Hatching new ideas

With Oregon’s pension plan sending checks to some newly retired public employees that amounted to 100 percent or greater of their salary, and unfunded costs mounting, the state legislature in 2000 decided the retirement system had to change. In 2003, it created a hybrid pension system that combines guaranteed but limited retirement benefits with a market-based contributory plan. With the changes, the state’s liability today has been reduced from 12 percent of the previous year’s liability to 3 percent, and retirees are receiving about 80 percent of their employment salary.

“I can’t imagine going back to the old system,” says David Crosley, communication officer for the Oregon Public Employee Retirement System. “Now we have our liabilities under control. This is more in line with what the legislature originally intended.”

With pension plans again facing a difficult environment after the severe turbulence in financial markets over the last two years, governments are looking for retirement plan models that will reduce their financial burdens. Fortunately, there are states and local governments that adjusted their pension plans years ago, and have notable results that could be instructive for others considering a change.

A CASE OF LIABILITY

In the world of retirement plans, there are two basic types of pension benefits, which are distinguished by whether the employer or employee bears the responsibility for retirement income. In a defined contribution (DC) plan, the employee, the employer or both contribute a percentage of salary to an employee’s account, which is invested either by the employee or the employer, depending on the plan. The actual benefit at retirement depends entirely on the final balance available to the employee at the time of withdrawal, based on the investment performance.

In a defined benefit plan (DB), the employer guarantees a final retirement payment based on a formula that usually considers the employee’s salary, the length of service and an estimated retirement year. Employers and often employees contribute to an employer-managed fund. Regardless of the fund’s investment performance, the employer is liable for the full benefit promised by the formula. To the extent that pension assets are insufficient to pay the promised benefit, the employer has an unfunded liability. Accounting rules require that employers keep the unfunded portion of the liability within general guidelines, and a serious shortfall can be hazardous to the employer’s credit rating.

Given the markets of the last five years, governments most likely will have to start increasing their pension contributions when the fiscal year begins in the middle of 2011, according to a June 2009 report by New York-based credit rating agency Standard & Poor’s (S&P). But, finding the money to devote to the unfunded liabilities will not be easy. “The problem is one of steady future increases [in pension costs] at a time when municipalities may continue to be strapped for cash because of the effects of the current recession,” S&P concludes.

According to S&P, public pension plans were generally within the 80 percent funding level that accounting guidelines consider acceptable before the economic downturn. But, the public pension plans in 2008 had a median loss of 24.9 percent and a five-year return of 1.95 percent. Given that pension plans typically assume an 8 percent return to meet their funding requirements, the shortfall will become apparent after plans are reviewed in 2010, S&P predicts. Estimates of the total state and local unfunded liability range from $1 trillion to $3.2 trillion, depending on funding assumptions.

From a budgeting perspective, employers prefer DC plans because they know from year to year how much they will be paying, because their contributions are governed by percentage of salary and not by fluctuations in the stock market. In addition, skeptics of DB plans believe they are too vulnerable to changes from employee negotiations and arbitration rulings.

“If you could devise a defined benefit plan that never changes, it’s a better plan,” says Doug Williams, who helped convert Oakland County, Mich.’s plan to a DC plan in 1993, when he was deputy county executive. “But, what happens is when you get into bargaining, the employees want to change things — allow people to retire earlier, provide higher factors, require reduced contributions. And the changes go back to the date of hire. All of a sudden, the government is in trouble.”

But, simply closing a DB plan and switching to a DC plan, will not necessarily solve the problem, according to Keith Brainard, research director for the Baton Rouge, La.-based National Association of State Retirement Administrators, First, he notes, when given the choice, 95 percent of public employees opt for a DB plan over a DC plan. He also points out that accounting rules actually raise the cost for employers if they close an underfunded DB plan and convert to a DC plan, until 10 to 15 years after the plan is closed. Finally, he contends, DB plans are important in human resource management, keeping employees on the job and then giving them enough money to retire. Rather than closing the plans, he says, “I believe we will be seeing lower benefits for future hires and higher contribution rates for employers and employees.”

MAKING A SWITCH

Three plans in Michigan, including Oakland County, have had different experiences in converting from DB to DC plans, which illustrate some of the issues involved with reforming pension plans.

The Michigan legislature in 1997 closed the DB plan, which covers half of the employees who work for the state, and moved new employees to a DC plan to set more predictable budgets. Phil Stoddard, the state’s director of retirement services, says that only after 14 years, in 2011, will the cost of the two plans together be less than maintaining the DB plan because of the unfunded liability issue. In addition, 30 percent of the state’s employees do not take advantage of the full state contribution by making their own contributions, so some employees might not retire as securely as they would if they had a defined benefit. “The real measure of the success of the change will be the number of people who stay above poverty and government assistance,” he says. “The consequence of an unsuccessful program will not really be felt for a couple of more decades.”

In Oakland County, north of Detroit, the timing of the conversion was critical to the performance of the plan, says Judy Fandale, the county’s retirement administrator. In 1994, when the county converted from DB to DC, the DB plan was actually overfunded, so it did not suffer a spike in payments. In the end, the conversion has saved the county a total of $70 million, she says. In addition, younger workers who do not stay on the job for long can take their pension plan to their next job, which they would not have been able to do with a DB plan.

“The people who converted, beginning in the 1990s — which were great years for investments — did very well,” she says. “It’s been hard times more recently. Some people are very happy, but I do hear people say they can’t retire because of the defined contribution plan. Perception or reality, it’s hard to say.”

The third Michigan plan that relied on the DC route has a tangled history. Washtenaw County, which includes Ann Arbor, converted to a DC plan in the late 1980s as a result of requests from the employees who wanted retirement benefits that they could move with them if they changed jobs, according to Monica Boote, the county’s retirement administrator.

About five years ago, employee unions expressed interest in returning to a DB plan, she says. “The DC plan was not providing the funds available to retire,” she says. As a result, the city and the unions formed a committee to study retirement plan alternatives. There was interest in a hybrid plan, but none was available at the time, so they came up with an “out-of-the-box” solution, she says.

Under the plan, the employee contribution to the DB plan is not fixed, but it is adjusted higher if the plan’s liabilities grow. In other words, the plan benefit is fixed, but employees share the increased costs if the investments do not meet expectations. The county benefits because employees who leave soon after they begin work do not take the city’s contributions with them, as with a DC plan.

Boote admits that the plan is unusual and that other communities do not understand the city’s decision to move back to a DB plan. But she thinks the county’s plan works for both the employer and the employees. “We share the liability,” she says. “It’s a shared approach.”

COMBINING THE BEST OF BOTH PLANS

With the difficulties of closing plans and the rising costs of keeping them open, the combination of the DC and the DB plans may begin to look more attractive to some employers and pension experts, who often cite the examples of the plans in Oregon and Washington state.

The Oregon legislature created a plan that corrected the problems of the previous plan, which were primarily caused by generous benefit increases during strong markets that left the plan underfunded during down markets, Crosley says. Under the new plan, employees contribute 6 percent of their salary to their Individual Account Program (IAP) account, and the employer contributes about 8 percent to the DB plan. An unusual feature of the plan is that IAP assets are not managed by employees but centrally by the Oregon Investment Council, which allocates its portfolio among a mix of stocks, bonds and other investments. The rate of return on the $51 billion DB portion of the plan is capped at 8 percent, regardless of market performance.

As a result of the changes, the plan has moved from a badly underfunded liability “to one of the best funded pension systems in the country,” Crosley says. “[Even after the significant market retrenchment,] we’re still 80 percent funded and better off than a lot of systems in the nation.”

In Washington state, the legislature created plans that largely leave to the employee the decision of whether to remain entirely in the DB plan or to participate in a hybrid benefit DB/DC plan, called Plan 3. “The policy goal was to be in line with a changing workforce, where employees are much more likely to move to different jobs, where people do not stay in their careers for 20 or 30 years,” says Jeff Wickman, assistant director of the state’s Department of Retirement Services.

Under the DC portion of the plan, employees have a choice of contribution amounts (in addition to employer contributions) and state-managed investment portfolios. Wickman says his agency has devoted considerable resources to providing sufficient information to eligible employees to help them to make the right decision. “We want them to think things all the way through,” he says. “We make them aware of the fact that they are taking personal responsibility on a major pension benefit.”

Hybrid plans, like those in Washington state and Oregon, will be given a closer look in the future, considering the performance of the pension funds in the weak markets, says Brian Graff, executive director of the Arlington, Va.-based American Society of Pension Professionals and Actuaries. “The defined benefit plan makes a terrific retirement benefit for the worker,” he says. “From the worker’s perspective, it’s much easier to deal with as opposed to having to manage those benefits for themselves.”

But given the rising costs, there will be more pressure to incorporate a DC component in the plans, Graff says. “Certainly, it would be preferable to maintain the defined benefit plan,” he says. “But it’s not what we wish. There’s a practical reality.”

• Read the “State and local hybrid retirement plans” sidebar to learn what some governments are doing.

Robert Barkin is a Bethesda, Md.-based freelance writer.

State and local hybrid retirement plans

Washtenaw County, Mich.

• the DB plan benefit is fixed, but employees share the increased costs if the investments do not meet expectations

• employees who leave soon after they begin work do not take the city’s contributions with them

Oregon Public Service Retirement Plan

Defined contribution component (Individual Account Program, IAP)

• employees put 6 percent of their salaries in their IAP accounts

• employees are automatically vested in their IAP accounts

• membership is portable to other IAP-participating employers

• IAP assets are managed by the Oregon Investment Council

Defined benefit component (Pension program)

• benefits are based on salary x length of service x factor

• rate of return is capped at 8 percent

Washington’s “Plan 3”

Defined contribution component

• funded by employee contributions and investment earnings

• employees have a choice of contribution amounts (in addition to employer contributions) and state-managed investment portfolios

Defined benefit component

• a 401(a) defined benefit plan

• participants receive a benefit based on service credit and average final compensation

• funded by employer contributions and investment earnings

• contributions are held in trust and invested by the Washington State Investment Board