Variety is the key in public retirement plans
For more than 30 years, Vermont had offered its employees a traditional defined benefit plan that featured fixed annuity pensions. But, faced with the increasingly difficult task of hiring and retaining talented workers, Vermont State Treasurer James Douglas decided it was time for a change. He determined that a competitive retirement savings plan was the first step toward improving the status of public sector employment.
After months of debate, the Vermont legislature approved a defined contribution plan in 1998. The plan was put into place in fall of that year, and, by year’s end, 43 percent of the state’s exempt employees had elected to join the new program. (Any new exempt employee hired after Jan. 1, 1999, was given the option of choosing between the two retirement plans.)
As the job market tightens, many states and municipalities are taking actions similar to Vermont’s. Seven states already have converted some portion of their plans, and eight more are considering the issue during the current legislative session. Additionally, hundreds of counties, cities and towns have either converted or are looking closely at the issue.
Governments following Vermont’s lead have received positive feedback from their employees. Last year, North Dakota offered its senior employees a choice and saw 35 percent of the eligible employees choose the defined contribution plan. Fulton County, Ga., and the city of Orlando, Fla., experienced comparable results with their choice programs. In Florida and Ohio, there is pending legislation that, if passed, will create a retirement choice for more than 1 million public employees.
The success of 401(k) plans — in which 36 million Americans currently participate — is one of the forces driving the conversion. Those plans’ balances have risen as a result of high contribution rates, strong performing equity allocations and long-term investing strategies. And, as in Vermont, public-sector employers are finding it difficult to attract employees to public service, in part because of the old fixed annuity pensions.
Defined benefit plans are not necessarily inferior to defined contribution plans; they are appropriate for employees who want to receive a fixed monthly benefit payment and who will stay with the same employer for an entire career. The latter, however, is rare today, and many “Generation X-ers” will work in three or four different jobs before they reach age 40. If they work in the public sector and decide to change jobs, their defined benefit plan cannot leave with them because those plans are not “portable,” meaning they cannot be touched until retirement.
Additionally, defined benefit plans typically promise that, upon retirement, an employee receives a guaranteed monthly benefit paid out over his or her lifetime. The benefit generally is determined by a formula based on a factor multiplied by the employee’s years of service. The resulting number is then multiplied by the employee’s final average salary to determine the amount the employee will receive once he or she retires.
The normal retirement age is set by the plan, but 62 or 65 is typical. To ensure adequate assets are available when each employee retires, employers usually put money in a trust fund throughout an employee’s career. Employees do not suffer any loss if the investments in the trust fund do poorly, nor do they benefit if the investments do well. Conversely, in a defined contribution plan, the employee directs the investing strategy. Under that arrangement, the employer deducts a fixed percentage from an employee’s wages each pay period. The employee determines the best investment options in the plan and is responsible for investing the assets and saving for his own retirement.
Under a traditional defined benefit plan, employees who take other jobs have their benefit frozen on the date of separation and at their salary rate at that time. Their retirement benefit income consequently will no longer grow. An employee 20 years from retirement has no choice but to watch inflation eat away at his retirement income.
By contrast, an employee with a defined contribution plan will either take his retirement savings with him to a new job or leave it in his current plan, continue to invest it and watch its tax-deferred growth. Even if the employee never worked another day, his retirement savings have the opportunity to continue to grow.
The bottom line is choice. Some employees are better served by defined contribution plans, others by defined benefit plans. The public-sector labor market is demanding benefits it finds in the private sector.
Offering a choice of retirement plans, including a competitive defined contribution plan, will bring the benefits of public sector employment more in line with those provided by corporate America.
Ellyn McColgan is president of Fidelity Investments Tax-Exempt Services Company, a subsidiary of Fidelity Investments, Boston, Mass.