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POLICY BRIEF FROM AMERICANS FOR TAX REFORM
By Peter
J. Ferrara
In this Policy Brief:
Introduction
Over the past 20 years, the private
sector has shifted dramatically towards "defined contribution"
pension programs, where the employer pays a specified amount into an
investment account for the worker and benefits equal what these accumulated
invested funds can finance. The number of private sector employees in
such plans soared from 11 million in 1975 to 43 million in 1995, an
increase of about 300%. Contrast that with the stagnation of private
defined benefit plans, where the employer promises a specified retirement
benefit and saves and invests the funds in a common investment pool
to finance those benefits. From 1975 to 1995, the number of private
sector employees in such plans grew by less than 10%, from 33 million
to 36 million. The majority of private sector employees with pensions
are in fact now in defined contribution plans. Yet, in the public sector,
government employees remain overwhelmingly tied to old-fashion defined
benefit plans. In 1994, 91% of public sector employees were in such
plans, little changed from 93% in 1987. The proportion of public employees
in defined contribution plans has remained stable at 9% over the years.1
The time has come for the public sector
to join the private sector in reaping the advantages of defined contribution
plans. This would benefit both public employees and taxpayers.
For workers, the defined contribution
plan is fully portable, as workers are able to take the funds paid into
their accounts wherever they go. Those who work for a few years in the
public sector and then move on, as most now do, would not lose all of
their employer pension contributions, as with typical defined benefit
plans. Moreover, the funds are under the control of each worker. They
don't have to worry about politicians mishandling the funds, accumulating
unfunded liabilities, or cutting their benefits. Indeed, in the private
market even the longer term workers may well earn higher benefits than
promised in defined benefit plans. Overall, such reform provides workers
with broad freedom of choice and control.
For taxpayers, the defined contribution
plan avoids the risks of having government bureaucrats invest huge pools
of retirement funds. Instead, the government's expenses are fixed as
a percentage of payroll each year, with no investment risk or danger
of unfunded liabilities. This promotes certainty and stability in budgeting.
In addition, the simple defined contribution plan saves large amounts
in administrative costs, and possibly funding costs as well. At the
same time, because of the above benefits of defined contribution plans
for workers, such plans will help public employers recruit the best
workers.
Because of these overwhelming advantages,
a legislative trend is developing in the states in favor of defined
contribution plans for public employees. Michigan has recently adopted
a plan creating a defined contribution option for all of its workers.
California has adopted legislation for such an option for some of its
workers, with more bills pending. Additional legislation is pending
in at least 20 states.
This report will analyze these proposals
and assorted issues. It will first describe in more detail the typical
structure and features of defined benefit and defined contribution plans.
It will then describe the benefits of defined contribution plans and
the criticisms. It will next discuss in detail the recent reform efforts
in Michigan and California, and briefly note developments in other states.
Two Retirement Plan Models
Under a traditional defined benefit
plan, workers are promised a specific benefit amount for each month
in retirement. The government employer pays retirement contributions
into a common investment pool for all covered workers. The workers may
be required to make some contribution as well. The government employer
then invests the funds in the common pool, which are used to pay promised
benefits in retirement.
The benefits are usually subject to
a "vesting" requirement, which provides that the employee
must work at least a minimum number of years to receive benefits. Typically,
the minimum is ten years. If the worker leaves his job for another employer
before satisfying the minimum vesting requirement, then the worker loses
any claim to the employer's contributions to the retirement pool made
for the worker during his employment. The worker typically gets back
any contributions he made to the common pool, plus interest.
The benefit amount in retirement is
usually determined by a formula multiplying some percentage, such as
1-2%, times the number of years of service for the employer, times the
worker's final salary, or average of 3 highest years of salary. For
example, suppose an employee works 30 years for the government employer
and then retires with a final salary of $50,000. If the percentage factor
is 1%, then the annual retirement benefit is 1% times 30 times $50,000,
or $15,000.
While the employee's benefit is specified
in advance under the defined benefit plan, the employer's cost of funding
the plan is highly uncertain. The employer must contribute enough each
year so that with investment returns the saved funds will be sufficient
to finance the promised benefits. But whether the contributions will
be sufficient depends on a wide range of factors that vary over time.
These include life expectancy, the growth in future earnings, investment
performance, inflation and other factors. If the amount saved in the
common investment pool falls below the level necessary to fund future
promised benefits, the shortfall is called an "unfunded liability."
This unfunded liability then has to be covered, usually by higher contributions.
Under a defined contribution plan,
the employer simply contributes a specified percentage of the worker's
salary, typically 7%-10%, to an individual investment account for the
worker. The worker may be required to make a contribution as well, perhaps
3% of salary. The worker then directs investment of the funds over the
years, within certain limits. The worker's retirement benefit then equals
what the accumulated funds can finance by that time.
The employer contributions under this
plan are typically not subject to vesting requirements. The contributions
become the property of the worker when paid into the account. Because
the worker's benefits equal whatever the invested funds can support,
there is no possibility of an unfunded liability. The employer's costs
under these plans are fixed and certain. Yet the employee's ultimate
benefit is not fixed in advance.
As previously noted, 91% of state and
local workers are covered by defined benefit plans, compared to 9% covered
by defined contribution plans. Retirement funds held by public sector
defined benefit plans total about $1.6 trillion, compared to $20-$25
billion held by public sector defined contribution plans.
Advantages of Defined Contribution
Plans
As noted above, public defined contribution
plans offer valuable advantages for both workers and taxpayers, as compared
to public defined benefit plans. These advantages are discussed in detail
below.
Advantages to Workers
Portability. The most obvious advantage
of defined contribution plans for workers is portability. Since the
contributions are paid directly into individual accounts for each worker,
it is easy simply to allow workers to take their accumulated funds with
them when they change jobs. As a result, workers get to keep the full
past contributions made on their behalf and their full accrued benefits.
In a defined benefit plan, by contrast, the contributions for each worker
are in a common pool where each worker's share is not separately identified.
Because of vesting requirements and other features of the benefit formula,
withdrawals and other payments from the common pool for workers who
depart before attaining long term service do not reflect their fair
share of past employer contributions, as discussed further below.
Immediate Vesting. In a pure defined
contribution plan, the employer's contributions to the individual account
become the full property of the worker upon payment. As a result, the
worker enjoys immediate vesting of employer retirement contributions.
This greatly benefits the majority of state and local government workers
who are not going to stay with one employer for the rest of their careers.
In a typical defined benefit plan,
by contrast, the employer contributions are again kept by the government
in a common pool, and the worker's rights to them typically vest only
after long periods of 10 years or so. As a result, most workers lose
out, as most remain with one state or local employer for less than 10
years. For example, in California 70% of state and local workers lose
all employer retirement contributions because they stay with one employer
for less than 10 years, and consequently fail to meet the 10 year vesting
requirement. Moreover, even workers who stay longer do not receive the
full benefit of the employer contributions until they have worked well
beyond 10 years.
Personal Control. In the defined contribution
plan, the retirement funds for each worker are under the control of
the worker in their own individual accounts. Workers can consequently
adopt the investment strategies and benefit plans that best suit their
own individual needs and preferences. As a result, they may well end
up with higher benefits than under a traditional defined benefit plan,
as discussed further below. Moreover, under the defined contribution
plan they don't have to worry about politicians taking away benefits
or bureaucrats mishandling funds and losing their retirement assets.
Fair Benefits. Under a traditional
defined benefit plan, the benefits are skewed to favor the longer term
and oldest workers over others, in at least 3 ways. First, the vesting
requirements eliminate benefits for those working less than 10 years
or so, with the funds then devoted to the longest term workers. Secondly,
the benefits are a percentage of final salary, which tends to be much
higher for those who have worked for the employer the longest, or for
older workers.
Thirdly, granting the same percentage
of final salary for each year worked (1%-2%) does not grant the full
benefit of the contributions for younger workers who remain employed
for several years, then leave. For example, take a worker who enters
government employment at 22, works for 15 years, and then leaves for
a private sector job. Under a traditional defined benefit plan, he will
qualify for benefits when he reaches retirement. But he will only receive
the same 1%-2% of final salary for each year worked as other workers
under the benefit formula. Yet, the contributions paid for him during
employment continued to earn investment returns for many years after
he left employment. The worker, however, receives no benefit from these
additional investment returns.
Indeed, contrast this younger worker
with an older worker who enters government employment at age 50 and
continues to work there for 15 years., retiring at age 65. The contributions
for this worker earned investment returns for far fewer years than those
for the younger worker. Yet, this worker will get the same 1%-2% of
final salary for each year worked as the younger worker. If the older
worker's salary was higher, as is likely, he will actually get more
benefits in retirement than the younger worker, even though the contributions
for the younger worker earning returns for many more years would have
accumulated to much more by retirement. The younger workers are consequently
denied the full benefit of their contributions, which are redistributed
in large measure to others.
None of these distortions occur in
a standard defined contribution plan. The contributions to the worker's
account immediately vest as the property of the worker, so the worker
gets to keep those full contributions in any event. The worker also
gets to keep the full returns earned by those contributions over the
years, rather than leaving them to others based on a calculated percentage
of final salary. The defined contribution plan consequently provides
fair, undistorted benefits to each worker, granting each the full value
of the contributions made for them.
Higher Benefits. The defined contribution
plan includes no limit on the benefits workers can receive. Those who
achieve strong investment performance in their individual accounts will
receive substantially higher benefits than offered under a standard
defined benefit plan. In fact, there is good reason to believe that
on average workers in defined contribution plans will receive substantially
higher benefits than offered by defined benefit plans.
Those managing the common investment
pool for a defined benefit plan are investing only to finance the targeted
benefit levels. For career workers, these will range from 30% to 80%
of final salary and cluster around 45%-65%.2 The
managers will not invest more aggressively to achieve higher benefits,
even when that can be done safely. If they do attain higher investment
returns, the employer will likely reduce contributions or withdraw the
excess assets.
Contributing a standard 10% of salary
each year to a defined contribution plan that earns the full standard
investment returns available in the market will produce higher benefits
than those targeted under a typical defined benefit plan. And those
who would benefit the most are the longest term workers who thought
they were getting the most out of the skewed benefits of defined benefit
plans.
The average real rate of return earned
in the stock market going back over the last 70 plus years, all the
way back to 1926, is 8%.3 The average real rate
of return on corporate bonds over that period is 3% or more.4
A conservative portfolio with half of each would earn 5.5%
Assume a worker who earns around $30,000
per year over his career in constant inflation adjusted dollars. If
10% of that salary is contributed to a personal investment account for
the worker earning a real return of 5.5% each year, then after 40 years
that investment account would total $432,357, again in constant, inflation
adjusted dollars. (See Table I) That amount would finance an annuity
paying about $60,000 per year each year for the rest of the worker's
career. A defined benefit plan paying 1.5% of final salary for each
year of work would pay only $18,000 per year. A defined benefit plan
paying 2% of final salary for each year of work would pay only $24,000
per year. So the defined contribution plan would pay 2 ½ to 3
½ times the benefits of the defined benefit plan. (See
Table 1)
A worker's earning $40,000 each year
would reach retirement after 40 years of work with a retirement account
total of $576,476, again in constant dollars. That amount would finance
an annuity of $80,000 per year, compared to $24,000 - $32,000 for a
defined benefit plan. A worker earning $50,000 each year would retire
with a fund of $720,595, paying about $100,000 per year, compared to
$30,000 to 40,000 for a defined benefit plan. Again, the defined contribution
benefits are 2 1/2 to 3 ½ times the defined benefit plan payments.
(See Table 1).
Now suppose the worker retires after
only 30 years of work. At a salary of $30,000 per year, the worker would
retire with a fund of $313,457, which would pay about $43,000 per year
in benefits compared to $13,500 to $18,000 for a defined benefit plan.
The defined contribution benefits are still 2.4 to 3.2 times the defined
benefit plan payments. (See Table I). The $40,000 per year worker would
retire after 30 years with a fund of $ 417,942, paying about $58,000
per year in benefits, compared to $18,000- $24,000 for the defined benefit
plan. The $50,000 per year worker would retire after 30 years with a
fund of $522,428, which would pay about $73,000 per year, compared to
$22,500 - $30,000 in the defined benefit plan. (See Table I) Again,
the defined contribution plan pays 2.4 to 3.2 times the defined benefit
plan.
Now suppose the worker's retirement
account doesn't perform as well as others for some reason and earns
only a 4 % real return, which is just half the average return in the
stock market over the last seventy years. A $30,000 per year worker
would retire after 40 years of work with a trust fund of almost $300,000.
That fund would pay almost $37,000 per year for the rest of the worker's
life, again all in constant, inflation adjusted dollars. The defined
benefit plan would pay $18,000 - $24,000 per year. (See
Table 2) So the defined contribution plan would pay 50-100% more.
A $40,000 per year worker would retire
after 40 years with a trust fund of almost $400,000, which would pay
almost $50,000 per year, compared to $24,000 - $32,000 for the defined
benefit plan. A $50,000 per year worker would retire with a trust fund
of almost $500,000 per year paying over $61,000 per year, compared to
$30,000 to $40,000 for the defined benefit plan. (See
Table 2) In these cases, the defined contribution plan again pays
50-100% more than the defined benefit plan.
Now suppose the worker's retires after
only 30 years. The $30,000 per year worker would retire with a trust
fund of about $175,000, paying about $21,000 per year, compared to $13,500
to $18,000 for the defined benefit plan. The $40,000 per year worker
would retire with a trust fund of $233,000 paying about $28,000 per
year, compared to $18,000-$24,000 for the defined benefit plan. The
$50,000 per year worker would retire with a trust fund of almost $300,000,
paying about $36,000 per year compared to $22,500 to $30,000 for the
defined benefit plan. (see Table 2). The defined
contribution benefits are still substantially more than the defined
benefit plan payments.
These calculations all assume retirement
at the standard Social Security retirement age, which is 65 today and
will rise to 67 over the next 25 years. To the extent workers can receive
retirement benefits under the defined benefit plans at earlier ages
those plans would do much better compared to the defined contribution
plans. But such defined benefit plans also require much higher contribution
rates than 10% of salary, which was used as the basis for the defined
contribution benefits alone. At a minimum, however, these calculations
show that the longer term workers would do quite well under defined
contribution plans, and would quite possibly receive significantly higher
benefits than under a typical defined benefit plan.
Freedom of Choice: Finally, the defined
contribution reform proposals maximize the freedom of choice of workers.
Under the defined contribution plans, workers can choose their own investments,
investments strategies, and investment managers. They can also choose
their own benefit structures and vary their benefits over time, perhaps
leaving more in the accounts to accumulate further earnings. Current
workers can also choose whether they want to be in the defined contribution
plans or stay in the defined benefit plans, and under most proposals
this is true for future workers as well. The bottom line is that the
defined contribution reform proposals give workers maximum freedom of
choice and control over their own money.
Advantages for Taxpayers
No Investment Risk: The most obvious
advantage for taxpayers of a defined contribution plan is that it eliminates
investment risk for them. With the government managing a common pool
of investment funds under a defined benefit plan, the taxpayers bear
the complete risk of poor investment performance. If such poor performance
leaves the pool unable to pay the promised defined benefits, then the
taxpayers will have to make up the difference.
Under the defined contribution plan,
however, the taxpayers simply make a specific contribution to the accounts
of the workers each month. The government is then not liable for the
investment performance of the funds. Workers' benefits equal whatever
the accumulated funds can finance. Taxpayers consequently are not subject
to any risk of investment performance.
No Political Risk: Defined contribution
plans eliminate another set of risks that are usually overlooked - political
risks. With the government specifying benefits far in the future, as
under defined benefit plans, there is always a strong danger of political
giveaways by short-sighted politicians. These politicians can promise
higher retirement benefits, while leaving future officials and taxpayers
to pay for them. Under a defined contribution plan, where the government
does not specify future benefits but only makes regular investment contributions,
this risk is eliminated.
Moreover, a large government investment
pool, as under a defined benefit plan, is always subject to the danger
of political interference that could raise costs. Political favoritism
may influence investment policy, prohibiting some investments and forcing
the fund into others. By taking the focus off of simply maximizing investment
returns, such political favoritism will reduce investment returns and
increase the cost of funding the specified defined benefits.
Politicians may seek to raid the large,
tempting investment pool in other ways as well. They may seek to withdraw
funds for other uses, claiming an excess of funds which may be temporary
or chimerical. Or they may try to use the funds for short-term added
benefits. These actions would again raise costs for taxpayers.
Government management of the funds
also creates the risk of mishandling of the funds by bureaucrats who
lack the incentives, competitive pressures, and expertise of private
investment managers. Attempts to insulate the funds from bureaucratic
control by contracting out to private investment managers may not be
entirely successful.
Finally, a large government investment
pool creates the risk for taxpayers of greater government control of
the private economy. Through such a pool, the government may end up
owning large shares of private companies. The government would also
hold a large share of investment capital that it could use to impose
mandates on the private sector. Even where there has been a good record
of avoiding such abuse in the past, the danger is always present.
None of these risks arising from a
large government investment pool exist in a defined contribution plan,
where the government does not maintain such a pool.
No Unfunded Liability. The defined
contribution plan also eliminates the danger of any unfunded liability
that must be covered by taxpayers. Under a defined benefit plan, any
shortfall in the common investment pool that leaves the pool unable
to pay the promised benefits, creating an unfunded liability, must be
covered by the taxpayers, regardless of the cause of the shortfall.
In the defined contribution plan, where the government does not maintain
a common investment pool but only pays a specified amount to each worker's
individual account each month, and benefits equal what those accounts
can finance, there is no possibility of an unfunded liability that taxpayers
would have to cover.
Greater Control Over Costs. The defined
contribution plan also provides the government and taxpayers greater
control over costs. Costs under a defined benefit plan, where the government
has pledged to provide a certain benefit regardless of cost, can vary
greatly, depending on a wide range of factors outside the government's
control. Retirees can live longer, greatly increasing costs. More workers
may stay with the government employer long term, increasing costs. Interest
rates or the stock market may decline, requiring increased contributions
to make up the difference.
A defined contribution plan by contrast,
the government is responsible only for a specified contribution each
year. This is completely under the government's control, depending only
on what the government agrees to pay. This means in turn greater certainty
and predictability in budgeting. There is no possibility that taxpayers
will be surprised with a large, unexpected cost that will require increased
taxes.
Reduced Costs. A defined contribution
plan can also significantly reduce costs. Defined benefit plans have
large administrative costs for the government employer. The government
must maintain and pay for the management of the large common pool of
assets. Moreover, federal law imposes many regulatory requirements on
such plans, regarding distribution of benefits, eligibility, investment
policies, etc. Complying with and reporting on these requirements significantly
adds to costs.
With a defined contribution plan, by
contrast, administrative costs are negligible. The government simply
pays an amount into each employee's own account as part of payroll processing.
The worker takes over administration of the account after that.
A defined contribution plan may save
the government on funding cost as well. The discussion above showed
that workers can get high benefits, paying more even than their final
salaries, with only 10% of salary paid into the individual defined contribution
accounts. Indeed, these benefits can be substantially higher than under
typical defined benefit plans. Yet, such plans typically cost more than
10% of payroll. With a defined contribution plan, government employers
may be able to get a better deal for their workers while paying less
into the plan.
In California, the state Department
of Finance estimated that the defined contribution plan offered by Assemblyman
Howard Kaloogian would save the state's taxpayers $1,642 per employee
each year, due to the above factors. That adds up to a very large benefit
for taxpayers.
Improved Employee Recruitment. Finally,
because of the advantages to employees noted above, defined contribution
plans can help employers attract better employees. Highly talented workers
may not be willing to commit to state government employment long-term.
But they may be willing to work for a state or local government for
a few years. The defined contribution plan would make it easier to recruit
such workers because it is fully portable, and the workers can take
the saved contributions with them when they leave. Moreover, these and
other workers would favor the freedom of choice, personal control, and
possibly higher benefits that they could get through defined contribution
plans.
Criticisms of Defined Contribution
Plans
Unsophisticated Workers
One of the major criticisms of defined
contribution plans is that most workers are too unsophisticated about
investing to handle the responsibility of directing their own retirement
investments. This underestimates the capabilities of working people.
Nevertheless, the plan can be easily structured to avoid this problem.
As part of the plan, the employer can
offer workers a preselected list of the major, highly reliable mutual
funds, complete with their performance records . The list can include
only highly diversified funds likely to achieve the average market returns
discussed above over the long run. There are hundreds of such plans
in the US. By picking these funds, workers would effectively be picking
only the investment managers for their accounts. These highly sophisticated
investment managers would then be picking the individual stocks, bonds
and other investments, not the workers.
The plan can also offer the workers
a list of investment managers who have agreed to follow certain guidelines
in investing the workers' accounts, again calculated to produce a diversified
portfolio that would likely follow average market returns over the long
run. The workers' union can be one of the investment managers. Here
as well, the worker would be picking only the investment manager and
that sophisticated manager would be picking the individual investments.
Workers need not be limited to these
options. But the availability of these options obviates the problem
of the unsophisticated worker.
Investment Risk
Probably the main criticism of defined
contribution plans is that they shift investment risk from the employer
to the worker. In a defined benefit plan, the worker receives the specified
benefits regardless of investment performance, so the worker bears no
investment risk. In a defined contribution plan, the worker's benefits
depend entirely on the investment performance of his retirement account,
so the worker bears full investment risk. Poor investment performance
leads directly to lower benefits.
What is not widely recognized is that
while defined contribution plans leave workers subject to investment
risk, defined benefit plans without inflation adjustments leave workers
fully subject to an unavoidable inflation risk that would be devastating
when inflation is high. As inflation rises, the specified benefit in
an unadjusted defined benefit plan is worth less and less, and there
is nothing the worker can do to avoid this. Under a defined contribution
plan, by contrast, the worker's investments would rise along with inflation
over the long run, providing a real, above inflation, market rate of
return. This would tend to keep prospective long run benefits rising
with inflation.
Also not sufficiently appreciated is
that workers can fully handle the investment risk posed by defined contribution
plans, for two main reasons. First, retirement investments are very
long term. The worker is investing not only for his entire career, but,
indeed, for his entire life, as the remaining retirement fund will continue
to be invested to support benefits throughout retirement. With such
a long-term investment horizon, perhaps 60 years or more, workers can
weather many ups and downs in investment performance, with the average
return on a diversified portfolio very likely over the long run to close
in on the average long term market return.
Secondly, workers can easily invest
in simple, widely available, highly diversified pools of stocks, bonds
and other investments, through mutual funds and other vehicles. Such
diversified pools will track the general market investment returns discussed
above over the long run. Indeed, with a sufficiently broad based investment
pool, the worker would basically own a piece of the economy as a whole.
If the entire economy collapses, state and local governments will not
be able to support defined benefit plan promises either.
Thirdly, market investment returns
leave a wide margin for error . Our calculations above showed that at
even half the average return earned in the stock market even the longest
term workers would receive much higher benefits through a defined contribution
investment account than through a typical defined benefit plan. So a
worker's investments can perform well below market averages and still
maintain adequate retirement support.
Workers, indeed, may be able to handle
this investment risk better than state and local governments. For they
can do so without all of the political risks discussed above.
Survivors and Disability Benefits
Some argue that defined contribution
plans do not include survivors and disability benefits while defined
benefit plans do. But defined contribution plans can be structured to
match any benefits offered by defined benefit plans. Funds in the defined
contribution plan can be devoted to purchasing life and disability insurance
that will fully cover survivors and disability benefits.
Transition Issues
Another argument is that the transition
to a defined contribution plan will be costly because the government
will have to pay the workers leaving the defined benefit plan their
share of accumulated funds to take to the new plan. But if the defined
benefit plan is fully funded, then it will have the money to pay the
departing workers saved in its common trust fund. If the defined benefit
plan is not fully funded, then it needs to be in any event, and the
government will have to bear that cost anyway.
Moreover, experience shows that those
who leave defined benefit plans to take a defined contribution option
are primarily the shorter term and younger workers with little in accumulated
funds in the defined benefit plan. As a result, while 63% of the government
workers in West Palm Beach, Florida chose the newly offered defined
contribution plan, they took with them only 14% of the assets of the
old defined benefit plan. The assets of that plan actually continued
to increase throughout the transition, climbing from $80.7 million before
the conversion to $86.4 million after the conversion. Similarly, while
42% of the government workers in Oakland County, Michigan chose the
new defined contribution plan, they took with them only 13% of the assets
of the old defined benefit plan. That plan's assets continued to increase
throughout the transition as well, climbing from $440.4 million before
the conversion to $513.6 million after.
Reform Plans
State reforms providing for defined
contribution plans are discussed below.
Michigan
Michigan Governor John Engler proposed
a defined contribution reform plan for state workers on November 7,
1996. The legislature passed it by the end of the year. It is now considered
one of the Governor's major accomplishments.
The reform provides that all new state
employees hired after March 31, 1997 and all new public school employees
hired after July 31, 1997 will be in the new defined contribution plan.
Current state and public school employees will have an option to join
the new defined contribution plan, or they can stay in the current defined
benefit plan.
Under the defined contribution plan,
the state contributes a minimum of 4% of the worker's salary to an individual
investment account for each worker. The employer will then match voluntary
employee contributions up to an additional 3% of salary, making a total
contribution of 10%. The worker can contribute up to an additional 13%
of salary without employer match at the worker's choice.
The plan includes a vesting feature
added to the traditional defined contribution model. The employer contributions
are vested 50% after 2 years , 75% after 3 years, and 100% after four
years. Before such vesting, the employer contribution to a worker's
individual account must be returned if the worker leaves to work for
another employer.
Current employees may choose to switch
to the new defined contribution plan only during an open window in the
first four months of 1998. If they do make the switch, all past employee
contributions to the defined benefit plan will be transferred to the
defined contribution plan. In addition, for workers who are vested in
the defined benefit plan, an amount equal to the present value of their
accumulated retirement benefits will be transferred to their defined
contribution account as well. Once a worker switches to the defined
contribution plan, he cannot later choose to go back to the defined
benefit plan. On the other hand, after the four month window in early
1998, workers in the defined benefit plan can no longer choose to switch
to the defined contribution plan. For current workers who do switch,
their prior service in the old defined benefit plan is counted toward
the 4 year vesting requirement of the defined contribution plan.
Investment options are structured for
workers to make investing easy for them. First, they can choose from
three core investment funds with set percentages of asset allocations
in different investment areas, reflecting a range of risk and return
variations. State Street Global Advisors, the third party administrator
for the plan and one of the largest pension investment firms in the
world, will maintain these three funds, choosing the particular investments
and holding to the preset asset allocation requirements.
Secondly, the worker can choose from
among 12 preselected mutual funds considered the best in their primary
investment areas, whether stocks, or bonds, or other private investments.
Finally, the worker can choose a self-directed option which includes
the choice of hundreds of mutual funds determined to be sound and suitable
for retirement investment.
Workers who leave state employment
under the defined contribution plan can leave their assets in the same
structured investment system, or roll them over into an Individual Retirement
Account or a retirement plan maintained by their next employer.
Current workers who switch to the defined
contribution plan will receive the same retiree health benefits as under
the old defined benefit plan. For new workers in the defined contribution
plan, the state will pay 3% of the cost of the health benefits for each
year of service, up to a maximum of 90%. The retiree pays the rest.
These benefits vest after 10 years of service. Retirees can choose any
alternative private health plan and direct the state premium contribution
towards payment of that plan. This includes private Medical Savings
Account plans.
The state's reform plan provides for
no change in the benefits of current retirees. Moreover, there will
be no change in benefits as well for employees who choose to stay in
the old defined benefit plan.
The state Department of Management
and Budget estimates that Michigan will save almost $100 million in
the first year alone because of the new defined contribution plan. Yet,
45% of state employees and 65% of public school employees who effectively
received no benefits under the old plan because they left state employment
too early will now be able to benefit under the new system after state
employment of only 2 years, with fully vested benefits after only 4
years.
In addition to the state, four major
counties in Michigan have switched to defined contribution plans for
their workers. These include Oakland County, Saginaw County, Washtenaw
County, and Wayne County. The state capitol, Lansing, has switched as
well, and the city of Kalamazoo has a partial defined contribution plan.
California
The reform process in California began
with legislation proposed in 1996 by Republican Assemblyman Howard Kaloogian,
from X. His bill would authorize but not require state and local employers
throughout the state to offer defined contribution plans as an alternative
to their defined benefit plans. The defined benefit option would have
to be maintained as well. Non school employers could choose to have
the defined contribution plan administered by the California Public
Employees Retirement System (CalPERS) and school employers could choose
the State Teacher's Retirement System (STRS). Alternatively, the employer
could choose any qualified private company, or could administer the
plan itself.
The bill required employers to transfer
accrued benefits from the defined benefit plan to the worker's defined
contribution account, for workers who chose the new plan option. Otherwise,
remaining details of the defined contribution plan, such as employer
and employee contributions, would be left to negotiations between employers
and workers. The bill in particular allows immediate vesting of all
employer contributions to the defined contribution accounts. It would
also allow a structured investment system as under the Michigan reforms
discussed above.
The bill would expand benefits to 70%
of state workers, who receive no benefits under the state's existing
defined benefit plan because they never satisfy the vesting requirements.
At the same time, because of savings on administration and funding costs,
the state Department of Finance estimated that the bill would save a
whopping $1,642 each year for each new employee who chose the new system.
The bill would affect 1.2 million workers in the CalPERS and STRS plans,
which hold $165 billion in vested assets.
The political course of the legislation
was revealing about the nature of the opposition, which seemed to stem
from special interest considerations, and the ultimate appeal of the
proposal. Before the special interests were activated, Kaloogian's proposal
sailed through the Assembly by a 43 to 29 margin, in a vote on May 31,
1996.
In the Senate, however, the bill ran
into strong opposition from public employee unions. Since the bill would
expand benefits to the 70% of workers now excluded, and so many workers
choose the defined contribution plan wherever it is offered, the unions'
opposition is plainly motivated by their own institutional interest,
rather than the interests of workers. The unions just want workers dependent
on explicitly union-negotiated benefits, not the workers own portable
assets.
Similarly motivated opposition arose
from CalPERS and STRS, the established retirement plans. They just didn't
want workers departing from their plans, and thereby reducing theirs
size and clout. They also didn't want competition from alternative administrators.
They suggested that they would develop a modified defined contribution
plan that they would administer. But as Kaloogian rightly told Pensions
and Investments newspaper, "Competition is necessary and the current
systems monopoly on management and administration of pensions must end."5
This opposition, however, was successful
in stopping Kaloogian's broad bill in the Senate. But the legislature
settled on a narrower compromise. The state's colleges and universities
lobbied heavily for the Kaloogian option because, they argued, it would
help them greatly in recruiting top academic talent. Top professors
would be more willing to move to California schools knowing that if
they stayed only a few years, they would still receive pension benefits
they could take with them. As a result, a final bill passing both houses
by unanimous consent and signed into law on August 9, 1996 provided
the Kaloogian option for employees of the state's colleges and universities.
This year Kaloogian is offering a new
proposal. His new bill (AB14) would provide the option to all employees
of the state legislature. Kaloogian argues that these are the shortest
term workers in the state on average and most need the new option. The
bill is cosponsored by Democrat Assemblyman Dick Floyd from Los Angeles,
the legislature's most pro-labor proponent.
Other States
Defined contribution plans for local
government workers have proliferated in Colorado, Florida, Michigan
and Texas. Options for such plans have been recently adopted for teachers
in West Virginia and Washington State, and other public employees in
Colorado.
In December, 1996, Ohio passed legislation
providing a defined contribution option for all higher education employees.
A similar option exists for higher education employees in South Dakota,
Missouri, Alabama, and now California. Ohio also passed legislation
last year requiring a study of expanding the option to all state employees.
Similar studies are under way in 9 other states, including Vermont,
Massachusetts, Connecticut, Virginia, West Virginia, Iowa, Missouri,
Oklahoma and Montana. Legislation to expand defined contribution plans
is pending in 20 states.
Conclusion
Proposals to provide a defined contribution
retirement option for state and local government workers involves a
unique opportunity to benefit these workers and state and local taxpayers
at the same time. State and local governments should consequently consider
adopting such an option for their workers.
TABLE I
Retirement Benefits under defined
contribution plans and defined benefits plans: 5.5% return on investment
(figures in 1997 dollars)(6)
Forty Years of Work: Defined Contribution
Plan vs. Defined Benefit Plan
| Annual Salary |
Total Investment Fund Accumulated
By Retirement |
Annual Annuity Benefit |
Replacement Rate |
Annual Benefit7 |
Replacement Rate |
|
$30,000
|
$432,357
|
$60,278
|
201%
|
$18,000-$24,000
|
60%-80%
|
|
40,000
|
576,476
|
80,481
|
201%
|
$24,000-32,000
|
60-80%
|
|
50,000
|
720,595
|
101,540
|
203%
|
$30,000-40,000
|
60-80%
|
Thirty Years of Work: Defined
Contribution Plan vs. Defined Benefit Plan
| Annual Salary |
Total Investment Fund Accumulated
By Retirement |
Annual Annuity Benefit |
Replacement Rate |
Annual Benefit(7) |
Replacement Rate |
|
$30,000
|
$313,457
|
$43,011
|
143%
|
$13,500 -$18,000
|
45% - 60%
|
|
40,000
|
417,942
|
58,268
|
146%
|
$18,000-24,000
|
45% - 60%
|
|
50,000
|
522,428
|
72,934
|
146%
|
$22,500-30,000
|
45% - 60%
|
TABLE II
Retirement Benefits under defined
contribution plans and defined benefits plans: 5.5% return on investment
(figures in 1997 dollars)(8)
Forty Years of Work: Defined
Contribution Plan vs. Defined Benefit Plan
| Annual Salary |
Total Investment Fund Accumulated
By Retirement |
Annual Annuity Benefit |
Replacement Rate |
Annual Benefit (9) |
Replacement Rate |
|
$30,000
|
$296,480
|
$36,882
|
123%
|
$18,000-$24,000
|
60%-80%
|
|
40,000
|
395,306
|
49,199
|
123%
|
$24,000-32,000
|
60-80%
|
|
50,000
|
494,133
|
61,655
|
123%
|
$30,000-40,000
|
60-80%
|
Thirty Years of Work: Defined
Contribution Plan vs. Defined Benefit Plan
|
Annual Salary
|
Total Investment Fund
Accumulated By Retirement
|
Annual Annuity Benefit
|
Replacement Rate
|
Annual Benefit
|
Replacement Rate
|
|
$30,000
|
$174,985
|
$20,981
|
70%
|
$13,500 -$18,000
|
45% - 60%
|
|
40,000
|
233,313
|
27,975
|
70%
|
$18,000-24,000
|
45% - 60%
|
|
50,000
|
291,642
|
36,280
|
73%
|
$22,500-30,000
|
45% - 60%
|
Footnotes
1. Some employers can have both plans,
using the defined contribution plan as a voluntary supplement to the
defined benefit plan. As a result, in the past the proportion of public
employees participating in each type of plan added up to over 100%.
2. At 1% of final salary for each year
worked, a 30 year worker will receive 30% of final salary. At 2% of
final salary for each year, a 40 year worker will receive 80% of final
salary.
3. Ibbottson and Sinquefeld; Shipman.
4. Peter J. Ferrara, Social Security
Rates of Return for Today’s Young Workers (Washington, D.C., National
Chamber Foundation, 1986).
5. Christina Williamson, "Calfornia
Funds Fear Asset Drain," Pensions and Investments, June 24, 1996.
P. 2.
6. Assumes retirement at the normal
Social Security age.
7. Range assumes defined benefit plan
provides 1.5% - 2% of final salary for each year of work.
8. Assumes retirement at the normal
Social Security age.
9. Range assumes defined benefit plan
provides 1.5% - 2% of final salary for each year of work.
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