Recession was catalyst for change

In the world of retirement systems, the traditional defined benefit (DB) plan ruled for generations in both the public and private sector. In a DB plan, the employer (and sometimes the employee) adds money to a fund, and the benefit that an employee receives at retirement is based on length of service and pay. Funds are invested by the fund (and its professional managers), and the responsibility for the benefit falls entirely to the employer. If investments do not meet expectations, employers must add funds from their general operations.

In the newer defined contribution plan (DC), the employer (and often the employee) adds money to an account in the employee’s name, and the benefit upon retirement depends entirely on the amount available in the fund. The investment risk falls to the employee.

While just 21 percent of private sector employees participate in a DB plan, almost 87 percent of public sector workers are covered by these plans, according to 2009 data from the U.S. Bureau of Labor Statistics. The vast majority of private sector employees who have any retirement plan are covered by DC plans.

When the deep recession hit the United States in 2008 and 2009, the decline of the stock market had a devastating impact on the investments in pension funds set aside to pay the promised benefits, with the unfunded liabilities — or the amount promised but not covered — skyrocketing to more than 50 percent for some plans. A study by Robert Novy-Marx and Joshua Rauh published in the Fall 2009 Journal of Economic Perspectives estimated that the unfunded liability across state governments amounted to $3.2 trillion. While others dispute the methodology of the study, everyone agreed that the public sector pension system was in deep trouble.

All in all, 41 states and many cities have made significant changes to some aspect of their pension plan, says Ilana Boivie, director of programs for the Washington-based National Institute on Retirement Security (NIRS). “They have run the gamut,” she says. “The common wisdom that the benefit was rock solid from the date of hire was challenged in the fiscal crisis.”

In some states, the initial focus has been on no longer offering the DB plan to new hires, as an immediate means of reducing the cost to the employer. While the thinking is that closing an under-funded plan would save money, the economics of retirement plans works against that solution.

Keith Brainard, research director for the Essex, Conn.-based National Association of State Retirement Administrators, points out that taking such an action requires changes to required payments because the life of the plan becomes limited and unfunded liabilities have to be paid out faster. “When you close an existing plan, your costs go up,” he says.

Instead, cities and states have focused on adjusting employee and employer contribution levels, restructuring benefits, or both.