Pension Reform

How to Prevent Future Pension Crises

State and local governments face an unprecedented crisis as a result of inadequately funded public pensions, as evidenced by a recent State Budget Solutions study that found on average, public plans across the country are only 41 percent funded. The crisis could have been averted. Discussion of how centers on reforms to long-standing defined benefit plans, including the use of defined contribution retirement plans.

Approximately 14 percent of full-time public employees currently participate in a DC retirement plan, including employees in a combined DC/DB plan. Under these plans, employers contribute a fixed percentage of an employee’s salary. Defined contribution plans offer governments at all levels a solution to the public pension crisis.

Three cities in Contra Costa County, California – Lafayette, Orinda, and Danville – have had defined contribution systems in place since at least 1985 and illustrate how DC plans are a fiscally responsible choice for municipal governments.

Budget benefits

From a budgeting perspective, DC plans offer long-term stability in employer contributions. On average, it is recommended that the total contribution (that is, the combined total from employer and employee) is around 12 percent for employees eligible for Social Security, and 18-20 percent for those not. This simplicity has several plusses. First, as long as total payrolls are projected out for the future, officials can be confident of the cost each year to fully fund employee retirement plans.

Orinda, California City Manager Janet Keeter offered praise specifically for this aspect of DC systems, saying, “There’s a lot to be said for knowing what your costs will be year to year, because it’s all based on payroll.” Sticking to a family budget is certainly easier knowing that, if everyone continues using roughly the same amount of electricity, water, and gas, total utility bills will be about the same next summer as they were the last. The same common sense idea applies here.

Ending gimmicks

In a DC system, employer contributions become less subject to political gimmickry. Under traditional DB plans, employer costs fluctuate with circumstances like investment returns, actuarial assumptions and budget priorities.

For example, when the Governmental Accounting Standards Board announced that it would require poorly funded systems to use lower investment return assumptions for parts of their pension debts, some officials said this would mean higher annual contributions from governments. This would mean less funding for other politically favored priorities. However, GASB formally decoupled accounting from funding requirements.

Of course, even if the change did not go far enough, that aspect only put actuarial accounting more in line with reality. To some officials, though, the new rules could get in the way of other political goals that ultimately require funding from the same pot of money. The example is illustrative of public officials’ propensity to grant priority to short-term political goals.

In states like Illinois and Connecticut, officials have borrowed money to pay required pension contributions. The bonds will, of course, have to be paid back later with both interest and the lost investment gains factored in.

DC retirement plans prevent such gimmicks. Contributions to employee retirement plans become as routine and knowable as meeting regular payroll obligations.

Good for budgets, good for taxpayers

The characteristics of DC systems that lend themselves to effective budgeting also offer enormous benefits to taxpayers. All of the aforementioned gimmickry currently utilized to fund, or underfund, DB systems puts scarce taxpayer dollars at risk in more ways than one. Many pension funds are shifting into riskier investments. In June, the New York Times wrote that, “By the end of 2011, retirement systems with at least $1 billion in assets had raised their stake in real estate, private equity and hedge funds to 18.3 percent, from 10.7 percent in 2007, according to the Wilshire Trust Universe Comparison Service.”

Three California cities have all filed for bankruptcy this year driven in part by pension liabilities. A fourth, Atwater, is on the horizon. Each case has had a devastating effect on citizen services.

Stockton, the largest city in the country to ever file for bankruptcy, was forced to eliminate a quarter of the city’s police officers, a third of the fire department staff, and 40 percent of all other employees. San Jose, which has actually passed pension reforms for new employees, built four new libraries only to find they could not afford any staff.

Effective budgeting requires understanding all of a government’s resources as one whole entity. Thought of in these terms, each dollar eventually spent making up for the difference in actual investment returns and assumptions is a dollar not spent on education, Medicaid, or any other state funding priority that is meant to benefit taxpayers.

Protecting employees

Lowered taxpayer risk does not have to mean inordinate risk placed on employees. A 2008 report by retirement provider TIAA-CREF laid out principles and best practices to achieve a system focused on retirement security, rather than wealth accumulation like many private sector DC plans. It starts with an acknowledgment that retirement security is a shared responsibility between employer and employee.

Recommended best practices include mandatory participation to lower costs through economies of scale, 100 percent vesting after one year, and an 18-20 percent total contribution for employees not eligible for Social Security. Both employer and employee contributions should be mandated by the plan. For the sake of investment security and simplicity, it recommends a limited selection of 15-20 participant directed investments, individual advice, and continuing employee education.

If designed properly, DC plans provide security to public employees. Though the responsibility to effectively manage the funds is shared between employee and employer, an employees’ individual sense of ownership over his or her retirement can create responsible stewardship currently missing from the world of public DB plans. For these reasons, in cases where DC plans are available, they remain popular. Many higher education employees have relied on them for years.

Officials in Orinda, Danville, and Lafayette, California say their employees have embraced the systems. Keeter, the Orinda City Manager, worried that it would hamper recruitment, found the opposite to be true and noted there is no shortage of qualified applicants. The Danville city manager noted that employees have been there for 15-20 years, indicating that the DC plan does not drive employees elsewhere.

The current condition of state and local public pensions is evidence that the old model of defined benefit plans has horrendously failed. In hindsight, the ideal time for state and local governments to have begun defined contribution plans was at their founding, just as the founders of Lafayette, California, did when incorporating the city in 1968. However, the saying “better late than never” applies in this situation.

Every missed payment and dollar that investment returns fall short of assumptions compounds a $4.6 trillion problem.

The time for state and local governments to offer defined contribution retirement plans that protect both taxpayer dollars and public employee retirement security is now.

In Depth: Pension Reform

Modern, 401(k)-style plans are now commonplace in the private sector. For state workers, however, traditional pensions are still the norm. As former Utah State Senator Dan Liljenquist wrote in Keeping the Promise: State Solutions for Government Pension Reform, this is not a partisan issue, but a math problem. State Budget…

+ Pension Reform In Depth