Gold Standard in Pension System Design Archives - Reason Foundation https://reason.org/topics/pension-reform/gold-standard/ Free Minds and Free Markets Mon, 24 Oct 2022 21:13:17 +0000 en-US hourly 1 https://reason.org/wp-content/uploads/2017/11/cropped-favicon-32x32.png Gold Standard in Pension System Design Archives - Reason Foundation https://reason.org/topics/pension-reform/gold-standard/ 32 32 Best practices for pension debt amortization https://reason.org/policy-brief/best-practices-for-pension-debt-amortization/ Wed, 21 Sep 2022 04:01:00 +0000 https://reason.org/?post_type=policy-brief&p=58180 State and local public pensions in the U.S. in 2020 faced a total unfunded actuarial liability (UAL) of about $1.4 trillion, and the average pension plan was only 73% funded. Although preliminary data suggest that the current average funded status … Continued

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State and local public pensions in the U.S. in 2020 faced a total unfunded actuarial liability (UAL) of about $1.4 trillion, and the average pension plan was only 73% funded. Although preliminary data suggest that the current average funded status is closer to 85%, thanks to the substantial investment returns in 2021, the 2022 Public Pension Forecaster finds aggregate unfunded liabilities will jump back over $1 trillion if 2022 investment results end up at or below 0%.

However, despite funding developments from year to year, public pension plans remain subject to an uncertain economic climate, and the next downturn can quickly widen the unfunded gap.

While there are several answers for resolving the enormous debt accrued by pension plans, the standard solution employs a systematic plan to pay off the debt over many years. Usually, UAL is not paid off as a lump sum but is “amortized” over some time.

While the two most common amortization methods are level-dollar and level-percent, only the level-dollar method ensures predictable amortization contributions from year to year. It requires lower payment in the initial years of the schedule because it creates a predictable path to solvency by ensuring that specific amounts are paid each year.

When it comes to open and closed amortization schedules, this analysis graphically illustrates that closed amortization schedules ensure a timely repayment of UAL. Open amortization schedules, on the contrary, run the risk of keeping the amortization payment continually below the interest expense. This leads to perpetual negative amortization and makes it impossible for the pension plan to pay out UAL.

It is also important to keep the amortization period short. For longer amortization horizons, like 25 years, the interest exceeds amortization, leading to wasteful spending. Keeping an amortization schedule at 15 years ensures the intergenerational equity principle, that is, to pay off UAL within the average remaining working lifetime of active members of a pension plan.

The analysis that goes into calculating the amortization schedule relies on an assumption about the payroll growth rate and discount rate to be realized. Notably, the level-dollar amortization does not rely on an assumption about payroll growth, highlighting another advantage of the method. The discount rate, however, plays a critical role in the amortization of pension debt regardless of the method chosen. Setting the proper discount rate reduces the chance that the annual payments will not earn enough returns to pay off the debt eventually.

After thoroughly evaluating these policies, best practices for amortizing pension debt call for several recommendations, these include using level-dollar amortization, a closed schedule that does not exceed 15 years and setting appropriate discount rates. Plan sponsors should adhere to these principles to ensure the pension plan is equipped to fulfill its promises to existing retirees, as well as to assure the future robust functioning of the plan.

When adopting a particular amortization policy for a public pension, policymakers must consider a number of factors and tradeoffs. Time preference and budgetary constraints may prove influential forces in selecting from among the amortization method choices.

However, from the perspective of plan solvency and intergenerational equity, there are best practices that a pension plan can follow in adopting the best possible amortization policy.

(1) The level-dollar method is better than the level-percent method. Using level-dollar avoids actuarial assumption sensitivity, the potential for negative amortization, and requires lower total contributions over time compared to level-percent.

(2) Closed amortization schedules are better than open schedules. Using a closed schedule ensures the unfunded liability will actually be paid off. The open amortization approach violates the basic principles of intergenerational equity because the unfunded liability is never paid off.

(3) The length of an amortization schedule should not exceed the average remaining service years of the plan. This practice adheres the closest to the intergenerational equity principle. Today’s taxpayers, not future ones, should fund the pension benefits of today’s government employees. A good rule of thumb is to adopt schedules that are 15 years or less.

(4) The shorter the amortization schedule, the better. Shorter amortization periods may mean a higher level of contribution rate volatility, but they save costs in the long run and allow the pension plan to better recover from a significant near-term negative experience.

(5) Discount rates should appropriately reflect the risk of the plan’s liabilities. If the discount rate is too high, the recognized value of liabilities will be too low; thus, the value of unfunded liabilities that are amortized will be too low, and the plan will risk not having enough assets to pay promised pensions.

Plans that choose to adopt alternative policies to this gold standard can still make choices that aim for long-term solvency. Specifically:

(6) If using the level-percent method, adopt a closed design with a schedule of 15 years or less. Amortization schedules should always be closed, and the shorter the schedule, the better the policy.

(7) To avoid contribution rate volatility, use a layering method. Seeking to avoid spikes in amortization payments is an understandable budgetary goal, but it is best pursued by layering closed amortization schedules, rather than by using an open schedule.

Full Policy Brief: Best Practices for Pension Debt Amortization

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Best practices in hybrid retirement plan design https://reason.org/policy-brief/best-practices-in-hybrid-retirement-plan-design/ Tue, 20 Sep 2022 04:22:00 +0000 https://reason.org/?post_type=policy-brief&p=58068 Intelligently designed hybrid retirement plans provide similar pension benefit accruals for employees at a much lower risk to the states and local governments who provide them.

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Introduction

The hybrid retirement pension plan design, a design that typically combines a guaranteed benefit and 401(k) style individual retirement account, has seen ever-increasing interest from public sector employers in the United States since the market downturns of the late 2000s. Although hybrid retirement plans have been around for decades—notably one of the first adopters being the Federal Employee’s Retirement System—most stakeholders know relatively little about their purpose and possible structure.

A hybrid plan’s goals are no different than any other retirement benefit design’s goals: to provide adequate benefits to workers at an affordable cost to them and their employers. Yet hybrid plans are also beginning to help answer a political question in the wake of the stock market volatility in the last 20 years: What is the appropriate level of risk that employers should shoulder to provide retirement benefits to their employees? The viability of future traditional defined benefit pension plans may depend on a common outlook on this question from both employers and participants.

The recent shift toward offering hybrid plans to newly hired government employees suggests that governmental employers may be changing their perceptions of the balance of financial risk between employees and employers and whether governments should put greater risk of investment returns on employees by distancing from the traditional defined benefit pension. Employee and labor associations on the other hand, often have extreme— whether fair or not—biases against the 401(k)-style defined contribution retirement plans that are typical in the private sector.

The hybrid retirement plan offers policymakers and stakeholders a potential compromise between the two opposing viewpoints, potentially offering a “best of both worlds” blended approach.

As with the design of any pension system, the quality of a hybrid plan comes down to how it is structured. A well-designed hybrid strikes a proper balance of risk between employees and employers while putting career-long employees on a secure path to retirement and granting non-career members the flexibility they need to get the most out of their retirement contributions. Intelligently designing the defined contribution portion of the benefit is crucial, as generally half of the hybrid employee’s retirement benefits will be paid out of their accumulated assets.

When designing the DC, policymakers need to ensure proper contributions are being made by employees (and sometimes employers), grant a wide array of investment options, and offer annuities to guarantee lifetime income.
Although the path to an adequate retirement benefit may look different from a traditional pension, intelligently designed hybrids have nonetheless shown to provide relatively similar pension benefit accruals for employees—at a much lower risk to the states and local governments who provide them.

Full Policy Brief: Best Practices in Hybrid Retirement Plan Design

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Best practices for cost-of-living adjustment designs in public pension systems https://reason.org/policy-brief/best-practices-for-cost-of-living-adjustment-designs-in-public-pension-systems/ Thu, 18 Aug 2022 04:00:00 +0000 https://reason.org/?post_type=policy-brief&p=56763 Gold Standard in Public Retirement System Design Series Inflation’s impact on the purchasing power of retirement benefits and savings needs to be managed when designing and funding effective retirement plans. Periods of high inflation show how important properly designing inflation … Continued

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Gold Standard in Public Retirement System Design Series

Inflation’s impact on the purchasing power of retirement benefits and savings needs to be managed when designing and funding effective retirement plans. Periods of high inflation show how important properly designing inflation protection measures is in public sector defined benefit (DB) pension plans.

These plans have addressed this dilemma in different ways over the years with varying degrees of effectiveness. More recently, public sector pension reform efforts have often significantly changed how cost-of-living adjustment (COLA) and post-retirement benefit increase (PBI) features are designed and funded.

This brief focuses on how state and local government defined benefit public employee retirement systems have used cost-of-living adjustment benefit features to address inflation’s risk to retirement security. It also provides a set of best practices to help guide policymakers and stakeholders in designing and funding inflation protection design elements for their defined benefit pension plans.

Executive Summary

Cost-of-living-adjustment (COLA) benefits are a common feature of many public employee retirement systems used to provide a level of protection against loss of purchasing power in retirement resulting from inflation. Public defined benefit (DB) pension plans use a wide variety of COLA benefit designs and funding methods that have led to a mixed bag of outcomes for retirees and have often exacerbated existing underfunding problems.

The principal problem with most COLA benefit provisions is failing to treat it as one of the plan’s core benefit objectives and to prefund it the same way as the primary retirement benefit. Instead, too many plan sponsors apply ad hoc COLAs unevenly. In addition, there is an issue of inconsistent timing. Moreover, not enough thought is given to how actual inflation impacts those who receive the increase. And finally, too little consideration is given to how the increase impacts the total program’s long-term funding.

This brief identifies several proposed best practices to guide public plan sponsors to a more coherent and financially sustainable COLA benefit design and funding for their pension systems. The best practices include:

  • Best Practice #1 – Public pension plan sponsors should create a formal cost-of-living adjustment benefit policy that is an integral part of the overall retirement plan objectives. This provides clarity for the retirees, sets expectations properly, and provides guardrails for future policymakers when faced with changing circumstances.
  • Best Practice #2 – The COLA benefit design should clearly identify 1) who is eligible for the COLA, 2) what benefit the COLA applies to, and 3) when it is payable. This is necessary to force recognition of the reality that the plan cannot and should not provide unlimited inflation protection for all participants.
  • Best Practice #3 – The COLA amount should reflect an objective inflation benchmark. This helps provide a more predictable amount of inflation protection and more equitable distribution of benefits for similarly situated retirees.
  • Best Practice #4 –The COLA Benefit amount should be consistent, predictable, and clearly communicated to the retirees. Retirees need to have a firm understanding of what COLA benefits will or will not be provided to set expectations and to allow them to manage their retirement assets and income more effectively.
  • Best Practice #5 – The COLA benefit amount should be limited. This recognizes that inflation varies over time and that the COLA benefit design distinguishes between “normal” inflation and periods of high inflation that are more difficult to predict. Establishing limits or caps on the COLA benefit is needed to allow more sustainable funding approaches.
  • Best Practice #6 – COLA costs should be pre-funded as part of the overall normal cost of the retirement plan. Pre-funding of COLA benefits is essential to ensure the consistent delivery of inflation protection to retirees and to avoid the creation of unfunded liabilities. It also avoids the creation of complicated and unpredictable COLA funding schemes, such as investment gain sharing or actuarial funding margin reserve allocations.
  • Best Practice #7 – COLA benefits should be subject to change for future accruals and new employees. COLA benefits should be subject to adjustment for future accruals for current active employees and for new hires to create benefit design and funding flexibility under changing circumstances.
  • Best Practice #8 – Plan sponsors must stop making the same mistakes. This recognizes that it is important to break the cycle of suboptimal COLA practices.
  • Best Practice #9 – New practices must refrain from trying to fix all past inflation. Not all past inflation has to be fixed. This recognizes that there are limited public funding resources, and prioritization among competing demands for the public treasury is necessary.

Cost-of-living adjustment design and funding are complicated at many levels. The need for some inflation protection for public pension retirees is clear, but resources to provide protection are limited. This means public pension plan sponsors should carefully craft COLA benefit and funding policies that help maintain financial security for retirees but do so in a financially prudent and risk-managed basis.

Following the best practices outlined in this paper should provide some important guardrails for designing effective COLA benefits, which will help plan sponsors as they strive to strike the proper balance between cost, risk, and benefit in a way that works for both employees and employers.

Full Brief — Best Practices for Cost-of-Living Adjustment (COLA) Designs in Public Pension Systems

This policy brief is part of the “Gold Standard in Public Retirement System Design Series,” which reviews the best practices of state-level public pensions and provides a design framework for states that are struggling under the burden of post-employment benefit debt.

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Defined Benefit Plans: Best Practices in Incorporating Risk Sharing https://reason.org/policy-brief/best-practices-in-incorporating-risk-sharing-into-defined-benefit-pension-plans/ Wed, 02 Dec 2020 19:30:35 +0000 https://reason.org/?post_type=policy-brief&p=38669 Public pension risk sharing can increase plan solvency, provide better accountability, and lessen the burden that unfunded liabilities have on taxpayers.

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Gold Standard in Public Retirement System Design Series

Introduction

For public sector pension systems across the United States, the past 20 years have seen a steady increase in unfunded liabilities—the difference between promised pension benefits and the assets in hand needed to pay those benefits—resulting in rising taxpayer costs and ultimately harming public employees’ take-home pay and benefits.

The most popular public pension plan design, the defined benefit (DB) pension plan, tends to be exposed to various forms of risk. Managing that risk and future costs is critical for the solvency of U.S public DB pensions, given that entering 2020, states were carrying over $1.2 trillion in public pension debt.1

Where did all this debt come from?

After all, most public pension plans were thought to be well funded up until the late 1990s. However, taking a closer look at the assumptions most plans used—covering a range of factors including investment return, inflation, discount rate, mortality, longevity, and more—shows a different picture.

By leaving assumptions regarding investment return and discount rates too high, contribution amounts were lower than what was required to pay for retiree benefits. Leaving them too high for an extended period compounded that error and put public sector pension plans in the position they are in today, with assumed investment returns averaging 7.2% nationally, while actual returns over the past 20 years totaled just 6.4%.

For public sector pension systems across the United States, the past 20 years has seen a steady increase in unfunded liabilities—the difference between promised pension benefits and the assets in hand needed to pay those benefits—resulting in rising taxpayer costs and ultimately harming public employees’ take home pay and benefits.

Outside of the debt element of pensions, employees and taxpayers must also look at the costs and benefits of the offered pension design itself. Are benefits too generous, forcing higher percentages of paychecks into the pension system? As an employee, are you planning on working the same job your entire career? And if not, are there more beneficial plan design options for employees like yourself?

What is Risk Sharing?

What does sharing risk mean in the context of public pensions? Basically, it means that employees join employers in sharing the risk that the actuarial assumptions required of DB pension plans are not met. Employees and employers share a percentage of any future unfunded liability amortization payments. For example, if the plan’s actual rate of return underperforms relative to the assumed return, resulting in unfunded liabilities, taxpayers will not bear 100% of the costs as they do in non-risk-shared plans. This risk sharing also incentivizes good retirement board decision-making, given the explicit knowledge that working employees have a much lower tolerance for risk and the immediate impacts to take-home pay.

Most U.S. state and local government DB plans failed to make structural changes after the market performance blows of the past 20 years, and have consequently seen their funding levels dip to historic lows year after year.

The concept of pension “risk” has only recently become a subject of interest for national organizations like the Actuarial Standards Board. Most U.S. state and local government DB plans failed to make structural changes after the market performance blows of the past 20 years, and have consequently seen their funding levels dip to historic lows year after year.2

Historically, unexpected increases in pension costs have fallen to the employer in nearly all public plans, which has placed an increasingly heavy burden on state and local budgets, not to mention the taxpayer. The past decade has therefore seen major reforms aimed at rebalancing the burden of unfunded liabilities/pension debt between employers and employees so both parties carry a part of the risk.

Pension risk can express itself in a variety of ways, but typically falls into one of four categories:

  • Investment Risk: This refers to the risk that a plan’s investment target will fall short in any given year. The investment return assumption—or assumed rate of return (ARR)—is the most important assumption in terms of its effect on a plan’s solvency, as investment returns have accounted for around 60% of all public pension assets over the past 30 years.3 4 Consequently, if plans’ actual returns consistently fall below the ARR, larger contributions will be required from plan stakeholders to make up the funding gap. This problem is likely to continue to be the most significant contributor to unfunded liabilities.5
  • Longevity Risk: There is also risk that retirees will live longer (on average) than is expected, and will consequently collect more pension payments than were originally accounted for.6 This unexpectedly increases the amount of benefits that will be paid to retirees, meaning assets saved throughout their careers will not be sufficient to cover promises made by employers.
  • Contribution Risk: Contribution risk is the possibility that actual future payments into the pension system deviate from what was expected. One measurement of contribution risk is the likelihood of a plan rapidly raising required payments due to funding shortfalls from not making adequate payments in the past. No matter the contribution policy, plan stakeholders—mainly employers but sometimes also employees—inevitably see their contributions go up when a plan chronically falls short in funding
  • Plan Maturity/Design Risk: There is also risk that the design of the pension plan itself is unsustainable, especially as the nation’s general population ages. Older, more mature pension plans tend to operate with different dynamics than newer pension plans. Older plans have an active-to-retiree ratio that is steady, while newer plans will have a rapidly decreasing ratio as members reach retirement age. Nationwide this ratio continues to fall, meaning plans are seeing more retirees in relation to actives, which shifts risk of pension debt onto future contributions.6 This additional risk is a result of the fact that any increase in unfunded liabilities—usually due to poor investment returns or chronic underpayments—will have to be amortized and funded using the payroll of a smaller group of active members.

Moving Toward Sharing Risk

Plan sponsors seeking to implement cost-sharing principles into their plans can take a few different strategies.

One strategy is to realign funding policy to implement a 50/50 (or similar split) cost sharing approach between employees and employers, meaning that for every dollar an employer is required to contribute into a pension plan, the employee is also required to contribute a dollar.

Another strategy has been to tie benefit levels to plan experience, with one example being a variable cost of living adjustment (COLA). When investment returns exceed what was expected, retirees would receive an additional increase to their yearly benefit amount in the form of a COLA. When investment returns fall short of what was expected, they would either not get an increase, or have their COLA reduced for the year.

One strategy is to realign funding policy to implement a 50/50 (or similar split) cost-sharing approach between employees and employers, meaning that for every dollar an employer is required to contribute into a pension plan, the employee is also required to contribute a dollar.

Another strategy is to change the plan design to a more risk-shared DB, hybrid, cash balance, or choice plan (option of choosing between any of the previous examples). One of these newer designs is the side-by-side hybrid retirement plan—a combination of a 401k-style savings plan supplemented with a risk-reduced DB. This hybrid uses contributions from both members and employers, typically in a 50/50 cost-sharing split, with members paying into the savings plan portion and employers covering the DB portion. Another newer design in post-employment benefits is the cash balance plan, where accrued contributions belong to an individual’s own account, an employee is guaranteed a minimum return on their account, and their benefit in retirement is determined by the value of their account.

Lastly, no matter the funding policy or plan design, pension plan sponsors must pay their bills when they come due and not allow politics to insert themselves where they should not.7 The long history of public defined benefit plans has seen quite a few poor funding decisions.


Four Common Plan Design Errors

Struggling public pensions have at least one of these four past poor decisions8 that helped lead to their current debt burden.

  • Policymakers sometimes choose to set contribution rates in statute based on what they want to pay, as opposed to what the actuaries calculate is required to contribute each year to continue making pension funding progress.
  • Some states (most notably, California near the turn of the century) have taken pension fund surpluses and, in the interest of raw politics, have used them to finance retroactive benefit increases to employees.
  • Some states vest in the legislature the authority to statutorily grant “13th checks” and other supplemental benefit increases at their discretion, depending on fiscal conditions in the pension plan, which risks spending down investment gains as they materialize instead of banking them to create a cushion that will likely be needed down the road when the next downturn hits.
  • In other states, policymakers have authority over the pension fund asset portfolio, allowing them to override the pension plan’s investor team’s investment strategies with political goals. This politicization aims to alter which companies or sectors plans invest in, or more commonly, divest from.

Risk-Sharing Principle #1: Cost Sharing

A cost sharing policy distributes the cost of the pension plan, and any future increases or decreases to that cost, equally between employees and employers. The defining function of a cost-sharing policy is for both employers and employees to be paying into the employees’ pension. Most public employees have long been required to contribute some percentage of their salary to their pension. Historically, however, this amount was set in statute at the time of plan origination, and any plan experience—investment performance, salary growth, mortality, and other assumptions differing from expectations—that added costs or unfunded liabilities became the responsibility of employers.

Equalizing employee and employer payments allows pension plans to avoid the lag from this cumbersome process and gives both groups equal skin in the game when it comes time to adjust assumptions, or when discussing benefit increases and/or reductions.

But since 2009 more than 35 states have increased employee contributions to make up for the massive investment losses from the Great Recession and decades of investment experience below expectations.9 These adjustments to employee contributions usually entail difficult and politically charged legislative action. Equalizing employee and employer payments allows pension plans to avoid the lag from this cumbersome process and gives both groups equal skin in the game when it comes time to adjust assumptions, or when discussing benefit increases and/or reductions.

50-50 Cost-Sharing Plans

While nearly all public employees are required to contribute to their pension, many plans have fixed percentages that they require employees to pay, while others allow the employee contribution rate to be set by the legislature or retirement board. Some plans will say they cost-share, but only for the normal cost of the plan—meaning all risk of assumptions not meeting expectations goes on the employer, which is the taxpayer. The most equitable solution is for an employee’s entire contribution to be directly tied to the employer’s entire contribution. In layman’s terms, this means that as normal and unfunded liability costs go up for employers, they go up equally for employees. When costs go down for employers, costs go down equally for employees. This equal, shared contribution rate takes some of the burden off employers for future risk and puts more management of that risk into employees’ hands. If investment return assumptions are too high and the plan consistently fails to meet it, employees and employers will both be paying more.

Examples of good 50/50 cost-sharing design include:

  • Arizona Public Safety Personnel Retirement System (PSPRS tier 3) and Arizona State Retirement System (ASRS);
  • Colorado Public Employees’ Retirement Association (PERA);
  • Maine Public Employees’ Retirement System;
  • Michigan Public School Employees’ Retirement System (MPSERS tier 2);
  • Pennsylvania State Employees’ (SERS) and Public School Employees’ Retirement Systems (PSERS);
  • South Dakota Retirement System (SDRS);
  • Washington State Retirement System Plan 2s; and
  • Wisconsin Retirement System (WRS).

Risk-Sharing Principle #2: Affordable Benefit Design

There is no one-size-fits-all approach to affordable benefit design for public employees. The most popular pension benefit designs—defined benefit, defined contribution, cash balance, and hybrid—all have current examples of being affordable for taxpayers and employees.

Defined Benefit Plan Design

Under a traditional defined benefit (DB) plan, an employee is promised a specific amount of monthly retirement income for their lifetime. This amount is based on a formula that includes the member’s years of service, their age at retirement, their average salary during the last few working years of their career, and a multiplier. Most public sector DB plans generally range between a 2% to 3% multiplier. A sample calculation for a member who worked 25 years and had a $60,000 average final salary would be:

2% x 25 years x $60,000 = $30,000 annual benefit

Where DB plans get in trouble is adjusting parts of this formula for a benefit increase, adding other accessory benefits that balloon the cost of the plan for employers and employees, or capping the costs of these benefits. For example, if the plan decided to increase the member’s multiplier to 2.5%, they would then receive a $37,500 annual benefit each year in retirement. That additional $7,500 each year must be paid for during the member’s working career through additional contributions. For plans that do not have cost sharing, that means the employer is on the hook for that amount each year until the employee dies.

Case Study: South Dakota Retirement System (SDRS)

South Dakota takes a different approach to risk sharing than most, and it has worked tremendously for the plan as it is one of only seven public pension plans at a 100% funded ratio or higher as of 2018.10 While it has enacted a 50/50 cost-sharing split between employee and employer, SDRS also locks their contribution rates in statute at 6%.11 Rather than allowing contribution rates to rise and fall with actuarial experience like most cost-sharing plans, SDRS instead adjusts the plan’s benefit levels through manipulation of the COLA. This has the benefit of contribution rate stability for members and employers, as members will no longer worry about having more of their salary impacted by rising contribution rates, and employers will have much-desired budget stability during down periods and not be forced into the types of layoffs that have been seen in other states.12

Rather than allowing contribution rates to rise and fall with actuarial experience like most cost-sharing plans, SDRS instead adjusts the plan’s benefit levels through manipulation of the COLA.

Case Study: Canadian Pension Plan

The Canadian Pension Plan (CPP) was originally a pay-as-you-go-plan, meaning benefits for one generation were largely paid for by later generations.13 The system’s founders believed this made sense at the time due to low returns on investments and other demographic conditions. However, rapid increases in benefits, as well as an influx of disability claims in the 1970s, 1980s, and 1990s, resulted in significantly higher costs. The plan’s finances crunched severely in the mid-1980s as asset values plummeted and contributions from taxpayers and employees began to increase quickly. According to the 2017-2018 annual report on Canada’s Pension Plan:

In 1993, CPP projected that the pay-as-you-go rate would be 14.2% by 2030. Continuing to finance the CPP on a pay-as-you-go basis would have meant imposing a heavy financial burden on the future Canadian workforce. This was deemed unacceptable by the participating governments.

In the late 1990s, reforms began to raise the funding level of the CPP. Changes included:

…increasing the contribution rates over the short term; reducing the growth of benefits over the long term; and investing cash flows not needed to pay benefits in the financial markets through the new CPP Investment Board (CPPIB) in order to achieve higher rates of return. A further amendment was included to ensure that any increase in benefits or new benefits provided under the CPP would be fully funded.14

If these minimum rates are ever higher than what is in statute, that statutory rate would automatically be increased through a three-year phase-in, and all cost of living adjustments would cease until that three-year phase-in is complete.

Hybrid Plan Design

The DB/DC hybrid seeks to create a shared-risk alternative to the typical DB structure. Instead of a larger benefit being fully guaranteed by the employer based on a years-of service and final-average-salary formula, the hybrid aims to provide a reduced-risk guaranteed benefit alongside an employee-sponsored defined contribution (DC) account. Combining these two features helps manage the risk of growing pension costs for employers and keeps a career member’s benefit at retirement roughly the same. For noncareer employees, a hybrid is a far better choice than a straightforward DB plan, because hybrids allow the DC portion of the benefit to go with the employee when they change careers, while a DB member is only entitled to a refund of their contributions if they choose to change careers prior to vesting.

For non-career employees, a hybrid is a far better choice than a straightforward DB plan, because hybrids allow the DC portion of the benefit to go with the employee when they change careers, while a DB member is only entitled to a refund of their contributions if they choose to change careers prior to vesting.

Case Study: Federal Employees Retirement System (FERS)

The FERS hybrid was created in the mid-1980s to solve two problems. First, Social Security was undergoing a major cash-flow crisis, and the creation of a new plan for federal employees that allowed them to participate in Social Security would partially alleviate that crisis. Second, the plan all federal employees were in at the time—the Civil Service Retirement System (CSRS)—was not sustainable and had never been fully funded by employer and employee contributions, as shown by the total unfunded liability sitting at $968.1 billion in 2017.

Retirement income for new federal employees hired after 1986 would come from the three components of what many know as the three-legged stool of retirement security: Social Security, a defined benefit (DB) pension, and individual defined contribution (DC) retirement savings. A new, more affordable annuity was offered under FERS—one that was fully funded by the sum of employee and employer contributions and interest earned by the Treasury bonds—and the DC account became known as the Thrift Savings Plan. Both the

Social Security and Thrift Savings Plan dollars are able to follow the employee to a new career if they so choose.

Case Study: Utah Retirement System

Utah had one of the best-funded pension systems in the country going into the 2008 market downturn. After the downturn, the state had lost about 22% of the value of its pension fund almost overnight. Former Utah State Senator Dan Liljenquist spoke with Reason in 2013, stating:

It was the biggest loss we’ve ever sustained as a system. As we started looking at it, we realized that even though we were well-funded, that the 22 percent loss in value actually opened up a 30 percent gap in our pension funding ratio—our funding ratio dropped from about 100 percent in 2007 to a projected 70 percent by 2013—even though we had paid every penny that the actuary had asked us to over the previous several decades. So one market crash opened up a 30 percent gap in our pension funding ratio.15

Following the 2009 recession, contribution rates for the Utah Retirement System (URS) were projected to spike and remain high for the next two decades. The Utah Legislature responded to these projected higher rates in 2010 by passing Senate Bill 63, which was sponsored by Dan Liljenquist. For all newly hired employees (post July 1, 2011), employer contributions were capped at 10% of pay, and all employees had the choice to opt into a hybrid plan or a DC plan. As of 2015, about 80% of all newly hired employees chose the hybrid over the DC.16 One unique feature of this hybrid plan is that employees only contribute to the plan if the normal cost of the plan exceeds 10% (or 12% for public safety personnel). Thus, whenever required contributions exceed 10%/12%, that amount is fully borne by employees. When the cost of the hybrid is less than 10%/12%, the employees receive the difference into a supplemental account, such as a 457 individual retirement account.

As alluded to previously, one significant benefit to the employers in URS’ new plan is that their rates will always remain relatively stable due to the 10% cap on contributions. This means any market downturns or other negative actuarial experience is on the employee’s shoulders, which is a worthy trade-off due to the plan otherwise being non-contributory for employees.

…one significant benefit to the employers in URS’ new plan is that their rates will always remain relatively stable due to the 10% cap on contributions.

Case Study: Oregon Public Service Retirement Plan

The Oregon Retirement System has modified its pension benefit structure twice in the past 25 years. The latest change, which occurred in 2003, put all new hires into a DB/DC hybrid plan: the Oregon Public Service Retirement Plan (OPSRP). The DB portion of the hybrid is fully funded by employers, while the DC portion is funded by a 6% employee contribution rate. Historically, this 6% was “picked-up” by Oregon employers, making the entire hybrid plan employer-funded. This pick-up has recently begun to phase out17 over the past year to reduce employer costs and foster cost-sharing principles.

The introduction of OPSRP increased the retirement age from 60 to 65 and dropped the benefit multiplier from 1.67% to 1.50%. OPSRP was designed to have the DB pension provide approximately 45% of a member’s final average salary at retirement (for general service members with a 30-year career), and the DC portion—the Individual Account Program (IAP)—to provide an extra estimated 15%-20% of a member’s final average salary.18 Under this plan, both benefits together net a career employee with an income replacement ratio of roughly 60%-65%.

Cash Balance Plan Design

A cash balance plan is a fusion of the individual accounts of DC plans and the lifetime benefits of DB plans. In a standard cash balance plan, the member receives their own individual retirement account like in a DC plan, which is then credited with an annual employer contribution and an annual interest credit.

Like a DB mechanism, this interest credit is guaranteed, usually at or just above the riskfree rate, and any plan investment experience below what is assumed is borne by the employer. When a member elects to retire, their annuity benefit will be based on their final account balance. Conversely, most cash balance plans allow the members the flexibility to simply take a lump sum of their account balance in lieu of receiving an annuity.

Cash balance systems can offer several advantages for public employees. One is that they are portable, and therefore a better fit for younger employees who are more likely than the previous generation of workers to change jobs.

Cash balance systems can offer several advantages for public employees. One is that they are portable, and therefore a better fit for younger employees who are more likely than the previous generation of workers to change jobs. Much like with a DC plan, cash balance members can take their account balance with them when they leave. Another pro is that the CB, much like a DB, offers a guaranteed return to plan members, taking much of the investment risk off their backs, yet still offering up-side protection during years of extraordinary investment performance.

Generally, this means that, of any investment return above what is guaranteed, some percentage of that will be granted to employee’s accounts. These types of plans establish a no-worries fixed rate of return and the possibility of a dividend in good years. Lastly, unlike many DC plans, members do not have to manage their own investments, and they can instead enjoy the benefits that come with a large, professionally managed fund. In a CB plan, the employee and employer contributions are co-mingled, and the state manages the investments in the plan just as it does in a traditional DB pension plan.

Case Study: Kentucky Retirement System (KRS)

The Kentucky cash balance is the third tier under KRS, open to all public employees—except for teachers—hired in 2014 or later. Tier 3 requires both employee and employer contributions and guarantees a minimum level of annual growth. Tier 3 replaced one of the worst-funded DB plans in the country, but because the cash balance assets are pooled with the legacy tiers, it does not receive its own actuarial valuation. This makes it hard to see the necessary contributions and outlook for Tier 3 and its positive effect on the state’s finances.

Functionally, Tier 3 grants an interest credit of 4% annually on both member and employer contributions. If investment returns exceed 4%, the member earns an increased benefit based on the five-year average geometric investment return. That benefit increase is 75% of the amount of returns over 4%.

Case Study: Nebraska Public Employees Retirement System (NPERS)

Cash balance plans in Nebraska were introduced in 2003 for new state and county public employees. These were the first non-DC plans offered in the state since the mid-1960s. As with most CB plans, this plan is exceptionally well funded, with the state plan at 104%. Governments that offer CB plans don’t have to worry about large funding shortfalls, because any impact of a bad year or two in market returns is softened by interest credits that tend to be lower than assumed rates of return in DB plans, not to mention the cushion provided by portions of returns that exceed the guaranteed rate. NPERS also offers an interest credit but takes a different approach than Kentucky. While there is a minimum interest credit of 5% in statute, the plan actually uses a rate based on the federal mid-term rate plus 1.5%.

Retirement Plan Design Choice

Plan choice is an important aspect of good pension design because not all members in the system are entering the workforce at the same time or have the goal of working in a job covered by that pension system for their entire career. A DB plan is structured to most benefit the long-term employee who will work and contribute for 30+ years in that plan. A DC plan will appeal to young new hires who might not want to work that long, those who want to start a new career and might already have a 401k from a private sector job, and management-level hires who are brought in from out of state and who don’t intend to work for more than 10 to 15 years in a DB plan. Providing prospective employees with two or more options for a pension benefit—a traditional defined benefit, a defined contribution retirement plan, cash balance plan or a DB/DC hybrid—will be most advantageous for the most members, as well as the least risky for employers as fewer members choose the pure DB system.

Providing prospective employees with two or more options for a pension benefit—a traditional defined benefit, a defined contribution retirement plan, cash balance plan or a DB/DC hybrid—will be most advantageous for the most members, as well as the least risky for employers as fewer members choose the pure DB system.

Case Study: Arizona Public Safety Personnel Retirement System (PSPRS)

Arizona sought to fix its ailing public safety plan in 2016 by creating an entirely new plan design for its future members.19 Employees hired after July 1, 2017 were given the option of entering a reduced-risk DB plan or a professionally managed DC plan. The risk-sharing features included a full 50/50 split on normal costs and any future debt costs, the limitation or elimination of paying out cost of living adjustments if the new DB tier falls below 90% funded (reducing the maximum pensionable salary allowable under the benefit calculation from $265,000 to $110,000), and capping any annual cost of living adjustment at no more than 2% of the members benefit.

PSPRS funding policy was changed to improve the plan’s long-term outlook and reduce total costs to taxpayers. For the new tier, a new policy requires that any debt payments—also known as amortization payments—toward paying down unfunded liabilities be made within 10 years. Having a longer debt payment schedule keeps debt costs low in the short term, but typically adds enormous amounts of interest onto the debt, thereby increasing total costs in the long term.

Having a longer debt payment schedule keeps debt costs low in the short term, but typically adds enormous amounts of interest onto the debt, thereby increasing total costs in the long term.

Lastly, the reforms prohibited employers from taking any future contribution rate holidays when the plan experiences a funding surplus. This makes certain that employers always pay the full costs needed for benefits as they accumulate. Paying the full cost is discussed later in Part 6.

Case Study: Michigan Public School Employees Pension Plus II (MPSERS PPII)

The year 2017 saw some major changes to MPSERS by auto-enrolling all new hires into a new DC plan, but also allowing employees to opt-in to a de-risked DB/DC hybrid plan instead if they chose. The DC plan starts out at a minimum 10% total contribution rate, with auto-escalators to 14% within four years. The hybrid plan had risk sharing built into it from the ground up. All normal costs and any potential debt payments in PPII have full cost sharing between employee and employer, the assumed rate of return is capped at a 6%, and any future debt must be amortized over a 10-year, level-dollar, layered basis.

Layered amortization comes into play when the plan experiences additional actuarial losses while paying off the current unfunded actuarial liability (UAL). In this case, the plan will not combine these new losses with the old UAL. Instead, it will create a separate 10-year closed amortization schedule for this new debt to be paid off, therefore not affecting its payment or schedule on the old debt. Level-dollar amortization means the plan expects to pay the same dollar amount each year of the schedule, rather than being tied to a salary growth assumption wherein plans pay less in the early years of the schedule due to assumed increases in plan payroll. Michigan passed a law to have MPSERS transition down to a 0% payroll growth assumption, getting the plan effectively to level dollar on its legacy debt as well.

Another unique feature in the PPII plan is the policy that, should the hybrid plan’s funded ratio drop below 85% for two years in a row, the hybrid plan will be closed until that status improves, and all new hires will be put into the existing DC plan during that period. One last aspect of plan choice is that it benefits not just members, but the pension system as well through reduced actuarial liabilities when members choose to enter the DC plan.

Risk-Sharing Principle #3: Flexible Cost of Living Adjustments

While a proven method for cost sharing, a 50/50 contribution policy is not the only way to promote shared responsibility. Some states have taken risk-sharing measures by adjusting employee benefits and cost of living payments. A cost of living adjustment (COLA) is a tool meant to help retirees make up for the effects of inflation on their pensions. Traditionally, some public pension plans use either an automatic COLA, meaning that each year a member is retired, they are granted a certain percentage increase to their annual pensions, typically anywhere from 0%-3%. Other public pension systems use ad-hoc COLAs, meaning retirees are granted an adjustment only when actual inflation reaches a certain threshold.

Case Study: South Dakota Retirement System (SDRS)

SDRS’s policy of adjusting the COLA, rather than allowing contribution rates to rise and fall with actuarial experience, greatly enhances contribution rate stability for members and employers. Members will no longer worry about having more of their salary impacted by rising contribution rates, and employers will have much-desired budget stability during down periods and not be forced into the types of layoffs that have been seen in other
states.20

The plan went a step further with benefit adjustments in 2017, which enrolled new hires into what SDRS called their “Generational” plan. This new plan mimics the defined benefit structure of its predecessor, but differs by eliminating the ability for members to be granted an early retirement subsidy and pushes the normal retirement age up to 67. In exchange, plan members are granted a higher benefit multiplier. These changes were enacted with the goal of producing a net savings to SDRS. Overall, the plan states that SDRS’ long-term desire for members is to provide a lifetime income replacement of at least 55% of the member’s final average salary, alongside some modest inflation protection through a cost of living adjustment.21

As mentioned previously, because the plan uses a fixed total contribution rate of 12%-6% (member) and 6% (employer), any future COLA payments must allow the plan to remain well-funded. SDRS manages this by setting lower maximums for its COLA payments when the plan drops below 100% funded.

If the plan is not forecasted to be at 100% funding, a lower maximum COLA will be enacted moving forward.

Further COLA changes were made in 2017 to safeguard SDRS’ goal of 100% funding.22 The plan actuaries are now required to determine for each valuation if the plan’s funded status will remain at 100%, assuming future COLAs are equal to the amount given the prior year. If the plan is not forecasted to be at 100% funding, a lower maximum COLA will be enacted moving forward.

Case Study: Wisconsin Retirement System (WRS)

Wisconsin is also one of the seven states with a funded ratio at or above 100%. The benefit structure is set up in a way that rewards short-term and long-term employees by offering two sets of annuities. The first, a formula-based defined benefit, and the second, a money purchase benefit that mimics a traditional defined contribution plan. WRS calculates the yearly annuity amount using both benefit structures, and provides the member with the greater dollar figure. Because of the accumulation structure of DB plans, the formula-based benefit favors longer-term employees, while the savings account aspect and the portability of the money purchase benefit fulfill the interests of shorter-term employees. A 2015 study from the Wisconsin Legislative Fiscal Bureau showed that about 74% of retirees received the formula-based pension benefit.23 Another benefit to shorter-term employees is the ability to place their contributions into a higher-yield portfolio called the Variable fund, allowing these members the chance at greater returns but at a higher level of risk.

The adjustable benefit comes into play at WRS because the plan does not offer any sort of guaranteed cost of living adjustment. Instead, the system only allows additional payments to retirees when investment returns are above the minimum threshold of 5%, but it does reduce a retiree’s benefit during periods of poor market performance.24 This benefit reduction is applied only to any additional payments granted by WRS in previous years, and does not affect the retiree’s base benefit.

…the system only allows additional payments to retirees when investment returns are above the minimum threshold of 5%, but it does reduce a retiree’s benefit during periods of poor market performance.

Risk-Sharing Principle #4: Pay the Bill, Or Else

All the previous principles mean nothing if plan sponsors do not pay their bill by meeting actuarially required contributions each year. This amount is based on numerous assumptions, so it is vital that plan sponsors maintain the discipline to always pay 100% of their determined costs. Just a few of these assumptions include:

What the plan will earn on investments;

  • How long members of the plan will live, and thus receive benefits;
  • How to pay off unexpected pension debt;
  • How much salaries will grow in the plan;
  • How much inflation will change per year; and
  • How membership will change in the plan, year to year.

Typically, a plan fails to pay 100% of its bill in a given year due to economic recessions and taking funding holidays to pay for other, more politically motivated programs.

State and local governments often do not have the necessary funds to pay into their pension systems when tax revenues decline.

For example, during the last recession (from 2008 to 2009), state tax income fell by 17% because of the slow down in economic activity. This reduced the money available in state budgets by billions of dollars. One of the common choices for states during and immediately after the recession was to reduce the amount of money paid into pension funds to balance state budgets. Depending on the situation, this may be a reasonable policy choice given various competing interests and need for trade-offs.25

As for funding holidays, they typically happen when a plan has surplus assets—more assets than liabilities—and thus, on paper, exceeds a 100% funded status. When a legislator or employer sees that, they may feel that a year off from paying required contributions to fund other projects might not be a bad idea. And this might be true if investments were a guaranteed venture, but they are not. Because investments have volatility, and some years will be better than others, not paying the bill during good times means you will be paying even more during bad times.

Case Study: Washington State Public Employees and Teachers Plan 1s (PERS 1 and TRS 1)

Washington State was an early adopter of pension reform, closing off its legacy plans (known as Plan 1s) in 1977 and putting all new hires into what are called Plan 2s. One major change accompanying the introduction of the Plan 2s removed fixed employee contribution rates from statute, allowing rates to be raised or lowered from year to year when plan experience didn’t match expectations. While this removed some of the predictability of rates for employees and increased their exposure to investment risks, it has greatly enhanced new hires’ plan solvency.

Unfortunately, Washington State’s legacy plans have turned into a cautionary tale for improper cost sharing, but in this case, it was the employers—not the members—that failed to pay their fair share.

Unfortunately, Washington State’s legacy plans have turned into a cautionary tale for improper cost sharing, but in this case, it was the employers—not the members—that failed to pay their fair share. In the years following the 2000 recession the employers paid far less than was required, leading not only to insufficient contributions, but also to payments that fell well below the rates paid by employees. While PERS 1 employees were mandated to pay 6% into their plan, employers only paid between 1.77% to 2.44% from 2001-2005. TRS 1 employees also paid 6%, while TRS employers paid between 1.28% and 2.92%. This put PERS 1 and TRS 1 into massive debt, as they are by far the worst-funded plans in the state. PERS 1 is 60% funded with $4.7 billion in unfunded liabilities, while TRS 1 is 63% funded with $3.1 billion in unfunded liabilities.26

In sharp contrast are the funded levels of the reformed plans: Law Enforcement Officers and Firefighters Plan 2 (109%), Public Employees Plans 2/3 (91%), Teachers Plans 2/3 (90%), School Employees Plans 2/3 (89%), and Public Safety Employees Plan 2 (96%).

Because of the lack of discipline to follow the statutory 6% cost-sharing provisions that were enacted some four decades prior, all current PERS and TRS Plan 2 employers must pay a surcharge on their contributions to help pay down the PERS/TRS 1 unfunded liabilities. This means that employers of current public employees and teachers are on the hook for paying the debts of pensioners in a plan that has been closed for 43 years.

Conclusion

A few outlier public pension systems have been ahead of the curve and shared risks between employee and employer from the outset. Generally, however, these risks have either been ignored, or have fallen on the shoulders of employers and taxpayers for much of the history of DB plans in the public sector. Using the risk-sharing principles outlined in this paper will lead to greater funding prosperity, more accountability, and an easing of the burden that unfunded liabilities have on taxpayers.


This brief is part of the Pension Integrity Project at Reason Foundation’s Gold Standard In Public Retirement System Design series reviewing the best practices of state-level public pension systems and providing a design framework for states that are struggling under a burden of post-employment benefit debt. The series includes recommendations to help states move into a more sustainable model for employees and taxpayers.

1    Reason Foundation, “State Pension Challenges – Unfunded Liabilities Before and After COVID-19-Related Economic Downturn,” May 2020. https://reason.org/data-visualization/state-pension-challengesunfunded-liabilities-before-and-after-covid-19/
2    Keith Brainard and Alex Brown, “NASRA Public Fund Survey,” December 2019.
www.nasra.org/publicfundsurvey
3    Keith Brainard and Alex Brown, “NASRA Issue Brief: Public Pension Plan Investment Return Assumptions,”
5    Anil Niraula, “The ‘New Normal’ In Public Pension Investment Returns,” April 2020. https://reason.org/policy-brief/the-new-normal-in-public-pension-investment-returns/
6    Anil Niraula, “Public Employees Are Living Longer Than Previously Assumed, New Report Finds,” April 2019. https://reason.org/commentary/public-employees-living-longer-than-previously-assumed-newreport/
7    Leonard Gilroy and Zachary Christensen, “Seeking Pension Resiliency,” April 2020. https://reason.org/commentary/seeking-pension-resiliency/
8    Source: Gilroy and Christensen, “Seeking Pension Resiliency.”
9    Brainard and Brown, “NASRA Issue Brief,” September 2019.
10    “Public Plans Data,” August 2020. https://publicplansdata.org/
11    Fiddler, Schrader, and Wylie, “The South Dakota Retirement System Generational Benefit Structure.”
12    Ashley Herzog, “Report: Illinois Local Governments Face ‘Service Insolvency’ Over Pension Funding,” May 2019. https://www.heartland.org/news-opinion/news/report-illinois-local-governments-face-serviceinsolvency-over-pension-funding
13    “Annual Report of the Canada Pension Plan for Fiscal Year 2017 to 2018,” Government of Canada, May 2019. https://www.Canada.Ca/En/Employment-Social-Development/Programs/Pensions/Reports/Annual2018.Html#H2.2
14    Ibid.
15    Leonard Gilroy, “Closing the Gap: Designing and Implementing Pension Reform in Utah,” September 2013. https://reason.org/commentary/utah-pension-reform/
16    Jennifer Erin Brown and Matt Larrabee, “Decisions, Decisions: An Update on Retirement Plan Choices for Public Employees and Employers,” August 2017. https://www.nirsonline.org/reports/decisions-decisionsan-update-on-retirement-plan-choices-for-public-employees-and-employers/
17    Ken Rocco and Paul Siebert, “2019-2021 Budgeted PERS Contribution Rates for State Government,” August 2018. https://www.oregonlegislature.gov/lfo/Documents/2018-
3%20Budgeted%20PERS%20Contribution%20Rates.pdf
18    Kevin Olineck, “PERS By The Numbers,” December 2019. https://www.oregon.gov/pers/Documents/General-Information/PERS-by-the-Numbers.pdf
19    Anthony Randazzo et al, “Arizona’s Public Safety Pension Reform Will Help Improve the Plan’s Solvency,” February 2016. https://reason.org/commentary/arizonas-public-safety-pension-reform-will-help-improvethe-plans-solvency/
20    Herzog, “Report: Illinois Local Governments Face ‘Service Insolvency’ Over Pension Funding.”
21    “South Dakota Retirement System Generational Member: Class A Handbook,” South Dakota Retirement System, July 2019. https://sdrs.sd.gov/docs/ClassAGenerationalMemberHandbook.pdf
22    Douglas Fiddler, “South Dakota Retirement System Actuarial Valuation,” June 2018. https://sdrs.sd.gov/docs/2018SDRSValuationReport.pdf
23    Rachel Janke, “Wisconsin Retirement System Informational Paper 82,” January 2017. http://docs.legis.wisconsin.gov/misc/lfb/informational_papers/january_2017/0082_wisconsin_retirement_s
ystem_informational_paper_82.pdf
24    “Annuity Payments and Adjustments,” Wisconsin Department of Employee Trust Funds, 2020.
https://etf.wi.gov/retirement/planning-retirement/annuity-payments-and-adjustments
25    “Pension Basics: Paying the Pension Bill,” August 2019. https://equable.org/pension-basics-paying-thepension-bill/
26    “2018 Actuarial Valuation Report,” Office of the State Actuary, September 2019. 27-28. http://leg.wa.gov/osa/presentations/Documents/Valuations/18AVR/2018FinalAVR-FundedStatus.pdf

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Defined Contribution Plans: Best Practices in Design and Utilization https://reason.org/policy-brief/best-practices-in-the-design-and-utilization-of-public-sector-defined-contribution-plans/ Wed, 02 Dec 2020 19:30:29 +0000 https://reason.org/?post_type=policy-brief&p=38677 If properly designed, defined contribution plans can meet the employee retirement needs of today’s evolving and dynamic public sector workforce.

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Gold Standard in Public Retirement System Design Series

Executive Summary

The primary objectives of any employer-sponsored retirement plan should be to enable employees to maintain their standard of living in retirement after a career in the workforce, to meet employer needs for recruiting and retaining a talented workforce, and to do both in a financially prudent and sustainable manner.

Several types of retirement plan designs have proven successful over long periods of time in achieving these objectives. In the public sector traditional defined benefit pensions have become increasingly strained financially, leading to more difficulty meeting the needs of a modern workforce that increasingly sees public service as a temporary stop along a varied career path blended with other private sector work, as opposed to a destination for full-career employment.

This has prompted policymakers at all levels of government in the U.S. to consider introducing alternative types of pensions and other portable retirement plan designs—including defined contribution (DC) retirement plans—as a viable alternative to better serve the needs of shorter-tenured workers and reduce financial risks for employers.

A retirement plan that effectively meets both employer and employee needs can encompass any number of plan types, as well as combinations. When structured properly, DC retirement plans—plans with individually controlled investment accounts with contributions made by both employers and employees—can offer governments an approach to retirement plan design that garners retirement security for employees while actively working. Defined contribution plans accomplish this by modernizing the retirement option set and managing employers’ financial risks that are inherent in traditional pension plans that have accumulated to over $1.28 trillion in unfunded public pension liabilities nationwide in 2019.

However, like any tool, a retirement plan can be designed well or poorly, and the design will ultimately determine any retirement plan’s ability to achieve its objectives.

The best practice design elements discussed in this paper are critical to building well-structured defined contribution retirement plans and should be considered in any plan design effort.

DC plans have certain key advantages over other retirement plan designs. Among these, especially for public sector employers, is that no unfunded liabilities can be created with a DC design. Employer obligations are fully met when contributions are made. This stands in stark contrast to the traditional defined benefit pension systems that have created unsustainable unfunded liabilities borne by governments, and ultimately taxpayers, in a number of jurisdictions. DC plans are also well suited to meeting the career mobility needs of public employees in the modern workforce. In today’s norm of working for several employers during a career, a retirement plan that recognizes this mobility addresses a key societal need for retirement savings adequacy.

In defined contribution plans, the contribution itself does not guarantee any fixed level of future benefit, which can be seen, understandably, as a shortcoming of DC. However, this paper discusses how policymakers can effectively mitigate this risk by incorporating products like annuities and even using emerging DC design innovations that focus on “lifetime income” via new investment strategies and technologies that ensure annuity-like income throughout retirement.

Critical steps toward creating an effective retirement plan design include:

  • Clearly articulating plan objectives for lifetime income and other key considerations,
  • Clearly stating and explaining the plan’s purpose to all interested parties,
  • Communicating important features and educating participants,
  • Using auto-enrollment,
  • Providing adequate contributions,
  • Choosing appropriate portfolio design, and
  • Providing benefit portability and flexibility of benefits distribution.

Designing and administering a core defined contribution retirement plan that meets these best practices will result in a plan that meets the employee retirement needs of today’s evolving and dynamic public sector workforce. A well-designed DC plan will also enable crucial recruiting and employee retention needs of the public sector.

Utilizing defined contribution plan best practices can ensure retirement security for public employees without the risk of accumulating the types of unfunded liabilities associated with many public sector defined benefit plans nationwide.


Introduction

Any employer sponsored retirement plan should aim to enable employees to maintain their standard of living in retirement after a career in the workforce, to meet employer needs for recruiting and retaining a talented workforce, and to do both in a financially prudent and sustainable manner. Several types of retirement plan designs have successfully achieved these objectives over long periods of time. But in the public sector, traditional defined benefit pensions have become increasingly strained financially, leading to more difficulty meeting the needs of a modern workforce that increasingly sees public service as a temporary stop along a varied career path blended with other private sector work, as opposed to a destination for full-career employment.

As a result, U.S. policymakers at all levels of government are considering introducing alternative types of pensions and other portable retirement plan designs—including defined contribution (DC) retirement plans—as a viable alternative to better serve the needs of shorter-tenured workers and reduce financial risks for employers. Although DB pension plans have been predominantly used in the public sector for many years, DC plans have proven their worth as core retirement plans. By including new and emerging financial services technologies available today, plan sponsors can design and implement DC plans that are more effective and efficient than ever in meeting plan objectives. To understand the role both DB and DC plans play within public sector retirement systems, we need to identify key features of both.

Defined contribution (DC) retirement plans have successfully served as the core retirement vehicle for certain public employees, including most academics in public higher education, for many decades. The availability of various DC plan features has evolved over time with the changing needs of the workforce and workplace needs of employers. Advances in financial technology have made innovative plan features available today that simply didn’t exist a generation ago. Utilizing the best practices outlined in this brief, a plan sponsor can create a plan that meets employee and employer needs without creating additional unfunded liabilities for state and local governments.

Utilizing the best practices outlined in this brief, a plan sponsor can create a plan that meets employee and employer needs without creating additional unfunded liabilities for state and local governments.

For traditional public DB pension programs, states like Wisconsin, South Dakota, and North Carolina have exceptionally well-funded plans, which demonstrates that a plan can work quite well if properly designed and managed, despite detractors’ claims that pensions are inherently unsustainable.1 By contrast, states like Kentucky, Illinois, and Connecticut need to see substantial and immediate improvements to keep their state-run public employee DB plans solvent. Nationwide, most public pension plans can be categorized as underfunded, meaning they don’t have sufficient funds invested today to cover all the long-term retirement promises made to their employees. A 2019 study by Milliman found the nation’s top 100 largest public pensions systems have on average only 73.4% of the assets needed to pay out future benefits.2 This suggests a strong need for states and local governments to adopt widespread reforms in order to improve the long-term financial sustainability of their pension systems.

Public sector defined contribution (DC) retirement plans differ in quality of plan design, but all provide retirement benefits for employees by making regular contributions into a retirement account invested in a defined portfolio. At the end of employment, the accumulated savings and investment returns fund the employee’s retirement. This eliminates the public investment underperformance exposure risk that DB pensions have, because under DC plans employer contributions into the plan remain constant despite good or bad returns on investments. Put differently, a DC plan cannot contribute to or create a debt liability, making it an attractive retirement option for public employers.

Nationwide, most public pension plans can be categorized as underfunded, meaning they don’t have sufficient funds invested today to cover all the long-term retirement promises made to their employees.

In this paper we lay out best practices, beginning with plan objectives that, when adhered to, will create a DC retirement plan that meets key stakeholder needs. We specifically address core plan design elements such as contribution rates, auto-escalation, transition cost, risk, and retirement security. We provide comparisons in functionality of both DC and DB plans to illuminate the pros and cons of reform elements. Finally, our analysis concludes with real-world examples of successful reforms.

Although each public retirement system is different, with varying levels of solvency, all plan managers should consider the reforms discussed in this brief to bolster future pension solvency.

Defined Benefit Plan vs Defined Contribution Plan

What Is a Defined Benefit Plan?

  • A defined benefit (DB) pension plan is an employer-sponsored core or supplemental retirement savings plan that specifies the monthly retirement money retirees will receive, which is typically based on the employee’s salary, years of work, and age.
  • Employers typically control the investment strategy in the account.
  • If sufficient assets are not available in the pension trust to pay out all promised
    benefits over time, the DB pension system will accrue unfunded liabilities that in most cases are borne entirely by employers, thus exposing taxpayers to significant financial risk.
  • DB pensions are designed to be pre-funded such that when an employee retires, the employer has reserved enough money to pay for all promised retirement benefits. Thus, there is no need to have new entrants into a DB pension plan to keep it working properly. DB pensions are very different from Social Security, which relies on contributions from active employees to finance current retiree benefits.

What Is a Defined Contribution Plan?

  • A defined contribution (DC) retirement plan is an employer-sponsored core or supplemental retirement savings plan that specifies the amount of money designated by the employee, the employer, or both to be contributed.
  • Employers direct these contributions into an investment account to accumulate a return in capital market investments commensurate with the funds needed for retirement. Employees typically control the investment strategy (e.g. risk tolerances, portfolio composition, etc.) in the account within the provisions allowed in the plan document.
  • Once the employer’s contribution is made, their obligation is fulfilled; thus there is no possibility of unfunded liabilities within a DC retirement plan.
  • Some DC plans provide a minimum contribution rate that could increase up to a maximum rate depending on matching contributions from employees.
  • Retirement planners typically recommend targeting enough retirement assets between an employer-sponsored DC retirement plan and Social Security to replace between 70% and 90% of pre-retirement income, depending on the employee’s lifestyle preferences.

Understanding Defined Contribution Retirement Plans

DC plans can offer many distribution options for assets ranging from cash withdrawals to guaranteed lifetime annuity payments, similar to a pension. This means that the plan can be tailored to different types of retirement income consumption patterns.

Tax-favored savings in DC plans are covered under Internal Revenue Code (IRC) sections 401(k), 403(b), 457(b) and 401(a) (among other IRC sections) depending on the particular employment sector. The IRS restricts maximum pre-tax contributions and distributions from the plan assets. Failure to comply with the restrictions results in significant financial penalties.

One important factor from the standpoint of plan managers is that DC plans cannot create unfunded liabilities like DB plans can. An employer’s obligation is fully satisfied when a contribution to the plan is made.

Core DC and supplemental DC plans…together with Social Security form a composite benefit that, when structured properly, supports lifetime financial security for the employee upon retirement.

Core DC and supplemental DC plans, which are discussed in the following sections, together with Social Security form a composite benefit that, when structured properly, supports lifetime financial security for the employee upon retirement.

Core DC Retirement Plans

The most widely known DC plan, defined under IRC Section 401(k), originally developed as a supplemental retirement savings plan. These 401(k) plans have come to define the corporate world’s primary or core retirement plans since the widespread demise of DB pensions in this market.

Like other IRC sections, 401(k) allows employees to defer a portion of their wages to an individually controlled account under the plan. Also, a 401(k) plan can utilize non-wage compensation such as profit-sharing and stock bonus.3 In a core DC retirement plan the employer makes a contribution, defined as a percentage of employee salary, into the individually controlled account. Often the employer mandates an employee contribution to receive the employer “match.”

For the purpose of this report, we focus on the public sector equivalents of corporate 401(k) plans. Sections 401(a), 403(b) and 457(b), in combination with several other IRC sections, define the public sector DC plans much like 401(k) does for the corporate sector.

Supplemental DC Plans

With the exception of public and private higher education, where DC plans have been the primary retirement plans for over a century, DC plans originally were designed to supplement an employee’s DB pension. For the public sector, the IRS uses code 457(b) to define supplemental DC plans. Depending on employment sector, 457(b) allows an employee to tax-defer income up to an amount defined formulaically under the Code into an individually controlled account. Distributions are limited and defined in order to maintain the tax-preferred status.

Today, many supplemental DC plans are used in conjunction with core DC plans to help meet the employee’s financial objectives in retirement. In the public sector, employers commonly offer traditional DB pension plans combined with supplemental DC plan benefits as a way of providing enhanced retirement security options without adding to the financial risks that often accompany public pension benefits in the United States.4

While DC plan retirement benefits are not defined, much of the longevity risk and other risks inherent in traditional DC plans can be mitigated through proper plan design, which the next section discusses.

The Gold Standard for Public Sector DC Core Retirement Plan Design

Designing a DC plan requires an understanding of human behavior. Studies show that employees are more likely to engage in passive decision-making with respect to retirement.5

This means that most employees depend on the default settings built within the plan to guide them to their retirement objectives. Plan design should account for this by mandating industry best practices and defining them within the plan document.

Define Plan Objectives

If any retirement plan is to be effective in meeting plan objectives, those objectives must first be defined. It is a best practice for a plan sponsor to define those objectives in writing as part of a comprehensive “benefits policy statement” or at least within a “retirement plan policy statement.” For a core DC retirement plan, this statement should discuss the plan’s objective to provide lifetime retirement income security in combination with other plans (personal savings and Social Security) following a career of employment.

The statement should clearly describe that a “career of employment” does not necessarily carry the expectation that the entire career would be with the current employer.

The statement should clearly describe that a “career of employment” does not necessarily carry the expectation that the entire career would be with the current employer. In January of 2020, according to the U.S. Bureau of Labor Statistics, median tenure for state government workers was just 5.6 years.6 While somewhat longer than private sector workers, this clearly shows that the vast majority of state government employees do not spend a career with one employer. Recognition of the reality of the modern workforce is essential to the success of a plan. Income security in retirement can be defined as a range, for example, 70% to 90% income replacement in retirement from all sources.

Communicate & Educate

Plan sponsors need to ensure plan members are educated on the available choices and have all the relevant information to make competent retirement choices. Not doing so could lead to the plan’s objectives not being met for a broad cross-section of participants. Education on plan objectives, investment options, and all plan features can be provided by the employer, the financial services provider hired by the plan sponsor, or by third-party financial education providers. The important factor is that the education must be unbiased and directly tied to plan objectives.

Additionally, best practice makes specific investment guidance and advice available to individual plan participants. To prevent a potential conflict of interest and ensure that the employee’s best interest takes precedent over firms seeking to sell financial instruments, an independent third party (not a party providing investments available in the plan) must formulate the advice for a plan participant. As compared to “guidance,” “advice” includes specific, fund-level investment recommendations. With advances in technology available in the financial services area, such advice can be provided for plan participants at very low cost. Plan sponsors can contract with independent advisors, making advice available to all plan participants without direct cost to them.

The first step of any competent core DC plan design is to mandate participation.

Auto-Enroll All Participants

In order for a core DC retirement plan to meet its defined objectives effectively, the employee must participate in it. This seemingly obvious observation is critical. The first step of any competent core DC plan design is to mandate participation. This can be accomplished through auto-enrollment features that enroll new employees immediately upon being hired. Research shows that the likelihood that an employee participates in a retirement plan and the timing of this decision are strongly correlated to auto-enrollment features. Absent auto-enrollment, employees may opt out of retirement planning altogether or wait too long to start saving, which lowers the probability of achieving satisfactory income replacement in retirement.7

Make Adequate Contributions

Any retirement plan’s most basic goal should provide enough income during retirement to maintain the retiree’s pre-retirement standard of living. As a rule of thumb, a well-designed retirement plan (or combination of employer-sponsored retirement plans, Social Security, and/or private savings) should replace approximately 80% of a worker’s final salary.8 This assumes retirees will have a lower cost of living with major financial commitments such as mortgages and childrearing complete. Public sector DC plans should be designed to meet this standard, with a more accurate replacement ratio ranging between 70% and 90% of average final income, with the actual percentage being inversely correlated to income. In other words, the higher the income, the lower the replacement ratio is necessary to maintain an employee’s standard of living.

Financial experts strongly recommend total contributions of 10% to 15% of pre-tax earnings into a retirement account throughout the employee’s career for those participating in Social Security; a higher 18%-25% is generally recommended for those with no other DB pension or Social Security to rely on.

An important component of plan design defines a contribution rate that, in combination with other plan features, will mitigate underfunding risk. Financial experts strongly recommend total contributions of 10% to 15% of pre-tax earnings into a retirement account throughout the employee’s career for those participating in Social Security; a higher 18%-25% is generally recommended for those with no other DB pension or Social Security to rely on.9 This is a combined employer/employee rate that could be divided any number of ways between the two parties.

Often, the employer contribution will be “matched” or dependent on the employee contribution. Older workers with a closer retirement horizon and inadequate savings may need to contribute even more than otherwise to achieve income adequacy in retirement.

One technology-based feature that plan sponsors can use to ensure the recommended contribution rates are reached is auto-escalation within plan design. Auto-escalation slowly increases employee contributions into DC plans over a period of several years. Auto- escalation can be tied to rising wages of an employee, so that it increases proportionally to the wage increase.

Use Retirement-Specific Portfolio Design

Achieving a plan’s ultimate objectives requires including investment options that directly target a long-term retirement time horizon. Among these, well-designed DC plans should offer “one-touch” investment options for employees who are not sophisticated investors and do not want to avail themselves of in-plan investment advice. Today’s plans often use target date funds that adjust asset allocation to the employee’s retirement horizon to mitigate investment loss risk as retirement approaches. Target date funds (TDFs) allow a worker to take on more risk while young for higher returns. The worker’s investment mix slowly shifts to a more conservative asset allocation as the worker nears retirement, locking in gains.10

Today’s plans often use target date funds that adjust asset allocation to the employee’s retirement horizon to mitigate investment loss risk as retirement approaches.

While a significant step forward, TDFs do have limitations. Basically, they treat everyone with the same birthdate as having the same asset allocation needs throughout their careers. While this is broadly accurate, individuals with common birthdates may realistically have vastly different investment and retirement planning needs.

With continuing technological advancements in the financial services industry, new methods of determining asset allocations on the individual level are becoming available. Whereas a generation ago these approaches were largely manual and thereby cost prohibitive, they are now based on highly sophisticated computer-based stochastic modeling that makes them cost effective for all employees and plan sponsors. This newly available approach to asset allocation is based on Liability Driven Investing (LDI) techniques. DB plans have long used LDI on the plan level, and now DC plans can use it on the individual participant level. In contrast to TDFs, which treat each individual of the same age the same, LDI looks at each participant’s specific financial picture and creates and manages the asset allocation for that individual over time. Furthermore, LDI modeling can heed the plan’s ultimate income replacement goal and manage assets over a career to best match that goal for each participant.

Make Benefits Portable

DC plans are uniquely able to meet the career mobility realities of the modern workforce, where median job tenure for state government employees’ is 5.6 years according to Bureau of Labor Statistics.11 However, plans need to be properly designed to meet this critical objective.

DC plans are uniquely able to meet the career mobility realities of the modern workforce, where median job tenure for state government employees’ is 5.6 years according to Bureau of Labor Statistics.

Plan sponsors should reduce or eliminate vesting periods (the time spent participating in the plan before the assets are fully “owned” by the participant). Since the amount of accumulated assets an individual owns determines the retirement income from a DC plan, short or immediate vesting is directly tied to retirement benefit adequacy and can help employees accumulate the assets necessary to meet plan income objectives.

Since plan participants will almost certainly work for several employers during a career, shorter vesting periods or immediate vesting at each career stop is critical to achieving adequate retirement income. Traditional defined benefit plans have long vesting periods that often take years. If an employee leaves before being fully vested, their benefits are either substantially reduced or eliminated. This punishes modern workers who change jobs often.

Offer Distribution Options

Many believe that DC retirement plans can only distribute plan assets to individuals as a lump sum, but this is inaccurate. A plan sponsor can very specifically define the asset distribution methods available in the plan document. Employers can distribute some or all of an individual’s accumulated assets as lifetime income (or “annuitizing” assets) using fixed and/or variable annuities, guaranteed minimum withdrawal benefits, or any number of other available products.

Distribution options minimize retirement income inadequacy and should align with plan objectives. In other words, if the plan’s defined and articulated objectives seek to maintain a standard of living in retirement, the plan should make lifetime income options available to participants. Advanced TDF offerings and LDI designs can increasingly factor future income needs into their product designs.

DC plans can also offer lump-sum withdrawals and rollovers, which may be appropriate for some plan participants depending on their specific financial circumstances. Traditional DB plans typically do not offer this range of distribution options. A lifetime income is the only distribution available at retirement under most of these plans.

Another distribution-related DC plan best practice prohibits participants from borrowing against their account balances. The legal structure of DC plans may allow participant loans but a plan sponsor need not make them available. While loans may have a place in supplemental DC plans, they most certainly do not in core retirement DC plans. A best-practice retirement plan focuses on providing lifetime income security in retirement as a primary objective. Borrowing from the assets in a core DC retirement plan is inconsistent with that objective.

A best-practice retirement plan focuses on providing lifetime income security in retirement as a primary objective. Borrowing from the assets in a core DC retirement plan is inconsistent with that objective.

Ensure Disability Coverage

Employees who suffer a long-term disability during their tenure need insurance coverage to replace the income suddenly lost as a result. Public DB pension plans normally provide a disability income benefit for employees, and DC plans should offer the same disability protection. Government employers can generally purchase a separate disability insurance benefit from a quality insurer—or even self-insure—for somewhere between 50 to 150 basis points (0.5% to 1.5% of salary).

Are Defined Contribution Plans Right for Your State Employee Benefits?

In the varied approaches to pension reform, debate often revolves around whether policymakers should improve an existing DB program or switch the program completely to a DC retirement plan. Reality isn’t so black and white: a much more robust set of policy options, choices, and hybrid concepts can be customized outside a simplistic “DB versus DC” framing. Optimal retirement plan designs vary with system objectives that may require different approaches, with pros and cons to every plan type. The overarching goal, however, is to design a sustainable plan that meets the needs of both public employers and employees.

Some perceive defined contribution (DC) retirement plans as less effective than defined benefit (DB) pension plans at providing retirement security in both the public and private sectors. When an unmanaged supplemental DC plan is employed as a core plan, this argument has merit. For example, West Virginia closed its traditional teachers’ pension plan, the Teacher Retirement System, in 1991 and replaced it with a DC plan. Only a few years later, in 2005, the state reversed course, closing the DC plan and switching all members back to a DB plan.12 While this failure was blamed on an alleged inherent inadequacy of DC plans, in reality the culprit was poor plan design for that particular DC plan.13 If the DC design had followed the best practices described in this report, the plan would likely have met its objectives effectively.

In general, DC plans shift investment risk to employees, given that account values fluctuate with financial markets. Compared to DB plans, which require taxpayers to bear the financial risks of fluctuating markets by paying out a fixed, scheduled benefit, DC plans tend to be perceived as risky or inadequate by employees. Employees may wonder if DC plans can offer adequate retirement security in the face of uncertain market returns. One need look no further than public higher education, however, to realize just how effective DC plans have been in meeting employee retirement needs over a long period of time.

When assessing adequacy and value to employees, DB to DC plan switch must account for the percentage of new hires who will leave public service before vesting in their DB pensions, thereby sacrificing the employer contributions made toward their benefit, and the likely detrimental impact this has on their retirement.

When DC plans are judged “inadequate,” one has to assess the defined objectives and plan design to pinpoint what actually led to the DC plan’s inadequate performance. While DB plans may look stronger to career employees than DC plans, this discounts the needs of shorter term employees, which comprise a growing share of the modern public sector workforce. When assessing adequacy and value to employees, DB to DC plan switch must account for the percentage of new hires who will leave public service before vesting in their DB pensions, thereby sacrificing the employer contributions made toward their benefit, and the likely detrimental impact this has on their retirement.

Recruitment and Retention

Employee benefits are a key aspect of total compensation and a key role in recruiting prospective employees and retaining current employees. The 2016 Metlife U.S. Employee Benefit Trends Study found that 83% of employers believe that retaining employees is their top goal. Similarly, 51% said that using benefits to retain employees will become even more important in the next five years. Empirical literature that suggest that compensation and benefits play a major role in recruitment and retention of quality employees further supports this idea.14

The aforementioned narrative gives rise to the debate over which structure improves public sector employers’ ability to recruit and retain talent. Again here, many DB advocates view DC plans as an inferior product that may harm the recruitment and retention of talented workers.15 But does the evidence bear this out?

Although the research in this area has mixed findings, there is evidence that DC retirement plans could benefit employee retention. Broadbent et al. (2006) examined the transition from DB to DC plans, finding that the gradual shift away from DB toward DC favors labor market mobility, which alleviates the accrual risk associated with DB plans. The authors argue that DC plans can provide employees with more control and flexibility in managing their retirement savings and investments. Likewise, researchers Goad, Jones, and Manchester (2013) found evidence of positive selection into DC plans over DB plans for employees with higher mobility tendencies.

Furthermore, academics Goldhaber, Grout, and Holden (2016) studied pension structure and employee turnover in public pension systems, finding no association between shifts away from DB plans and higher turnover. DC retirement plans were introduced in higher education over a century ago specifically to address the recruitment and retention of mobile faculty in a nationwide employment pool, and today almost all professions are mobile. State government employees’ (including public school teachers, public safety, and other state government workers) median employment tenure in 2020 was just 5.6 years, which belies the notion that people seek public sector work for permanent, lifetime employment anymore these days, as was assumed in the past.16

State retirement system data support these numbers. For example, Colorado PERA School Division data show that only 37% of hires remain in the system after five years of service. Today’s typical public sector DB plans simply do not meet the portability needs of the modern mobile workforce.

Transitioning from DB to DC

Properly designed public sector DC plans should not siphon off funds from the traditional DB plans when new employees choose between traditional DB and DC. As DB plans fund promised benefits, implementing a DC plan does not eliminate the need to continue full, actuarially determined contributions to any legacy DB plan still in operation. Continuing funding discipline for legacy DB pensions has been a challenging policy issue in states like West Virginia and Michigan over the years. This is important because it’s easy for policymakers and stakeholders to mistakenly believe that shifting workers toward DC plans either inherently poaches funding away from, or removes the need to continue to fully fund, legacy DB plans, which is not the case.

Properly designed, prefunded, public DB pension plans do not and should not require future employee contributions to cover benefits promised to current employees…

Properly designed, prefunded, public DB pension plans do not and should not require future employee contributions to cover benefits promised to current employees—this would be, by definition, a Ponzi scheme, not a prefunded, actuarially sound pension. At the same time, even if a traditional DB pension plan has no new future entrants joining the plan, governments are still fiduciarily obligated to continue making payments to amortize legacy unfunded liabilities. The best approach for employers—used in states like Arizona, Oklahoma, and Florida—is to, from an unfunded liability amortization policy perspective, act as if all new DC retirement plan entrants had instead entered the legacy DB plan, and thus continue making the usual percent-of-payroll-based pension contributions over a total payroll that includes the full employee headcount, no matter whether or not employees are in the DB or DC plans.

Furthermore, adding a DC option does not prevent the state legislature from making additional payments and changing current members’ contribution schedule to pay down any existing pension debt over time. Notably, the vast majority of public pension plans do not operate on a pay-as-you-go basis. This makes it possible to decouple employment growth (or the number of new workers paying into the system) from pension liabilities. Using level-dollar amortization can accomplish the task successfully, removing membership or payroll growth expectations from the pension contribution and debt calculations.

Notably, the vast majority of public pension plans do not operate on a pay-as-you-go basis. This makes it possible to decouple employment growth (or the number of new workers paying into the system) from pension liabilities.

Traditional DB pension plans took root and became the most common plan type in the public sector decades ago. Accordingly, with the notable exception of public higher education, the number of primary DC retirement plans used by U.S. state and local governments is relatively limited. However, policymakers can use some historical examples as a guide for good and bad practices when developing a DC plan design.

Some jurisdictions have successfully achieved this transition, with DC plans that have stood the test of time. In 1987, Washington D.C. closed its defined benefit plan to new employees and replaced it with a hybrid retirement plan—the Federal Employees Retirement System— that pairs a modest DB pension benefit (with a 1% or 1.1% annual accrual rate) with a world-class DC plan (the popular Thrift Savings Plan) and Social Security membership.

Michigan became the first state to close its state employee DB pension plan to new entrants and enroll all new hires in a DC plan back in 1996. Though this plan began with weak contribution rates and governance, it has improved remarkably over the last two decades—improving contribution rate adequacy, adding auto-default and auto-escalation policies, and offering annuities, for example—evolving over time into a high-quality DC plan. Likewise, Alaska closed its defined benefit plans in 2006 for new employees in favor of a DC plan with healthy contribution rates.17 And in public higher education, DC plans have predominantly provided successful retirement benefits in nearly every state, some for more than 100 years.

Case Studies in the Best Practice Public Sector DC Retirement Plan Design

Arizona Public Safety Personnel Defined Contribution Retirement Plan (Tier 3 DC Option)

Arizona significantly reformed its Public Safety Personnel Retirement System (PSPRS) in 2016, which created a new and more affordable tier of benefits for public safety personnel. Due to this reform, new public safety employees hired since July 1, 2017 (referred to as Tier 3 employees) are offered a choice between a risk-managed defined benefit pension plan (or a hybrid variant for those personnel under employers not participating in Social Security) and a pure DC plan—the Public Safety Personnel Defined Contribution Retirement Plan (PSPDCRP)—as their primary retirement benefit. Employees have 90 days to elect the PSPDCRP; otherwise they are defaulted into the risk-managed pension option. Personnel are also eligible to participate in a deferred compensation (e.g., supplemental) DC plan too, regardless of the primary plan chosen.

Those Tier 3 new hires choosing the PSPDCRP in an irrevocable election within the first 90 days of employment receive tax-deferred retirement savings in a professionally managed and self-directed 401(a) plan, including these features:

  • Employees contribute a minimum of 9% of salary and can contribute up to limits established by the IRS, and vesting of employee contributions is immediate.
  • Employers contribute 9% to employee DC accounts, and those contributions vest at a rate of 10% per year over 10 years.
  • Participants are defaulted into an appropriate target date fund and can choose between five and 25 total investment fund options, including options that reflect different risk profiles and various automatically rebalancing target date funds. Participants can mix and match, splitting their DC investments across several of the predetermined investment portfolio options.
  • PSPRS is required to hire a third party administrator, with periodic rebidding, to manage the PSPDCRP using evaluation criteria that cover the company’s financial stability, its ability to provide the participants’ benefits, fees and cost structures, experience in administering primary DC retirement plans in the public sector, and experience in providing member education.
  • The third party administrator for PSPDCRP—currently Nationwide—is required by law to provide education, counseling, and objective participant-specific plan advice to participants through a federally registered investment advisor that acts as a fiduciary to participants and is thus required to act in the participant’s best interest.
  • Upon retirement, participants can roll over their DC plans to an IRA plan or, alternatively, PSPRS is required to offer participants a menu of lifetime annuity options, either fixed or variable or a combination of both.
  • Members and employers also make a relatively small contribution each pay period to the PSPRS DC disability program; those contributions are sent to PSPRS and are not included in their DC plan assets.

The 18% minimum annual contribution to the PSPDCRP exceeds the 10%-15% recommendation commonly made by financial advisors and retirement planners for those workers covered by Social Security. This means participants are substantially more likely to accomplish (maybe even exceed) the desired income replacement levels during retirement, making Arizona’s standalone DC retirement plan one of the nation’s best.

… participants are substantially more likely to accomplish (maybe even exceed) the desired income replacement levels during retirement, making Arizona’s standalone DC retirement plan one of the nation’s best.

That said, Arizona reform efforts faced a unique issue—a large portion of current public safety personnel work for employers that participate in Social Security while many others do not. This created a discrepancy in which some employees will both participate in Social Security and receive a PSPRS pension, while other employees receive only the PSPRS pension. To remedy this, the 2016 reforms introduced a PSPRS DB hybrid plan for employees not covered by Social Security. The hybrid plan offers those employees the risk- managed Tier 3 pension benefit along with a small 401(a) component of a 3% of pay employer contribution with an equal employee match for a total 6% supplemental DC contribution. This hybrid plan was also made retroactively available to all workers hired between 1/1/2012 and 6/30/2017 (“Tier 2” employees), and these workers received “catch- up” contributions as if they had been in the new PSPDCRP since the beginning of Tier 2.

A subsequent reform in 2017 opened up the PSPDCRP to state and local corrections officers, who are defaulted into a 7% employee contribution rate, but can drop that to no lower than 5% (or contribute more). However, the contribution rate they choose when they join the plan cannot be changed. These workers receive a far more generous vesting schedule. Members in this plan always own their contributions and investment earnings and will gain “vested” ownership of them at a rate of 25% after year one, 50% after year two, and 100% after three years.

Arizona’s PSPDCRP structure provides a road map for legislators and stakeholders seeking to reform their antiquated systems to reduce financial risk while ensuring multiple pathways to retirement security. Arizona created a credible DC retirement plan option to stand up next to a traditional pension and built out a generous contribution schedule that exceeds best practices. The system has adequate defaults that ensure workers are taken care of even if they do not take an active interest in their retirement planning. The system also offers varying investment options for workers seeking a more proactive role in their own retirement planning. Arizona PSPRS isn’t perfect; police and fire personnel members face a 10-year vesting period for the employer portion of the contributions, but the average job tenure in the U.S. is less than six years. Nevertheless, there is still a lot to learn from Arizona’s pension reform efforts.

Michigan’s Evolving DC Reforms

In 1996, former Michigan Governor John Engler and State Treasurer Douglas Roberts successfully pushed to create the nation’s first modern, large-scale, state-level DC plan for state employees covered by the Michigan State Employee Retirement System, under the notion that the traditional pension system was a poor fit for a changing workforce with shorter tenures. As Roberts told Reason Foundation in a 2014 interview:

Even in the late 1990s, it was clear that society was changing. Our technology and our workforce were changing. People were no longer working for a single employer over their lifetime, but taking advantage of our strong sense of upward mobility. An individual might change jobs five, six, or seven times over a career. It’s very difficult to vest in a pension system when you’re changing jobs so frequently, assuming that your workplace requires 10 years of work to qualify for pension benefits.18

Under Michigan House Bill 6229—later to become Public Act 487 of 1996 after being signed into law in December 2016—all state employees hired on or after March 31, 1997 were automatically enrolled in a defined contribution retirement plan called “MSERS Tier 2.19 The MSERS Tier 2 DC plan began as a fairly meager benefit; the only mandatory contribution was a 4% required employer contribution. If employees chose they could contribute an additional 3% of pay that would be matched by the employer, but many did not since this was not a default option.

Hence, this contribution policy led to fairly small DC account balances for the first waves of employees hired under the new plan. Over time the legislature and Office of Retirement Services, which administers the state’s largest pension plans, rectified the situation, steadily improving the contribution policy in both state law and administrative rules to focus on promoting retirement security. The plan has evolved to feature the following characteristics today:

  • The state contributes 4% of each employee’s salary into their DC account, with immediate vesting of employee contributions. Employer contributions to the account vest over four years.
  • Employees are now auto-enrolled at a 3% of salary contribution to their DC accounts, triggering an equal matching payment by the state of 3%, leading to a default 10% contribution rate for all new hires in Michigan state employment.
  • Employees can contribute more beyond the required 3% without a match, and in fact the Office of Retirement Services maintains an auto-escalation policy that increases employee contributions by 1% per year as a means of “nudging” higher retirement savings.
  • The current Tier 2 DC plan offers 11 target date fund options and another 18 asset class-based funds for individuals to choose from, depending on their investment appetite and retirement goals, including a totally self-managed plan.
  • The current third-party administrator for the Tier 2 DC plan—Voya Financial—offers financial advisory services to plan participants, as well as fee-based professional financial portfolio management.

In 2010, the legislature extended DC retirement plans into public education, creating a hybrid DB/DC plan for new teachers and school personnel called the Pension Plus Plan to be administered by the Michigan Public Schools Employees’ Retirement System (MPSERS). Public Act 75 of 2010 enrolled new hires by MPSERS employers after July 1, 2010 into a new DB pension plan with the same benefit formula as before, but the benefit left out cost- of-living adjustment, extended some members’ final average salary numbers from three to five years, and capped the assumed rate of return on that DB tier at 7% (relative to the 8% in use at the time for the legacy DB tier). This pension was paired with a small DC element—a 2% of salary contribution to a DC fund with up to 1% of salary matched by the state—to create a fairly weak and unbalanced DB-heavy hybrid.

In 2012, Public Act 300 introduced the concept of DC choice to teachers and school district employees. MPSERS-participating employees could keep the same pension benefit but increase employee contributions, keep the same contribution rate but accrue prospective benefits using a lower benefit formula, or drop the pension portion of the hybrid to retain only the DC portion (with a low default contribution rate). New hires were defaulted into the new, reduced-benefit Pension Plus hybrid plan, but for the first time they were also offered a full DC retirement plan option if chosen in the first 75 days of employment. Rather than mirror the DC offered to state employees, the optional MPSERS DC required a 6% employee contribution with a 50% match up to 3% of salary. Notably, at a 9% aggregate contribution rate, the full DC retirement plan offered to new hires came fairly close to the 10% rate offered in the MSERS Tier 2 DC plan for state employees, but both were far higher than the 3% default rate offered to existing teachers opting to switch plans under the 2012 law.

In 2017, the legislature continued its reform efforts. Public Act 92 of 2017 led to a different retirement option—either a revamped DC retirement plan or a redesigned “Pension Plus 2” hybrid plan—for all Michigan public school employees who began working on or after February 1, 2018. One important change in the 2017 reform package is that it changed the default plan to the DC retirement plan.

The upgrades to the core DC plan come from essentially replicating the MSERS DC plan design—with a 4% minimum employer contribution, triggering another 3% employer contribution and 3% employer match—extending the provisions backward in time to those hired since the first DC option launched in 2012. Another upgrade involved improving retirement security through auto-escalating contributions. Auto-escalation automatically increases employee contributions by 1% each year up to a maximum of four years. This feature can be disabled, and contributions can be voluntarily reduced by the employee. But if left to operate, in a short span of time—the same time required for employer contributions to fully vest in the DC plan—the aggregate DC default contribution rate rises from 10% to 14% of salary. This auto-escalation feature represents an upgrade from the 3% default some existing teachers selected in the wake of the 2012 legislation passage to strengthen retirement readiness.

Furthermore, Public Act 92 required the Michigan Treasury Department, which manages the DC Plan, to add at least one fixed rate annuity and at least one variable rate annuity to its investment option mix to provide more benefit withdrawal options at retirement and improve the system’s ability to provide lifetime income.

On the hybrid side, the choice improved as well, particularly from concerning long-term financial resiliency. While the Pension Plus 2 Plan still combines the same post-2012 pension benefit with a small (3% aggregate contribution) DC plan in a weak hybrid structure, it nonetheless exemplifies a newer generation DB pension design built to be risk- managed, using 50/50 employer and employee cost-sharing and short amortization schedules, minimizing the potential for contribution rate volatility. And, like the Pension Plus Plan before it, Pension Plus 2 capped the investment assumed rate of return for that tier of the pension system, this time at an even lower 6%. The reform push has been praised by Standard & Poor’s, which cited pension reform as key in its subsequent decision to increase the state’s credit rating from -AA to AA with a stable outlook after the 2017 reform passed.

The reform push has been praised by Standard & Poor’s, which cited pension reform as key in its subsequent decision to increase the state’s credit rating from -AA to AA with a stable outlook after the 2017 reform passed.

The reform push has been praised by Standard & Poor’s, which cited pension reform as key in its subsequent decision to increase the state’s credit rating from -AA to AA with a stable outlook after the 2017 reform passed.

All pension reform efforts should primarily seek to keep all promises made to existing employees and retirees and to support retirement security for current and future members. These principles were on display in Michigan. The state’s pension reforms placed a major focus on limiting the state’s current and future financial exposure. Some Michigan stakeholders insisted employees have the option for a traditional defined benefit, while other stakeholders focused on providing a sound DC plan that would provide portable, quality benefits for the more mobile teachers of today and tomorrow. Although these could be mistaken as competing interests, Michigan proves that is not the case—different plan designs offer different trade-offs and ultimately expand personal choice and responsibility.

Colorado’s PERAChoice DC Option

Colorado Public Employees’ Retirement Association (PERA) provides retirement and other benefits to employees at more than 500 government agencies and public entities in the state. Colorado has a long history of offering choice options to its public workers, a tradition the state excels in and continues to build upon.

Colorado PERA’s core DC plan—PERAChoice—was established in 2006 and is structured as a 401(a) for state employees hired from that year on seeking an alternative to PERA’s current defined benefit plan. The legislature expanded eligibility for the PERAChoice DC plan to community college employees in 2008, then to state university and local government employees in 2019.20

Currently, members contribute 10% of salary for state division employees, 8.5% for local government participant, and 12% for public safety officers. Employers contribute an additional 10.9% for state division employees, 13.6% for state safety officers, and 10.5% for local government division. This adds up to 20.9%, 23.6%, and 20.9% in total contributions for state employers.21 These contribution rates exceed the 10%-15% commonly recommended by financial advisors because many members do not participate in Social Security.

For PERAChoice’s core DC, employee contributions automatically vest at 100%, and employer contributions vest at 50%, rising an additional 10 percentage points every year for five years until they reach 100%, at which point if an employee decides to leave he will be entitled to 100% of the employer contributions.

A third party vendor manages the PERAChoice DC core plan and the various supplemental DC plans it offers. Each plan has identical investment options. The plan design allows participants to set their own investment allocation. Members can choose among a list of varying investment funds or a self-directed brokerage account, allowing users a wide breadth of investment options. The vendor provides education and advice to new members and defaults all core DC participants in the appropriate aged-based target date fund.

Colorado’s PERA DC does not negatively affect the DB plan.

Furthermore, Colorado’s PERA DC does not negatively affect the DB plan. Colorado requires employers to remit an Amortization Equalization Disbursement and Supplemental Amortization Equalization Disbursement to amortize the DB plan’s legacy debt across total payroll for all PERA members. Actuaries calculate these additional contributions to direct payment to legacy pension debt even as more employees opt for DC benefits.

Reform efforts in Michigan, Arizona, and Colorado are apt evidence that policymakers need not view DB and DC plans as an either/or proposition. These systems can be very complementary. A jurisdiction can find an appropriate balance between the two options that reduces costs and risks to taxpayers while still providing attractive and reliable retirement options for public servants.

Conclusion

Many public retirement systems desperately need modernization that recognizes and accommodates an evolving modern workforce’s professional and geographic mobility. Retirement systems built around an expectation of full, multi-decade service at one employer will increasingly fail to ensure retirement security for a workforce largely comprising non-full-career employees. This mismatch creates a need for serious conversations about modernizing benefit offerings, including expanding choice and offering more-portable plan designs, including DC retirement plans.

This brief delineates the best practices that ensure functionality and successful DC retirement plans execution, notably the following features, which are inseparable to a well- designed, well-functioning DC plan:

  • Plan Objectives: The plan’s purpose must be clearly stated and understood by all stakeholders.
  • Communication and Education: Communicating plan features and educating participants on their options is critical to fulfilling objectives.
  • Auto-Enrollment: Making sure all eligible employees participate in the plan is essential.
  • Contribution Adequacy: Both employer and employee plan contributions must be sufficient to meet future income needs in retirement.
  • Retirement-Specific Portfolio Design: Investments available within the plan should be specifically selected to meet plan objectives, and “one-touch” default options (such as target date funds) must be provided.
  • Benefit Portability: Plan design features must meet the modern public sector workforce’s needs.
  • Distribution: Asset distribution in retirement should target plan objectives by offering flexible lifetime income options to meet the varying needs of employees.

A properly designed DC retirement plan can meet employee needs for retirement security and mitigate inherent financial risks to taxpayers. Following the best practices outlined here, a jurisdiction can be confident that its public retirement plan will meet the modern workforce’s needs while also addressing state and local governments’ critical financial solvency needs.


Download Policy Brief

This brief is part of the Pension Integrity Project at Reason Foundation’s Gold Standard In Public Retirement System Design series reviewing the best practices of state-level public pension systems and providing a design framework for states that are struggling under a burden of post-employment benefit debt. The series includes recommendations to help states move into a more sustainable model for employees and taxpayers.

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