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State Pensions and Defined Contribution Plans

Sept. 16, 2013
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When most of us think of the word “pension,” we associate it with a guaranteed minimum retirement income for the life of the worker, or the joint lifetimes of the worker and his or her spouse. The technical term for this kind of pension is “defined benefit.” That is, the benefit is defined by the plan, and the actuaries who run it adjust and try to convince the government or corporate plan sponsor to contribute enough to fund the benefits promised.

In theory, that’s a very efficient and equitable system: Its administration costs are modest, since there aren’t any separate accounts to maintain – everything goes into one pool of capital. Plus, it shelters workers from the ups and downs of the stock market. In practice, this is a very good thing, because few workers are also very good investors. Indeed, study after study demonstrates that the average individual significantly underperforms the returns realized by professional money managers and pension plans. This is important, because even a 1 or 2 percent shortfall compared to a baseline, replicated across a 30+ year working career, can mean a difference of tens of thousands of dollars in wealth accumulation.

Even more importantly, because traditional pensions are paid out in the form of an annuity, or lifetime stream of income, pension participants are protected from the devastating downside of longevity risk: Left to their own devices, a significant number of retirees will run out of money before they run out of heartbeats. Meanwhile, their neighbor in a defined benefit system has no such worry: He or she will continue to receive a monthly income for as long as the pension remains solvent. In the event that a pension fund collapses, then a quasi-government agency, the Pension Benefit Guaranty Corporation, steps in and makes good on at least a minimum contribution. The worker, therefore, may not have much flexibility in choosing his or her income, but he or she also doesn’t have to worry much about having no income.

The problem, of course, is that both governments and corporations have a funny way of not funding these pensions adequately. The result is a full-blown, nationwide pension funding crisis that is already starting to force cities into bankruptcy court. Other pensions are paying current benefits for now, but their overall assets are not even close to enough to pay out all promised benefits to future workers. CalPERS, the State of California pension fund for state workers and for workers in thousands of municipal agencies, has a shortfall as high as $100 billion. This means that the net present value of all the plans promised benefits, plus the expected benefits to new members, is $100 billion more than the value of the plan’s assets. Something, sooner or later, is going to have to give.

But California’s got company. Indeed, it’s not even the worst: Funded to only 24 percent of expected liabilities, Illinois’s pension plan is most severely underfunded plan in the country – to the tune of $287 billion. Connecticut’s plan is only 25 percent funded, Kentucky’s plan is 27 percent funded,  and Mississippi, New Hampshire and Alaska are only funded at 30 percent.

Rhode Island, a relatively small state of about 1 million people, was in a bind. Its pension was underfunded by about 51 percent in 2010 – meaning plan assets were only enough to cover 49 percent of expected benefits.

But Rhode Island’s state General Assembly passed some significant reforms in 2011, via the Retirement Security Act – reforms which may well be adopted by other states going forward.

To put this in perspective, private sector pension funds funded at anything less than 80 percent of obligations are thought of as “at risk,” and they come under closer scrutiny from regulators and the Pension Benefit Guaranty Corporation.

To address this problem, the State of Rhode Island enacted the following reforms:

  • The pure defined-benefit plan model was dropped. Instead, Rhode Island enacted a ‘hybrid’ plan, which involved a smaller defined benefit, or traditional pension plan, and a defined contribution plan, similar to 401(k)s, 403(b)s, and the federal Thrift Savings Plan. In this plan, benefits are a function of what employees contribute to them and returns on those investments.
  • Employees will now have to contribute much more towards their own retirement.
  • Because the defined benefit portion of the plan is smaller, the actuarially necessary contributions are smaller going forward. It is easier for the Rhode Island taxpayer to fund a smaller plan at 100 percent than a large one. Supporters of the plan also noted that benefits are more portable for employees who move on to other jobs before retirement.
  • Retirement age was raised to 67 for new hires and for everyone who was not yet vested. Workers who are vested received credit based on years of service, but in no case would a worker be eligible for full retirement before age 59. However, the plan allows for reduced benefits if a worker retires early.
  • Rhode Island also suspended COLA increases until plan assets are at least 80 percent of fully-funded. Interim increases will be paid every five years, based on investment returns, according to the Institute for Illinois Fiscal Sustainability.

The public employees unions didn’t care for the plan, and complained bitterly. The path Rhode Island chose for implementation is not without non-union critics, either. But simply by passing, the plan reduced the unfunded liability by about $2.7 billion, and the plan was immediately funded – as far as actuaries were concerned – to 59.8 percent of expected liabilities. That’s a big jump from the 48 percent level they started from.

Nationwide, the pension underfunding for the 3,500 government plans around the country has exploded to $4.1 trillion. As we discussed in a previous column, the City of Detroit alone has a shortfall of as much as $3.5 billion – hence their bankruptcy filing. With no way of raising taxes without risking driving business away to more stable jurisdictions, state and municipal government options are narrowing rapidly. Further reforms in the Rhode Island vein are a near certainty – or fiscal realities will combine with Chapter 9 Bankruptcy laws to make even more painful reforms for them down the road.

The Illinois Policy Center has already embraced moving to a defined contribution model as the only way to resolve a shortfall that large. Yes, the retirement incomes for all these state workers have to come from somewhere. Under a purely defined contribution plan, future workers will have to fund it themselves – and take on the risk of market underperformance as individuals, which could be devastating for some who make poor investment choices. The stark choice these workers face is the transition from a system in which their retirement income is theoretically guaranteed (until bankruptcy occurs, as Detroit workers are learning now) and one in which their income is not guaranteed.


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CalPERS image courtesy of Wikimedia