitted by the Internal Revenue Code with no employer match. Employees will be 100 percent vested in the employer contributions after four years of service.
Alaska	2005	Primary for new hires on or after July 1, 2006	8 percent mandatory member contribution 5 percent employer contribution to the Defined Contribution Retirement (DCR) Plan Member is immediately vested in the balance of the member contributions. Member is not 100 percent vested in the employer contributions until five years of service is accrued.

It is worth noting that the employer contributions for these state plans (4% - 7%) are significantly higher than the norm for private sector 401k's. According to Boston College's Center for Retirement Research, for private sector workers, "the typical employer match consists of a 50 percent match on 6 percent of the employee’s salary...the typical employer match is thus 3 percent of employee earnings. Most employers permit their workers to continue contributing on an unmatched basis past the 6 percent match level."³

Understandably, public employees (and their unions) will not readily give up the lifetime guarantee of a defined benefit retirement for a 401k-style retirement plan - even one that is far richer than than their private sector counterparts enjoy. Instead, this type of change on a nationwide scale will likely come about via a grassroots citizen movement fueled by outrage: outrage over the inequity of public vs private pensions and outrage over the higher taxes needed to fund public defined benefit pensions.

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Notes:

1. Several other states - including Colorado, Florida, Montana, North Dakota, Ohio, and South Carolina - offered DC plans as "optional primary plans" meaning "new employees may elect to be members of a defined benefit plan or a defined contribution plan, but must be a member of one or the other. Under current law in these states, both kinds of plan remain open to new members, and limited transfer between them is available." [↩]
2. IRS rules prohibited establishment of new governmental 401k plans effective May 6, 1986. Some governments - including Michigan - had 401k plans in existence on that date and were grandfathered in. Thus, Michigan's DC offering is, in fact, a 401k plan. [↩]
3. Why Did Some Employers Suspend Their 401(k) Match?, p. 2. [↩]

The Coming Shift to Public Sector 401k’s

Public pension programs are at the center of a brewing storm. The financial market collapse has required plan administrators to sharply increase the annual required contributions (ARC) that government units need to make to keep the plans actuarially sound. In some cases, required contributions are doubling or tripling at the same time governments are trying to cope with the sharpest revenue fall-off in generations.

The budget pressures are immense; while the recession has created vast needs for more spending on public safety and social programs, these programs are instead being cut because money is drained away to pay for rich public employee pensions.

Many experts say that the future of defined benefit (DB) pensions in the public sector is seriously threatened. Until now, government has been largely shielded from the massive shift from DB pensions to defined contribution (DC) retirement systems that took place in the private sector over the last 25 years. ¹ About 80% of public sector employees are covered by a DB plan that provides a guaranteed retirement benefit for life; in the private sector, only 10% have this benefit.

Ron Seeling, chief actuary of CALPERS² shook things up with comments made at an August 2009 seminar in Sacramento California:

“I don’t want to sugarcoat anything,” Seeling said as he neared the end of his comments. “We are facing decades without significant turnarounds in assets, decades of — what I, my personal words, nobody else’s — unsustainable pension costs of between 25 percent of pay for a miscellaneous plan and 40 to 50 percent of pay for a safety plan (police and firefighters) … unsustainable pension costs. We’ve got to find some other solutions.”

While Seeling did not specifically call for replacement of government defined benefit pensions with a new defined contribution model, Raymond Scheppach, executive director of the National Governors Association, does not mince words. From a February 1, 2010 Neal Pierce article appearing in Nation's Cities Weekly:

So what about the hundreds of billions of dollars that the state governments owe in unfunded pension obligations and retiree health care? Scheppach has one answer: the so-called "defined benefits" system, with its lifetime guarantees, "just has to go." State workers - at least new ones - would have to manage their own 401k or comparable plans.

So too are citizen-taxpayers starting to realize that a big share of their taxes goes to pay for public pension benefits - benefits far beyond those they will ever enjoy in retirement. Many public pension funds are in poor financial shape. This means that the tax dollars funneled into them goes not just to pay for today's vital public services but also to pay down employee benefit debts incurred years - even decades - ago.

In our view, the 401k³ tidal wave that swept over the private sector will soon hit the public sector. However, there will be some big hurdles standing in the way:

1. First, unions are far more prevalent and powerful in the public sector than in the private sector. Just recently, the Bureau of Labor Statistics reported that in 2009 for the first time the number of unionized workers who work for the government surpassed those in the private economy. Unionized government workers present a potent political force that will not easily succumb to the need for major pension reforms.
2. Second, retirement benefits for current public workers in many cases are protected by state constitution bans on "diminishing" benefits. The practical effect of this is that a government 401k system can only be mandated for new workers. Pension benefits, once earned, are strongly protected. ⁴ Existing workers covered by defined benefit plans can be given an option to voluntarily switch to a 401k style retirement, but few would have sound reason to do so.
3. Finally, the collapse of the financial markets in 2009 underscored weaknesses in the 401k retirement model. Workers saw their retirement account balances plummet and millions nearing retirement had to abruptly change retirement plans. Many experts seriously doubt that 401k's, even in conjunction with a stable social security system, can provide adequate resources for workers to retire on.

But regardless of the hurdles, the overriding economic fact is that governments and their taxpayers simply will not be able afford to provide guaranteed lifetime benefits to public employees. The b-word (bankruptcy) is uttered more frequently in government finance circles these days. Vallejo, California (pop. 117,000) is now going through a bankruptcy brought on primarily by out-of-control DB pensions. Much larger governments including the State of Illinois and San Diego are the subject of bankruptcy discussions as well - again, with DB pension costs as the main cause. We suspect that once a major government bankruptcy occurs, it will be the logjam break that results in a major shift away from public defined benefit plans.

Presently, among the 50 states, only Michigan and Alaska require new employees to go into defined contribution retirement plans. But serious discussion and proposed legislation shifting public sector retirement systems is underway in may other states including Pennsylvania, Utah and others. Additionally, numerous counties and municipalities have moved to DC. We believe this is certain to grow and come to dominate the public sector as it has in the private sector. It's a topic we will closely monitor in the coming months.

"The solution to the funding crises in state pension plans will require fundamental reform. Everything should be on the table, including changes in benefits and increased employee contribution rates, as well as employer contribution rates. These plans should consider replacing their defined benefit plans with defined-contribution plans for new employees." (emphasis added)

- State Pension Funds Fall Off a Cliff, American Legislative Exchange Council

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Notes:

1. Pension plans can generally be characterized as either defined benefit or defined contribution plans. In a defined benefit plan, the amount of the benefit payment is determined by a formula typically based on the retiree’s years of service and final average salary, and is most often provided as a lifetime annuity. In a defined contribution plan, the key determinants of the benefit amount are the employee’s and employer’s contribution rates, and the rate of return achieved on the amounts contributed to an individual’s account over time. The employee assumes the investment risk; the account balance at the time of retirement is the total amount of funds available. [↩]
2. California Public Employees Retirement System - the country's largest defined benefit program. [↩]
3. Under current IRS rules, 401k's are not available for government workers. However, DC retirement plans very similar to the 401k can be structured under IRS section 401a. [↩]
4. According to GAO, the majority of states have some form of constitutional protection for their pensions. In 2000, 31 states had a total of 93 constitutional provisions explicitly protecting pensions. The other 19 states all have pension protections in their statutes or recognize legal protections under common law. [↩]

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