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.