What Defined Contribution Plans Mean for State Employees, Retirees and Taxpayers

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February 23, 2013

From the Desk of James Preston – Florida State Lodge FOP President

What Defined Contribution Plans Mean for State Employees, Retirees and Taxpayers

As lawmakers continue to push their “pension reform” in state capitols across the country, the public is learning that there is more than meets the eye in their proposals. Studies widely acknowledge that pension overhaul proposal that adopt “Defined Contribution” (DC) plans reduce retirement benefits for employees. Even worse for taxpayers is that experts have reported that DC plans also pose higher costs for states to maintain compared to current “Defined Benefit” (DB) systems. What may appear as a quick fix in fact has serious repercussions that would haunt state budgets for decades.

The following are key takeaways from actuarial reports that examined DC plans proposed in Michigan and New Hampshire, and currently under consideration in Nevada for public-sector employees:

  • Costs to state: Generally, the reports found that the DC plans carried a higher price-tag than maintaining the current DB systems. In both the Michigan and New Hampshire reports, the proposed employer DC contribution rates were scored to be comparably higher than the normal DB cost. The studies cite that higher costs derive primarily from administrative costs – whether they are outsourced to a third-party or expanded internally, legal and consulting fees assumed by public pension fund handlers, and additional operating costs.

 

Additionally, the studies found in all three cases that the DC proposals would increase the unfunded liability shortfall over time, further exacerbating the very reason why these states are facing their pension crises. Specifically in New Hampshire and Michigan, while the legislative proposals succeed in shift future costs onto employees, they fail to address their respective rising unfunded liabilities.

Noteworthy in the Nevada study is the claim that DB plans can have an “efficient frontier” compared to an individualized DC plan. This would occur assuming that all assets are pooled together, professional asset managers run the pool responsibly, and investments are diversified.

  • Costs to state employee benefits: All three studies concluded that DB plans generally lead to decreased retirement benefits by 1) structuring a plan so that employees assumes all of the investment risk, 2) placing responsibility of investment decisions on employees who might not have adequate financial knowledge and 3) exposing retired employees to financial risk due to unexpected cost-of-living increases (and emergency expenses) during retirement.

 

  • Costs to taxpayers: The actuarial report acknowledges that DC plans negatively impact retaining public sector workers. A perceived reduction in retirement benefits would harm the state’s ability to attract a proficient workforce, reducing the quality of public services for taxpayers.

 

The actuarial report, prepared by the Segal Group, analyzes the costs and benefits of Public Act 300 (PA 300), legislation that gives new state employees the choice between participating in the existent Hybrid plan or in a defined contribution (DC) plan.

Among the key findings in the actuarial report:

  • Costs to the state: The plan proposed in Michigan is expected to carry with it higher costs. According to the study, over a 3—year period, “the annual contributions to the Hybrid plan would increase by $500 million and to the State DC plan by $1.6 billion.” While the study projects that cost savings might apply, it is too difficult to determine an actual cost over this time period. Additionally, the report concludes that while costs of the DC plan are fixed for the employer, offering a choice might increase the per-person cost of the Hybrid plan.

 

The report argues that while PA 300 shifts costs onto the employee, it fails to address the unfunded liability. To reduce the unfunded liability, the report recommends establishing a retiree health benefits trust fund and investing the assets, giving MPSERS a “vehicle to accumulate funds to pay future benefits.”

  • Costs to state employees: While the report suggests that PA 300 might help to reduce unfunded liabilities, shifting retiree health costs entirely on employees would substantially reduce retirement income. In using a replacement ratio adequacy test to compare the retirement income afforded between the Hybrid plan and the DC plan, as proposed in PA 300, the report found that the Hybrid plan meets the replacement ratio adequacy test, while the DC plan – when combined with Social Security – falls short. Further, the inadequate benefits and retirement income associated with PA 300 would require retirees to rely on Medicare and/or health insurance exchanges mandated by the Affordable Care Act (ACA).

 

  • Costs to state taxpayers: The actuarial report acknowledges that DC plans negatively impact retaining public sector workers. A perceived reduction in retirement benefits would harm the state’s ability to attract a proficient workforce, reducing the quality of public services for taxpayers.

 

The report recommends that solving the rising costs of retiree health benefits while addressing the unfunded liabilities should include a two-fold plan: 1) government employers set retiree benefits at a sustainable level, while still taking into account inflation and shifts in demographics and 2) a plan that pays down the unfunded liabilities over time. Finally, the report notes towards the end that PA 300 does not address the problem of a shrinking employee population. While the ratio of retirees to active state employees increases, the report flags that any reform proposal must take this into account. 

The following actuarial report, conducted by Gabriel Roeder Smith & Co., was commissioned to analyze the proposed pension reform legislation (LSR 12-2876). The measure transitions state employees from a Defined-Benefit (DB) plan into a Defined-Contribution (DC) plan. Among the various conclusions, the following key findings are included below:

  • Costs to state: Specifically, the report found that the plan carried a higher price-tag than maintaining the current system. The report calculated that the proposed employer DC contribution rates would be comparably higher than the normal DB cost:

 

In all areas, over time, transitioning to the proposed Defined Contribution plan will be more expensive for the employees and employers than maintaining the current Defined Benefit plan based on the recent changes made by the legislature to the Defined Benefit plan.

 

More importantly, the study found that the legislative proposal would increase the unfunded liability shortfall over time, further exacerbating the very reason why New Hampshire is facing its pension crisis. Eliminating future employer contributions would increase the Unfunded Actuarial Accrued Liability (UAAL) and lower the funded ratio.

 

  • Costs to state employee benefits: Equal to concern about increased costs to the state, the proposed plan is also expected to deliver added benefit costs to state workers. Under the proposed measure, the changes enacted by the DC plan are expected to deliver retirement benefits that are near or lower to the current benefits received by employees under the DB plan.

 

One of the more prominently discussed conclusions in the report is the finding that DC plan’s reduction in retirement income is due to state employees’ lack of financial sophistication and knowledge. The report cites surveys that have been carried out showing that 20-40% of the general population is uninterested or afraid of making investment decisions. Therefore, DC participants are much more likely to do worse comparably to DB participants.

While the report generally credits the DC plan for what it aims to achieve – placing retirement costs and risk on employee rather than employer, it does highlight that the DC plan provides some guaranteed retirement security. The proposed legislation would convert 50% of DC members’ account balances to annuities. However, the report does flag that while this might appear as security, the fact that annuity purchases will be conducted by a third-party insurance company exposes employees’ retirement security to the incompetency of the insurance company.

While the report was not commissioned to analyze any specific pension legislation, the purpose of this actuarial summary is to deliver a comparative analysis of Defines Benefit and Defined Contribution plans for Nevada state employees.

  • Costs to the state: One of the more noteworthy findings in the report is its insight into additional costs associated with DC plans. The report concludes that “DC plans are more costly to establish and maintain than DB plans,” thus refuting the very purpose for transitioning into DC plans. Higher costs derive primarily from administrative costs – whether they are outsourced to a third-party or expanded internally, legal and consulting fees assumed by public pension fund handlers, and additional operating costs. Further, the report finds that DC plans would.

 

  • Costs to state employee benefits: While the report acknowledges that DC contribution plans do not necessarily equate to smaller costs for the state, it also concludes that reducing costs to the state through DC plans are generally achieved through reduction of state employee benefits.

 

Even though the contribution requirements for a DB plan will vary, the cost is generally known. Increases or decreases in costs are due to actuarial losses and/or gains as well as changes in assumptions and plan provisions. Changes in benefit design can be used to control costs within the DB structure. The main difference between DB and DC plans is not the overall cost, since a DC plan could be designed to be approximately the same cost as the current DB plan. The most significant difference between the two types of plans is who bears the risks involved with providing the retirement benefits.

DC plans place heavier risk on state employees: The report found that DC plans place shoulder much of the risk onto the backs of state employees on several levels by 1) structuring plan so that employee assumes all of the investment risk, 2) placing responsibility of investment decisions on employees who might not have adequate financial knowledge and 3) exposing retired employees to financial risk due to unexpected cost-of-living increases. The report also argues that DB plans can have an “efficient frontier” compared to an individualized DC plan assuming that all assets are pooled together, professional asset managers run the pool responsibly, and investments are diversified.

The report also concluded that DC plans can potentially raise workforce recruitment and retention issues, leading to less-appealing public sector jobs and a general decrease in the quality of public-sector services.

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