Choices for a secure retirement
Just as the roles of public employees have changed over the years, so have their pension plans. Although some plans were started in the late 1800s, public pensions came to the fore with the advent of Social Security. They have continued to change with the national shift toward individual responsibility for saving and the subsequent demands for portability.
More than a few plans are available to localities, and each has advantages and disadvantages. Therefore, local government administrators must not only understand the mechanics of the plans but must choose the most appropriate plans to balance short-term concerns, such as plan costs and the number of eligible employees, with long-term security.
The options More than 14 million state and local government employees and retirees are covered by public pension plans, which, according to Chicago-based Government Finance Officers Association, hold nearly $2 trillion in assets.
Although they are established by state and local governments, public pension plans are independent entities, usually governed by elected officials. They are subject to myriad laws and rules, ranging from federal law and IRS codes to local ordinances and the policies of their own boards. The plans vary widely in design and implementation, and hybrids are evolving every day.
In both the public and the private sectors, two major types of retirement plans – defined benefit and defined contribution – have evolved. Jennifer Harris, executive director for the Public Retirement Institute (PRI) in Alexandria, Va., says most cities and counties offer defined benefit plans.
Defined benefit plans pay retirement benefits according to a formula that is generally based on length of service and final average salary. The employer (and often the employee) makes plan contributions based on actuarial assumptions about the employee base (e.g., turnover, salary increases, longevity) and investment earnings.
Many defined benefit plans are “contributory,” according to GFOA’s “An Elected Official’s Guide to Public Retirement Plans.” It states that 72 percent of public employees in defined benefit plans make contributions along with their employers.
Unlike the defined benefit plan, a defined contribution plan pays retirement benefits based solely on contributions and earnings. Contributions are made by the employer, the employee or both.
(In the private sector, the most common defined contribution plan is the 401(k), named after the tax code section that describes it. The 401(k) has rapidly become the preferred plan for employers, primarily because it can be less expensive and less complex to administer, and it can limit the employer’s liability for future payouts. Employees can make their own investment decisions, and the accounts are portable, meaning that they can be rolled over to another employer’s plan or to an individual retirement account. The plan also may include contributions from the employer.)
Although local governments generally cannot offer 401(k)s, they do offer 403(b)s, which allow local government employees such as teachers and health care workers to participate in a tax-deferred annuity (TDA). Federal law restricts the amount the employer and employee may contribute to a TDA; generally, the maximum contribution is based on current earnings, years of service and previous employer contributions to a TDA or other pension plan. The 403(b) plans allow matching contributions from employers, and, like 401(k)s, they permit the employer to establish a vesting schedule for the matching funds.
Among government-deferred compensation plans, Section 457 is another commonly used option. Benefits usually consist only of employee contributions and earnings.
If a 457 plan provides benefits commensurate with Social Security (see the story on page 43), it theoretically could be set up as the mandatory substitute plan. However, 457s most often are set up as voluntary plans that supplement pension plans, Social Security or both. Although 457 plans also can include an employer match, only a handful of governments actually make matching contributions.
Withdrawal regulations make 457s unique among public pension plans. Because the 457 plans are not considered retirement plans, contributors may begin taking payouts at any time, regardless of age. Taxes are due upon withdrawal of the funds, but there is no “premature distribution” penalty.
Multiple groups and needs Governments, like most large corporate employers, primarily offer defined benefit plans, perhaps with supplemental defined contribution plans. Some state and local governments are beginning to consider converting part (or, in rare instances, all) of a defined benefit plan to defined contribution.
If the area has a stable population and the government wants long-term employees, a defined benefit plan may compensate for significantly lower salaries than are offered in the private sector. On the other hand, the area may be populated by transients – perhaps it is tourist-oriented – or the government may want to encourage a certain amount of turnover. In those cases, the youngest and the brightest potential workers might be most attracted by portability of benefits.
Local officials considering conversion, as well as those who are setting up new plans, should examine the potential workforce carefully when choosing a retirement plan. While cost can be a primary consideration in converting a defined benefit plan to a defined contribution plan (i.e., converting from a primarily employer-funded plan to one that is funded primarily through salary deferral), decision-makers may fail to consider long-term consequences of a conversion.
For example: * even though the employer may reduce its plan-related expense by implementing a defined contribution plan, it may have to increase salaries to compensate for the lack of such a benefit; * defined contribution plans require greater employee investment education – at a greater expense to the government – than defined benefit plans; and * if employees fail to participate in the defined contribution plan, or if they withdraw their money through loan provisions (available in some 403(b)s) or invest imprudently,the locality could be saddled with a population of poor seniors.
Converting a retirement plan is an arduous task, and it is sometimes expensive since it involves consultants, actuaries, lawyers and plan providers. That is not to say that a conversion is necessarily undesirable – only that it is important for officials to learn as much as possible, determine their objectives and design the pension plan(s) accordingly.
In cases in which a locality is establishing a defined contribution plan, each government entity may have to garner the support of as many as 10 to 15 unions, depending on the services the locality provides. For example, it will need to discuss proposed changes with union representatives of public safety, health care, transportation, corrections and more.
The local government administrator probably will appoint a board consisting of the government’s finance director, budget director, head of human resources and council/commission members to oversee the transition. Discussions should be broad-based, and all players must understand the advantages and disadvantages of the retirement plans from both the employee and the employer perspectives.
In addition to considering costs and labor issues related to a new plan, officials must seek to design a conversion that will not disappoint those employees who have worked the longest with the expectation of a secure retirement. Defined benefit plans usually are more generous than defined contribution plans; their benefits are fixed (most often, as a percentage of ending salary) for life, whereas benefits from defined contribution plans are finite. Therefore, their elimination is likely to produce an outcry from employees.
Legislative adjustments Recent legislation has revised public pension regulations, and pending legislation suggests that more changes are on the way. Some reforms resulting from the Small Business Job Protection Act of 1996 included: * asset protection; * relief from Section 415 contribution and benefit limitations and nondiscrimination rules; * a requirement that 457 plan assets be placed in trust; * the stipulation that the maximum contribution level in 457 plans be indexed for inflation, as it is in 401(k)s; and * the stipulation that plans are allowed to “cash out” or pay inactive accounts under $3,500 in value.
The trend in the private pension universe is to enhance the portability of defined contribution plans, and government employees are demanding the same portability for 457 and 403(b) plans. This year, Rep. Earl Pomeroy (D-N.D.) introduced the Retirement Account Portability Act of 1998, which has drawn bipartisan support in Congress.
Provisions of the bill would allow employees to “roll over” benefits among 401(k), 403(b) and 457 plans. They also would enable 403(b) and 457 account holders to “park” their tax-deferred compensation assets in a “conduit” IRA while they are between jobs or waiting to put the assets into another employer’s plan. Finally, the bill would permit public employees to transfer assets from all defined contribution plans to public defined benefit plans, improving portability between the public and private sectors.
Similar portability provisions are included in the Retirement Security for the 21st Century Act of 1998, introduced by Reps. Rob Portman (R-Ohio) and Ben Cardin (D-Md.). The bill also would: * enhance and give greater flexibility to 457s; * increase annual limits on contributions to defined contribution plans; * increase the annual benefit limits for defined benefit plans; and * increase the amount of compensation that may be taken into account in determining contributions to qualified retirement plans.
Although the provisions make specialized pension plans more portable, officials administering tax-regulated 457s still have some concerns. For example, depending on how a portability law is interpreted, the provisions may allow 457s to adopt the loan features of 401(k)s and 403(b)s.
Opponents of 457 portability cite estimates that about one-third of the assets of 401(k)s is currently borrowed by accountholders. Although participants must pay themselves interest as they re-pay their loans, some of those funds will never go back into the plans, meaning participants may not accumulate the necessary funds for a secure retirement.
The administrative burden presented to plan sponsors is another concern about portability. Furthermore, if the 457s are adapted to resemble 401(k)s and 403(b)s (i.e., if the three tax code sections were combined), the 457s would likely have to adopt the 591/2 age threshold for penalty-free withdrawals.
The number of plan choices and pending legislation have created an unprecedented need for financial education among public pension administrators and plan participants. Designers should begin with a look at the needs of the locality and its employees, then complete their blueprints with knowledge of all the options. Only then can they construct a program that meets short- and long-term goals for secure retirements.
Irene Khavari is assistant vice president and national director of industry relations for Aetna Retirement Services, Hartford, Conn.
More than a few state and local employees – 22 percent in 1994, according to the Bureau of Labor Statistics – do not contribute to Social Security. Public jurisdictions were prohibited from participation in Social Security when it first began, and most created their own pension systems to meet the particular needs of their employees.
When Social Security was opened to public entities in the 1950s, many jurisdictions voluntarily adopted it to cover retirement for all or some of their employees. However, others determined that they could best provide retirement benefits for all or some of their employees through their own plans. (Any locality that opts out of Social Security is required to provide a comparable, alternative retirement benefit.)
The Public Retirement Institute, Alexandria, Va., reports that, today, of all public pension plans, those covering public safety employees are the most likely to have opted out of Social Security. According to the organization, 86 percent of the nation’s public safety employees are not covered by Social Security.
Should national Social Security reform become a reality, the most sweeping change for cities and counties could be the requirement that all government employees contribute to the system. The General Accounting Office (GAO) has studied the potential effects of such a change and plans to issue a report later this year. In the meantime, GAO’s testimony regarding the results is available on the web at www.gao.gov. – Irene Khavari
There is perhaps no greater reward for a lifetime of hard work than a comfortable retirement. But realizing that dream takes a good deal of financial planning and preparation.
Many local governments offer 457 deferred compensation plans, in which employees voluntarily invest a portion of their salaries. The savings plans have become popular supplements to Social Security and/or traditional pension plans.
The package of services and investment options that make up the 457 plan can directly affect a plan’s performance. The provider is best chosen through a competitive bidding process, and city and county officials should consider several elements when making their selections.
* Can the provider educate participants? Perhaps the most critical aspect of retirement planning is getting the right assistance and information. After all, what point is there in providing employees with a host of investment tools without teaching them how to use them?
Educational services, especially when personalized, are the most effective tool to encourage plan participation. Employees can benefit from group seminars on the basics of investing, determining financial goals, deciding how much investment risk to assume, selecting the right type of investment options and other issues.
Seminars should be supported by clearly written, easy-to-understand brochures, booklets and videos. And all of that often is provided at no additional cost to the plan’s sponsor or participants.
* Can the provider evaluat e plan performance and assist individual participants? Retirement planners should be available to meet with employees individually to discuss their personal financial needs. Those sessions should be scheduled periodically to review investment results and to help employees allocate their assets to meet their current financial goals.
* Does the plan offer multiple investment options? Having a wide choice of investment options allows employees to tailor investments to fit their individual needs. For instance, if someone has many years before retirement, equity-based investment options may be most appropriate because they offer the greatest potential for long-term gain. Conversely, someone closer to retirement may be more concerned about preserving current savings and may choose lower-risk, more stable investment options.
In any case, the provider should be able to produce long-term records of performance for all the investment options. The performance histories should cover at least five years (and preferably 10 or more), and they should be evaluated net of all fees so that participants understand what they are actually getting for their money.
* Does the plan offer annuitization? As employees approach retirement, their focus begins to shift from saving retirement dollars to finally enjoying them. Employees want to know if they will have enough retirement income to last a lifetime and that loved ones will receive the plan benefits should the employee die before retirement.
The right deferred compensation plan can help answer those questions with variable annuities, which allow plan participants to choose a regular stream of income that will continue for a specific number of years, for life or for the life of the retiree and his or her spouse.
* Is the plan cost-effective? When comparing providers, it may be helpful to compare costs per specific services. For example, “discount” providers may charge extra for education programs, literature, seminars, administration or other services. In setting up retirement plans, local governments are looking for savings programs that meet employees’
financial needs through a variety of stages – from the time they first think about retirement savings to the time when they begin drawing on them. The plan provider should be able offer services and investments that accommodate those stages. By defining their goals and asking a questions during the bidding process, local officials can lower the risk in choosing such a guide.
This article was written by Janet Gorski, an assistant vice president and director of product development for Hartford Life Insurance Cos., Simsbury, Conn.