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. [↩]