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. [↩]