POLICY BRIEF FROM AMERICANS FOR TAX REFORM

By Peter J. Ferrara

In this Policy Brief:

• Introduction
• The Arizona Public Employee Retirement System
• A Defined Contribution Plan for Arizona
• Advantages of Defined Contribution Reforms
• Criticisms of Defined Contribution Plans
• Transition Issues
• Conclusion
• Table 1: Retirement Benefits under defined contribution plans and defined benefits plans: 5.5% return on investment
• Footnotes
• SUPPLEMENT: Map of Defined Contribution States

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 these funds plus accumulated returns over the years finance retirement benefits. 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.

A trend is now developing among the states to begin to shift public employee pensions towards defined contribution plans as well. Michigan adopted a comprehensive defined contribution system for state workers in 1996. California began adopting such a plan for some of its workers that year as well, and the reform process there continues. Ten states have now adopted defined contribution reforms for a portion of their workers. Legislation for such reform is now pending in six states, including Arizona, and formal legislative studies for such reforms are under way in 12 other states.

Arizona's public employee pension system has been well run. But reform providing for defined contribution retirement plans would provide important benefits for both workers and taxpayers. The current system lacks portability for workers, while a defined contribution plan would provide full and immediate portability. For taxpayers, while the current system is fully funded, a defined contribution system avoids any dangers of unfunded liabilities arising in the future. Moreover, the defined contribution plan reduces administrative costs for the state, as it then merely pays a specified portion of salary into a worker's account each month, and no longer has to administer plan benefits or a large, centralized pool of investments to finance those benefits. Both taxpayers and workers also consequently avoid the political risks of administration of such a large investment pool in the public sector, where the funds can be mishandled, subject to political giveaways, exposed to counterproductive political favoritism in investment, and other risks. While these may not have been problems in Arizona in the past, they can be in the future.

Basically, the defined contribution plan privatizes the investment function of the public employee pension system, producing these and other benefits.

The Arizona Public Employee Retirement System

The Arizona retirement system for public employees actually includes four plans. Almost 90% of state workers are in the Arizona State Retirement System (ASRS). Law enforcement officers, firefighters and others are in the Public Safety Personnel Retirement System. Correction officers are in the Correction Officers Retirement Plan. State and county elected officials and judges are in the Elected Officials Retirement Plan.

All of these plans are similar, traditional defined benefit plans. Because the great majority of workers are in the ASRS, that plan will be described in more detail later.

Under ASRS, workers can retire when their age plus years of service totals 80. So, for example, a worker can retire at 55 with 25 years of service. Workers can retire in any event at age 65, or at 62 with 10 years of service.

Retirement benefit are equal to 2% times years of service times average earnings during the last three years of service. So a worker who retires at 55 with 25 years of service would receive benefits equal to 50% of pre-retirement income. Some inflation adjustments are payable, depending on years of service up to 3%, if investment earnings for the year exceed 9%. The retiree may choose survivors benefit options as well, which may reduce retirement benefits.

The right to these benefits vests after five years. Workers who leave before then receive back only their own contributions plus fixed interest, and lose all employer contributions and investment returns. Even after five years, workers who leave state employment cannot take their employer contributions and investment returns with them. They can only take out their own contributions plus fixed interest, and forego all future benefits under the system. Or they can wait until retirement and receive whatever retirement benefits they are entitled to given their years of service.

The system is financed by equal contributions from the employer and employee set each year at the level actuarially necessary to maintain full funding of benefits. Current contribution rates are about 3% of earnings from the employer and each employee, for a total of 6% of earnings for each worker. This reflects the strong performance of the stock market in recent years. In times of more average or even below average returns, the contribution rate would climb, perhaps much higher. Another 0.5% of wages from employer and each employee, for a total of 1% per worker, are assessed for disability benefits.

The ASRS is totally funded, with assets equal to about 114% of accrued benefits.

Pension Liberation Across America

States across the country are now starting to move to new defined contribution retirement plans for their public employees, in place of the older defined benefit plans. The leader was Michigan, which adapted a comprehensive plan in 1996 proposed by Governor John Engler.

Under that reform, current state employees can choose the new defined contribution plan or stay in the old defined benefit plan. All newly hired employees will be in the defined contribution plan. The reform originally committed to including all public school employees in the reform. But since the old defined benefit plan was not fully funded, this has been delayed to avoid transition funding problems.

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 could choose to switch to the new defined contribution plan only during an open season in the first four months of 1998. For those that make the switch, all past employee contributions to the defined benefit plan are 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 is 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 pre-selected 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 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.

The reform process in California began with legislation proposed in 1996 by Assemblyman Howard Kaloogian (R-San Diego). His bill would have authorized but not required 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.

A limited version of Kaloogians's plan passed in 1996, providing for new defined contribution options for employees of the state's colleges and universities. Kaloogian is continuing legislative efforts to expand this option to all government workers in the states. His most recent bill would expand the option to all employees of the state legislature.

Other states with defined contribution systems for some of their employees includes Ohio (university employees), Illinois (university employees), Washington (public school employees), Alabama (university employees), West Virginia (public school employees), South Dakota (university and some other employees), Colorado (public school employees) and Missouri (university employees). Legislation to provide for such plans for more government workers is pending in California, Colorado, South Dakota, Florida, and Oklahoma, as well as Arizona. Twelve states also have formal legislative studies under way to consider such reform--Connecticut, Iowa, Massachusetts, Missouri, Montana, New Mexico, North Dakota, Ohio, Oklahoma, Vermont, Virginia, and West Virginia.

A Defined Contribution Plan for Arizona

Arizona should offer its workers an alternative defined contribution retirement plan as well. This plan can be structured as follows.

Workers and employers would each pay the same amount into this defined contribution retirement plan that they pay for the current retirement system. This is presently about 3.5% of wages each for employer and employee counting the disability benefits. Workers can be allowed to voluntarily contribute additional amounts, up to a total of 10% of their wages counting the employer contributions, or any higher limit allowed by federal tax law. Under the current defined benefit plan, the required contribution can rise as necessary to finance the promised benefits depending on investment performance. The employer would be required to pay any such increased amounts for the current defined benefit plan into the defined contribution plan. But the worker would be left free to decide whether to match those required contributions.

All contributions to the defined contribution plan would go into an individual investment account for each worker. These contributions would immediately become the private property of each worker with no vesting period. The worker would then choose an investment company to manage his or her account and pick the particular investments for the account. The workers could choose from a wide range of different companies approved by the state. Companies that wanted to manage such funds would apply to the state for approval. The state would approve only reliable firms with established expertise, which would commit to comply with the state's rules and regulations. Such companies would include major stock brokerage firms, banks, insurance companies, mutual funds and others. Workers could switch among these investment companies during an open season each year.

The investment companies would then determine what particular stocks, bonds and other investments to buy with the funds in each worker's account. Highly risky and speculative investments would be prohibited. But the funds could be invested in domestic and foreign stocks and bonds, government securities, perhaps certain real estate vehicles, and other instruments. The Federal regulations currently applying to investments in Individual Retirement Accounts and 401(k) plans would be a good model to follow.

Investment returns to the accounts would be tax free over the years. Some of the contributed funds would be set aside to buy private life and disability insurance matching the survivors and disability benefits of the current defined benefit system. The investment company chosen by the worker would be responsible for obtaining such insurance. No withdrawals from the defined contribution investment account would be allowed before retirement.

The worker could retire at any age at which retirement is permissible under the current defined benefit system. Retirement benefits would equal what the funds accumulated in each worker's retirement account could support. Workers could choose to buy a private annuity with some or all of the funds, which would guarantee specified benefits for the rest of the worker's life. Or the worker could rely on periodic withdrawals from the accounts, which would be limited to ensure that workers would not run out of funds before a reasonable life expectancy.

Workers in the work force today who have already paid into the current defined benefit plan by any number of years would be free to choose to switch to this new defined contribution plan. They would each receive a lump sum payment from the current defined benefit plan into their new defined contribution retirement accounts. This payment would be equal to their share of the assets in the current defined benefit plan which had been set aside to finance their accrued retirement benefits. This should compensate them sufficiently for both the employer and employee contributions paid into the system over the years for them.

The new defined contribution plan would only be an option for all current and future government workers in the state covered by any of the current defined benefit plans. They would each be free to choose it or to choose to stay in the current defined benefit plan if they desire. Workers still in the defined benefit plan would continue to be free to choose the new defined contribution alternative during an open season each year.

Advantages of Defined Contribution Reforms

Such a defined contribution reform plan would produce enormous advantages for the state workers and taxpayers of Arizona.

Advantages for Workers

Portability. The clearest advantage for workers of the defined contribution plan is portability. The funds would be paid directly into each individual worker's own account and immediately become the worker's direct property. When a worker leaves state employment for another job, he or she can then take this individual retirement account with them. This account would include all past employer and employee contribution plus full market investment returns. Consequently, the defined contribution plan provides for full portability..

The current defined benefit ASRS plan, by contrast, has no real portability. When a worker leaves, he or she can take with them only their own past contributions plus fixed interest. They must give up the employer contributions for all of their years of work, all investment returns on those contributions, and the full market investment returns on their own contribution in excess of the fixed interest they can withdraw.

This lack of portability is highly damaging to shorter term and younger workers. And shorter term here means those working less than about 15 years in state employment. For reasons discussed fully below, the ASRS, like defined benefit plans generally, does not provide good benefits for younger workers who stay less than 15 years or so in service. The system is skewed to favor the longest term workers. As a result, the shorter term workers cannot take anything but their own money with them when they leave, and they are not offered good benefits if they just wait to receive what the system will later pay them. These workers can frankly do much better by just taking their own money out and investing it, rather than waiting for these future benefits from the system.

While specific data was not available for Arizona, the same is probably true here as for other states. As a result of the lack of portability and the plan's benefit structure, most state workers end up not getting any significant benefits from a typical defined benefit retirement system. They just end up leaving with their own money back. In California, which has defined benefit plans for their government workers similar to the ASRS, 70% of state and local workers end up not getting any retirement benefits from the system. In Michigan, 45% of state workers and 65% of public school employees effectively received no benefits under the old defined benefit plan.

The defined contribution plan solves these problems with full and immediate portability. Under this plan, 100% of workers would get retirement benefits for the years they worked for state or local government. And they would take those benefits with them wherever they go. This would be highly beneficial for younger and shorter term workers who stay in public employment roughly 15 years or less, which probably constitutes the majority of people who work for state or local government for at least part of their lives.

Vesting. The defined contribution plan also eliminates any vesting requirement. The funds paid into the worker's account immediately become the property of the worker and remain fully available to pay future retirement benefits. This includes the employer as well as employee contributions and all investment returns on those contributions. Under the current defined benefit system, by contrast, the 5 year vesting requirement eliminates any real benefit for workers who stay less than 5 years.

The defined contribution plan is consequently highly beneficial for these shortest term workers. A vesting requirement can be imposed on a defined contribution plan, as in Michigan, allowing workers to take permanent control of the funds in their own accounts only after the vesting period. But there is really no good reason for such a requirement in the defined contribution context. A vesting requirement in a defined benefit plan makes sense to eliminate small and relatively inconsequential benefit payments to numerous short term employees, and the burden of keeping track of the financing and payment of such benefits. But in a defined contribution plan, the government simply pays a proportion of the worker's salary into the worker's own account and leaves it to the worker after that. Eliminating any vesting requirement here would allow all workers to receive retirement contributions for the years they worked for the government employer, without any significant administrative burden on the system.

Fair Benefits. Under traditional defined benefit plans, benefits are skewed to favor the longer term and oldest workers and disadvantage the younger and shorter term workers. This occurs in the ASRS as well, in several standard ways.

First, of course, the vesting requirements eliminate benefits for those working less than 5 years, with the funds devoted to benefits for those working longer term.

Secondly, the benefits are a percentage of final salary, which tends to be much higher for those have worked the longest, and for older workers. Take the example of a worker who enters governmental employment at 22, continues that employment for 15 years, and then leaves for a private sector job. The final three years of salary used to calculate the worker's benefits at retirement will be the years when the worker was 35-37. No salary increases for the next 25-30 years of the worker's career will be counted. By contrast, suppose another worker starts employment at 22, continues working for the same government employer for 40 years, and retires at 62. As compared to the first worker, this worker's benefits will naturally equal an additional 2% of salary for each additional year worked past age 37, which fairly gives the worker credit for the additional years worked. But this additional 2% per year will be taken against the final salary at age 62, which will include 25 years of additional salary increases. This gives the second worker more benefits for each year of work than the first worker.

Indeed, compare the first worker to an older worker who also works 15 years for the government employer. Assume this older worker starts government employment at age 47, continues that employment for 15 years, and retires at age 62. That worker will receive benefits equal to 2% for each of the 15 years of service, or 30%, times the average salary at ages 60-62. The average salary at these ages will incorporate an additional 25 years of salary increases as compared to the salary at ages 35-37 which is used to calculate the benefits of the first worker, who will receive 30% times this lower average salary. So the older worker will receive much higher benefits even though he or she worked the same number of years as the younger worker.

Thirdly, granting the same percentage of final salary for each year worked, 2%, does not give the full value to younger workers of the contributions made for them. Consider again our worker who enters government employment at 22, works for 15 years, and then leaves for private sector work. The contributions paid into the system for him during his years of employment, including his own contributions, continue to earn investment returns for many years after he leaves government employment. Yet, this worker will only get the same 2% of final salary for each of his 15 years of government employment as other workers. Consequently, the worker will get nothing for all the years of investment returns on his contributions after he leaves employment. These returns will be redistributed to finance the higher benefits of older and longer term workers. Indeed, the contributions for the older worker who entered government employment at age 47 and retired at 62 only earn returns for 15 years before the worker's retirement, while the contributions for the younger worker earned returns over a 40 year period before retirement at age 62. Yet, the older worker receives more in benefits rather then less, with funds effectively redistributed to that worker from the younger worker.

Inflation makes the problem even worse. Salary increases over the years usually incorporate compensation for inflation. When benefits are calculated based on salary, they will incorporate the compensation for inflation included in the salary increases over the worker's career. But for younger, shorter term workers, this inflation compensation stops when they leave government employment, as the salary used for their benefit calculations is fixed at that age. So, for our 15 year worker who leaves for the private sector at age 37, the value of his salary for retirement benefit calculations will be depreciated by inflation over the next 25 years, until retirement at age 62. The value of the worker's benefits will consequently be depreciated by such inflation as well. By contrast, the longer term and older workers will be fully compensated for inflation through their salary increases over working years.

None of these distortions occur in the 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 contributions in any event. Each worker also gets the full market investment returns on the contributions for every year thereafter, giving him the full value of those contributions, rather than redistributing some to others based on a calculated percentage of final salary. Finally, those investment returns over the years will also include an inflation compensation component, again giving the worker compensation for inflation for each year after the contribution is made.

Consequently, the defined contribution plan gives fair, undistorted benefits to each and every worker. Those who work longer get proportionally higher benefits to the extent they worked longer. But they do not get disproportionally higher benefits, skewed to favor them over other workers, and effectively redistributing funds from these workers to them.

Personal Control. In the defined contribution plan, the retirement funds for each worker are under the direct ownership of the worker in his or her own individual account. Workers can then pick the private investment manager that will best serve them in the private competitive market. They consequently no longer have to worry about adverse changes in their retirement plan or politicians failing to make good on their promises, at least for the years already worked, as the contributions for those years already belong to them in full.

Better Benefits. Younger and shorter term workers who work roughly 20 years or less in government employment would generally get much better benefits from the defined contribution plan, because of the all the factors discussed above. Suprisingly, however, even the longest term workers would likely get better benefits form the defined contribution plan as well.

This is shown in the accompanying Table. The table assumes a 5.5% real rate of return earned on retirement investments over the long run. In fact, over the 70 year period from 1926 to 1996, the composite real rate of return on all stocks in the Standard and Poors 500 was 7.5%.1 The composite real rate of return on smaller company stocks on the New York Stock Exchange over this period was even higher, at 9.5%.2 A diversified portfolio of 75% large stocks and 25% small stocks would have earned a real return of 8%. Over the long term, the real return paid by investment quality corporate bonds has been 3-4%.3 So a 5.5% real return is a quite fair assumption allowing for some diversification of stocks and bonds, reasonable administrative costs (which should be less than 50 basis points), and quite ordinary investment performance.

Take the example of a worker who earns $30,000 per year over his career after inflation. The table assumes that the same 6% of salary is paid into the defined contribution plan each year as paid currently into the ASRS. After 40 years of work, this worker would retire with a fund of about $250,000 in today's dollars. Assuming retirement at the normal Social Security retirement age, that fund would finance an annuity paying the worker almost $35,000 per year each year for the rest of his life, or about 116% of preretirement income. The ASRS would pay the worker 80% of final salary, or $24,000 per year. So the defined contribution plan would actually pay the worker about 45% more. For those who work for 30 instead of 40 years, the table shows that for those who retire at the normal Social Security age the defined contribution plan would still pay slightly more than the ASRS defined benefit plan. This would apply to a worker who started employment in his mid 30s and retired in his mid 60s. But under ASRS those who start covered employment in their early 20s can retire after 30 years and receive the benefits shown starting in their early 50s. This is a substantial advantage of the ASRS plan for these workers.

However, this comparison is based on the current 6% contribution rate that is due to the recent fabulous stock market performance. When that performance returns to the normal long term levels reflected in the assumption of a 5.5% real return on investment in the table, this contribution rate will have to increase substantially. Such a higher contribution rate paid into the defined contribution plan would allow earlier retirement for these 30 year workers closer to the ASRS. Moreover, the advantages of the ASRS for these workers is based on a redistribution from other workers in the system, primarily younger and shorter term workers, which is unfair.

Advantage for Taxpayers

No Investment Risk. The most obvious advantage for taxpayers of the 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 like the ASRS, 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.

No Political Risk. Defined contribution plans greatly reduce another set of risks that are usually overlooked- political risks. With the government specifying benefits far in the future, as under a defined benefit plan like the ASRS, 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 favortism 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 draw supposedly excess funds out of the pool in one way or another, perhaps by replacing an overfunded plan with a new one, or reducing the government's contributions. Or they may try to use the funds for short-term added benefits. Politicians and bureaucrats have been known even to siphon funds out of these plans improperly or illegally. These actions would again raise costs for taxpayers.

Government management of the funds also creates the risk of mishandling 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 these abuses in the past, as in Arizona, the danger is always present. However, 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 eliminates the danger of any unfunded liability, from any source, that must be covered by taxpayers. Under a defined benefit plan, like the

ASRS, 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, with these funds financing each worker's future benefits, there is no possibility of an unfunded liability that taxpayers would have to cover.

Greater Control Over Costs. The defined contribution plan 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 amount 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.

With the defined contribution plan, by contrast, the government is responsible only for a specified contribution each year. This contribution is completely dependent only on what the government agrees with workers or their union 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 unfunded liability that will require increased taxes.

Reduced Costs. A defined contribution plan will 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. It must also administer the benefits, determining eligibility and making payments.

With a defined contribution plan, by contrast, administrative costs for the government employer 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.

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. Because the ASRS seems to be much better run than the California system, immediate cost savings from a defined contribution reform here would probably not be nearly as great, but would still probably be significant.

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 proposed above was carefully structured to avoid this problem. Under that plan, workers would simply pick from a wide range of sophisticated, highly reliable, investment management companies. These would include large banks, insurance companies, stock brokerage firms, and others. These highly sophisticated investment managers would then be picking the individual stocks, bonds and other investments, not the workers.

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 subject to inflation risk. As inflation rises, the specified benefit in an unadjusted defined benefit plan is worth less and less. 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 several 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, with professional investment managers handling the specific investments for workers, investment risk can be minimized in a sophisticated and reliable manner through diversification and other market strategies.

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.

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, like the ASRS and the other current Arizona plans, 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 through the transition, climbing from $80.7 million before the conversion to $86.4 million after the conversion.4 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.5

Conclusion

Arizona should adopt the defined contribution reform plan advanced in this study. That plan would offer state and local government workers the choice of a defined contribution retirement plan in place of their current defined benefit plans. This new plan offers great advantages for both workers and taxpayers.

Defined Contribution Retirement Benefits

Assumes 5.5% Real Return on Investments, (figures in 1998 dollars)

Defined Contribution Plan vs. Defined Benefit Plan: 40 Years of work

 

Defined Contribution Plan vs. Defined Benefit Plan: 30 Years of work

 

Defined Contribution Plan vs. Defined Benefit Plan: 20 Years of work

 

Defined Contribution Plan vs. Defined Benefit Plan: 10 Years of work

 

Footnotes

1. Stocks, Bonds, Bills and Inflation, 1997 Yearbook, (Chicago, Ill., Ibbotson Associates, Inc., 1997)

2. Ibid.

3. Calculated from Moody's Investor Services, Industrial Manual, Bond Survey

4. Peter J. Ferrara, Pension Liberation, American Legislative Exchange Council, State Factor, 1996

5. Ibid.