Public Employee Pension Plans Under Fire

by Charles Nash and Eric Hays, February, 2005

For reasons that appear to be infinitely more political than fiscal, Governor Schwarzenegger and the Howard Jarvis Taxpayers Association have joined forces with the expressed intent of changing the structure of all public employee pension plans, including UCRS, from defined benefit plans to defined contribution plans for all employees hired on or after July 1, 2007. They propose to do that by means of a Constitutional Amendment that they threaten to put to a vote of the people either via an act of the legislature or by collecting signatures in the parking lots of shopping malls.

In the legislative arena Assemblymember Keith Richman (R, Northridge) has introduced two measures ACA X1 and ACA 5 that have yet to go anywhere, and as a practical matter were effectively dead on arrival in their current form. That is because it takes a 2/3 majority vote in both houses for the legislature to put a Legislative Constitutional Amendment on the ballot, and the current legislature has a huge Democrat majority in both houses. What Richman has done, however, is insert benefits funding near the front end of a long list of budgetary matters that the legislature must now consider.

Legislative Committees have just started holding informational hearings on the structural features of the two types of retirement plans and the fiscal health of some specific public-employee plans in California. On February 15 the CEO of CalPERS, the CEO of CalSTRS, the Chair of the Legislative Committee of the State Association of County Retirement Systems, and Judy Boyette (UC’s Associate Vice President, Human Resources) discussed public pension plans at a hearing on the “Budget Implications of the Privatization of Public Pensions: Defined Benefit vs. Defined Contribution” held by Subcommittee #4 of the Senate Budget and Fiscal Review Committee.

On the surface, the debate would seem to be over the economics of defined benefit plans vs.defined contribution plans, so at this point it is worth describing their salient features. In brief, a defined benefit plan pools contributions from employees and employers and upon retirement pays a guaranteed monthly annuity to the employee or the employee’s dependent spouse for life. (UCRS is such a plan.) A defined benefit plan is administered entirely by the employer. Because the annuity amount is guaranteed, the plan must be fiscally sound (by actuarial standards) at all times. Typically, California public employees make contractually-fixed contributions to the system and if there is “underfunding” after that, the employer bears full responsibility for maintaining the soundness of the plan.

A defined contribution plan creates individual retirement accounts to which both the employer and employee contribute. The employee invests these funds in one or more externally-managed investment vehicles, which are often contracted for by the employer. At retirement the account balance is paid to the employee (in most plans as a lump sum, but it can also be paid as an annuity over the life of just the retiree). With this type of plan there can be no such thing as “underfunding.” The financial risks and rewards are born entirely by the employee. A more detailed comparison of the two types of plans is given in the table below.

Proponents of the Amendment assert that changing all the public retirement systems to defined contribution plans would save the taxpayers money, and to date the general public seems to believe that fable In an Op-Ed piece in the Sacramento Bee Assemblymember Richman asserted that “…public employee pensions are devastating government budgets throughout California, threatening priorities such as education, transportation, public safety and health care.” He noted that a “Public Policy Research Institute of California poll showed seven in ten California voters believe public pensions are a problem for state and local government.” His punch line was “Fortunately, a fiscally responsible solution is available—defined contribution plans—that would help eliminate deficits, lower costs and improve budget predictability.”

What he knows, but did not say in that piece, is that it will take at least ten, and probably more like twenty years for taxpayers to realize any savings whatever. Public employees earn vested rights to benefits for the performance of their services. Under the contract clauses of both the US and California Constitutions these rights cannot be impaired. Pension system staff and the Legislative Counsel hold that the benefits of existing plan members, including the right to accrue benefits from future service and compensation, cannot be reduced for current members without an offsetting benefit.

As a practical matter, therefore, anyone currently employed by a public agency, or anyone hired on or before June 30, 2007, will be entitled to collect benefits equal to or better than those currently offered by the defined benefit plan in which they are enrolled as of the date of hire. An Assistant Professor, Step I, whose employment begins on July 1, 2006, must be able to retire some 35 years later with a benefits package (adjusted for inflation etc.) identical to the one provided to a departing high-step Full Professor who retires effective that same date.

If the Jarvis/Schwarzenegger forces are successful, it is virtually a given that public employers will be required to administer two different retirement plans for almost four decades. To contradict an old saw: two (retirement plans) CANNOT live (be administered) as cheaply as one.

It is abundantly clear that the Governor is determined to get rid of defined benefit plans. He summarily revoked the appointments of four of the five individuals (two Republicans and two Democrats) he had named to the board of the State Teachers’ Retirement System because they were part of a 10-2 majority that voted to oppose ACA 5. (The law allows a Board appointee to serve for one year without Senate confirmation. These individuals were in that grace period.). On February 16 the CalPERS Board also opposed changing to a defined contribution plan by a vote of 9-3. The Sacramento Bee’s report on this outcome quoted a spokesman for the Governor as saying “the vote signals that PERS prefers to be a spectator instead of a participant (in discussions). While we wish that isn’t the case, the debate on reforming the state public employee pension system will move forward.”

As the legislative hearings progress, the debate will surely be highly partisan. In the Senate Subcommittee hearing mentioned above a Republican Senator attacked CalPERS for what he judged to be highly inappropriate meddling in corporate affairs. (Both CalPers and CalSTRS have blocks of stock that are large enough to give them a significant voice in annual stockholder meetings.) After the CalPERS Board meeting on February 16 the newly-elected Board President, Rob Feckner, said that the $183 billion fund’s corporate governance agenda, including trying to rein in executive pay and health care costs would not change. “One thing should be abundantly clear to the corporate wrongdoers: We will not retreat from our fiduciary duty to protect our shareowner interests.”

Comparison of Traditional Defined Benefit with Traditional Defined Contribution Plans
Source: "An Evolving Pension System: Trends in Defined Benefit and Defined Contribution Plans" by David Rajnes, Employee Benefit Research Institute, September, 2001.
Items in italics are fundamental features of DB and DC plans that cannot be modified without changing the plan to another type.
Strategic Business Considerations	Defined Benefit	Defined Contribution
Employees Attracted and/or Most Benefited	Longer-tenure and/or older employees.	Shorter-tenure and/or younger employees.
Job Tenure Patterns Encouraged	Longer-tenure because employees receive greatest benefit accruals at end of long-time service. May lock people into jobs they would otherwise leave.	Although employees receive benefits based on salary, not tenure, may encourage employees to change jobs in order to receive access to lump-sum distribution from retirement accounts.
Influence on Retirement Patterns	Can be designed to encourage early retirement; may financially penalize workers for working additional years beyond the normal retirement age. May pressure workers who would not otherwise retire to do so.	Cannot be designed to encourage early retirement but instead rewards employees for working additional years.
Cost/Funding Flexibility Concerns
Cost variability/risk	Employer assumes investment and possibly preretirement inflation risk and therefore annual plan costs are less predictable. While costs might be higher than anticipated, pension costs in a booming stock market may be zero because of investment returns on past contributions.	Employer assumes none of the investment risk on retirement fund assets. As a result, annual costs are more predictable although the employer cannot take advantage of high stock market or other investment returns on retirement plans’ assets.
Annual funding flexibility	However, there tends to be more flexibility as to when employer may meet these costs contributions in defined benefit plans.	However, money purchase and some types of profit-sharing plans have less flexibility in when those costs are to be paid. In addition, defined contribution accounts can be designed to entail no employer contributions at all, unlike defined benefit plans.
Termination benefits	Termination benefits are usually small for employees with less job tenure.	Termination benefits equal account balances, when vested, based on both salary and years of plan participation. Tend to be larger than those for defined benefit plans, cet. par.
Plan termination	Can be very costly if plan is underfunded.	Not applicable, because defined contribution plans are by definition never underfunded
Administrative costs	Managing a large pool of funds is less expensive than managing individual accounts, but there may be more overall expenses because of the provision of annuities (which can be relatively complex to administer) and the need for professional actuarial and investment advice to ensure compliance with regulations.	While actuarial services are not required to the extent necessary for defined benefit plans, the provision of participant investment education and the cost of administering many individual funds for loans, hardship, and/or retirement benefits may make defined contribution plans more expensive. Generally, however, defined contribution plans are less expensive to administer, especially for smaller employers.
Administrative Complexity	More.	Less.
Integration with Social Security Benefits	Employers fulfill a specific retirement income objective (e.g., to replace 60 percent of preretirement income with Social Security and pension benefits), and therefore Social Security integration is accomplished more efficiently under defined benefit plans.	Integration can be accomplished, but the process focuses on the disparity in contributions and does not attempt to target a specific replacement ratio.
Providing Substantial Benefits Over a Short Time Period	Employees can be grandfathered into a new defined benefit system so as to provide special benefits that are not possible under a defined contribution approach (e.g., the quick accumulation of benefits to participants who have not participated in the system for a substantial period of time).	Unless grandfathered into a defined benefit plan, shorter tenure workers leave service with more substantial benefits under a defined contribution arrangement.
Collective Bargaining	Unions prefer defined benefit plans.	Less favored as primary plans by union leaders.
Flexible Benefit Retirement Plan Provision	Defined benefit plans cannot be part of a flexible benefit package.	Some types of defined contribution plans (401(k), profit sharing, and stock bonus) may be included in a flexible benefit package.
Company Identity/Linking Benefits with Company Performance	Investment of pension assets in company stock is prohibited beyond 10 percent of assets.	Employer contributions may be in the form of employer stock so as to tie company performance to retirement funds. In addition, profit-sharing defined contribution plans tie employee productivity to retirement security.
Paternalistic View
Responsibility given to participants.	Generally do not require employee contributions except in state and local government plans. Employer says, “Don’t worry about your retirement plan. We’ll take care of your retirement plan.”	Employees usually help fund their own retirement accounts. Employer says, “We’ll help you help yourself.” Participant-directed accounts encourage financial literacy and awareness of savings.
Investment risk given to participants.	Employer absorbs investment risk in exchange for investment control.	Employees absorb investment risk in exchange for potential investment rewards.
Inflation risk given to participants.	COLAs may be provided and are often done so for public plans. Employer may share responsibility for inflation after retirement if ad hoc COLAs are used in private plans. Employer assumes preretirement risk if defined benefit formula is based on final averages.	No room in plan design for COLA adjustments. Employees assume risk for inflation both prior to and after retirement.
Access to funds.	No preretirement access to accounts is usually provided.	Preretirement access to accounts is often provided.
Benefit provided at retirement	Benefits are usually paid in the form of life annuities.	Benefits are usually paid in the form of lump-sum distributions, which the employees may spend as they please.
Automatic enrollment.	Enrollment is automatic.	Enrollment is usually not automatic.
Investment Horizons and Expected Impact on Investment Income	A defined benefit plan allows the burden of retirement security (including the attendant investment risk) to be spread over a long period of time. In theory, defined benefit plans may be expected to hold a larger percentage of more risky (and higher yielding) investments since their relevant investment horizon spans several decades if the plan is assumed to be an ongoing operation.	A defined contribution plan usually requires employees to invest for their retirement on an individual basis. This may cause them to increase their asset allocation in less risky (and lower yielding) investments to mitigate the impact of market downturns near retirement age.
Tax Advantages	In defined benefit plans, only employer contributions are given tax-favored status.	In defined contribution plans, both employer and employee contributions may be given tax-favored status.
Best Use of Employer Retirement Funds	In defined benefit plans, all benefits accrue to retired workers and/or spouses.	In a defined contribution plan, account balances may be inherited by heirs other than spouse upon beneficiary’s death.
Approach to Informational Parity	Dedicated governance: investment expertise means that those buying and selling pension investment services have informational parity.	Employers sometimes offer participant education to increase informational parity between investors and investment services.