Press Releases Legislative Alerts Congressional Ratings Heroes and Enemies Maps Email ATR Site Map Search
Home Press National Issues State Issues The Pledge Special Projects Get Active Join Donate
Legislative Alerts
Open Letters
National Projects
Cost of Government Day
Congressional Caucuses
Legislative Advisory Project
Congressional Ratings
K Street Project
National Issue Areas
Speeches and Testimony
Join ATR
Take Action!
Search ATR
Get Acrobat Reader

POLICY BRIEF FROM AMERICANS FOR TAX REFORM

Public Sector Pension Reform

Creating Portable Pensions for Government Employees

By Peter J. Ferrara
April 2002

Executive Summary

Over the past 25 years, private-sector pension plans have shifted dramatically away from defined benefit (DB) plans and towards defined contribution (DC) plans, with more than twice as many private workers now in DC plans as in DB plans.

The states have now begun to shift public employer pensions towards DC plans as well:

  • Three states, Michigan, Nebraska, and West Virginia have or are phasing in a system based on a DC plan only;
  • Six states, Florida, Montana, New Jersey, North Dakota, Ohio and South Carolina, have or are phasing in a system allowing state employees and/or school teachers the freedom to choose to substitute a DC plan in place of the old DB plan;
  • Three states, Washington, Indiana and Oregon, have hybrid DB/DC plans;
    --Another 20 states offer small groups of their workers a DC plan in place of the traditional DB plan;
  • Forty-eight states in all allow workers to choose a supplemental DC plan in addition to the main DB or DC plan; and
  • Forty-nine states overall offer at least some workers some DC plan.

These DC plans offer valuable advantages for both workers and taxpayers. Recent federal legislation has now substantially expanded the contribution limits for DC plans.

States should move aggressively on the following reform agenda:

1. States that do not even have a supplemental DC plan should establish them for their workers;
2. States should at a minimum establish DC plan options for college and university employees, elected officials and their staffs, political appointees, and temporary, seasonal and part-time workers; and
3. Over the long run, the DC plan option should be extended to all state and local employees and schoolteachers.

These reforms would make full scale pension liberation a reality.

Pension Liberation: The Battle Continues
Introduction

Over the past 25 years, private-sector employers have shifted sharply towards defined contribution (DC) pension programs. Under these programs, 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 workers in DC plans has soared by more than four times since 1975. It now totals close to 50 million workers.

By contrast, traditional defined benefit (DB) employer plans have actually declined. Under these plans, the employer promises a specified retirement benefit and saves and invests the funds in a common pool to finance those benefits. The number of workers in DB plans has fallen from 33 million in 1975 to 23 million today.

As a result, more than twice as many private-sector workers are now in DC plans as are in DB plans. Moreover, almost twice as many private-sector employers offer DC plans as offer DB plans.

The states have now begun to shift public employer pensions towards DC plans as well. Florida and Michigan have been the leaders in establishing DC plans that perform not as a supplement but as a substitute for DB plans. Seven other states have adopted such plans for their workers as well. At least 20 others have adopted such plans for at least some of their workers. Three states have hybrid DB/DC plans in place of traditional DB plans for their workers.

Such reform provides important benefits for both workers and taxpayers. We will discuss that in the next section. Then we will review the latest data regarding public-sector DC and DB plan participation and equity ownership in America. After that, we will review the provisions of the DC plans in the states, focusing in particular on the leading plans in Florida and Michigan. The next section will review recent federal legislation that improves DC plans available to both private- and public-sector employees.

The Benefits of DC Plans

Reform allowing workers the simple freedom to choose a DC plan instead of a traditional DB plan would have broad benefits for workers and taxpayers.
For workers:

  • The DC plan is fully portable. 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;
  • The funds in the DC plan 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;
  • Short- and medium-term workers would get higher benefits through DC plans because DB plans almost always distribute benefits away from them to the long-term workers. But with the funds under worker control consistently earning average returns over the long run, even the longer-term workers may well earn higher benefits through a DC plan than promised in a traditional DB plan; and
  • Workers have maximum freedom of choice with the DC plans because they own the money in their own accounts. They can structure their investments and benefits to best suit their needs and preferences as well as those of their families.

For taxpayers:

  • The defined contribution plan avoids the risks of having the government responsible for investing 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;
  • The simple DC plan saves the employer large amounts in administrative costs, and possibly funding costs as well. The employer just pays the regular contributions into the workers' accounts. Because workers can get such high benefits relative to pre-retirement income at just average long-term returns, employers could possibly provide a fully beneficial plan with somewhat less in contribution costs than under a DB plan; and
  • Because of the above benefits of DC plans for workers, such plans will help public employers recruit the best workers, particularly short- and medium-term workers, who may be well-paid experts from the private sector or professionals with lots of other opportunities they will ultimately pursue.

Basically, the DC plan privatizes the investment function of the public employee pension system, producing these and other benefits. For all of these reasons, the movement towards DC reforms in public employment pensions is called pension liberation.

Public Pensions and Stock Ownership in America: The Basic Facts

  • Three states have or are phasing in a system based on a DC plan only. Nebraska has had such a system for all regular state employees since 1964. In Michigan, all such employees hired after April 1, 1997, are covered by such a system as well. An exclusive DC system also applies to all West Virginia public school teachers hired after June 30, 1991.
  • Six states, Florida, Montana, New Jersey, North Dakota, Ohio and South Carolina, allow state employees and/or teachers the freedom to choose to substitute a DC plan in place of the old DB plan.
  • Three states have hybrid DB/DC plans. In Washington and Indiana, part of the contributions go to fund a DB and part goes to a DC plan where workers choose among investment funds and their benefits depend on the performance of those funds. Oregon allows workers to choose to devote some of the money in their DB plans to optional investment funds, leaving some of their benefits dependent on performance of the funds.
  • Another 20 states offer small groups of their workers a DC plan in place of the traditional DB plan. These include Alabama (college and university employees), Arizona (public safety workers and elected officials), California (college and university employees and temporary, seasonal and part-time workers), Colorado (college and university employees and state elected officials), Georgia (temporary, seasonal and part-time workers), Hawaii (temporary, seasonal and part-time workers), Illinois (college and university employees), Kansas (unclassified workers), Louisiana (higher education and unclassified workers), Maine (some local government workers), Massachusetts (some local government workers), Minnesota (higher education, elected officials, public safety and unclassified employees), Mississippi (college and university employees), Missouri (college and university employees), Pennsylvania (college and university employees), South Dakota (college and university employees), Utah(legislators),Vermont, (municipal workers), Virginia (college and university employees and political appointees) and Wyoming (college and university employees).
  • About 12.1 million state and local workers have DB plans, but about 9.5 million are able to enter some sort of DC plan.
  • About 2.5 million federal employees, an astounding 85% of all federal employees, participate in the highly successful Federal Thrift Savings Plan, a supplemental plan to the standard federal DB retirement plan.
  • The number of workers in private-sector DC plans has soared by more than four times since 1975, and now totals close to 50 million workers.
  • The number of workers in private sector DB plans has actually declined since 1975, from 33 million to 23 million.
  • As a result, more than twice as many private-sector workers are now in DC plans as are in DB plans. Almost twice as many private-sector employers offer DC plans as offer DB plans.
  • Based on the latest figures, 78.7 million individuals owned stocks in 1999, up 85.6% from 42.4 million in 1983, when the last major survey was done.
  • Almost half (48.2%) of all U.S. households owned stock in 1999, up from 19% in 1983.
  • Many households, 31.8%, own stocks through participation in company-sponsored pension plans. But even more, 35.5%, own stock on their own, outside pension plans.
  • Half of all the households who own stock own $50,000 or more in stock holdings.
  • Only 7% of those who own stock are from families earning less than $20,000 per year, and only 15% are from families earning less than $30,000 per year. In contrast, families earning over $50,000 per year account for 59% of those who own stock.

Pension Liberation Across America

The most recent major DC reform plan was adopted in Florida in 2000. The Florida Retirement System (FRS) covers all full- or part-time employees working for a state agency, county government, school district, state university or community college. Cities and special local government districts can also choose to have their workers participate. About 600,000 government workers overall participate in the FRS. The system pays close to $2 billion each year in retirement, survivors' and disability benefits to about 165,000 beneficiaries.
Before the reform, the FRS was a standard DB plan. The plan allowed government workers covered by the FRS a 90-day period during which they could choose to switch to a personal account DC plan for their retirement benefits in place of the FRS. In addition, all new employees have the chance to choose the new personal account option in place of the old DB plan during their first 180 days of employment.

For workers who choose the DC personal account plan, their government employers would pay the same as they do for the FRS plan. They would pay 9% of wages into a personal account for each worker to finance their future retirement benefits. Remaining contributions would continue to be paid to the FRS to finance health insurance in retirement and disability benefits. Workers make no contributions of their own in the FRS, whether in the DB or DC plans.
Each worker with a personal account would choose investment funds for that account from a list approved by the state government through the State Board of Administration. In retirement, the worker can take the personal account benefits in the form of an annuity paid through a third party administrator for the program, providing a guaranteed monthly income for life. Or the worker can choose various lump-sum withdrawal options, with only some or none of the funds devoted to an annuity.

Michigan adopted an even more aggressive reform plan in 1996, proposed by Gov. John Engler. Under that reform, all newly hired employees enter the DC plan. The state contributes a minimum of 4% of the worker's salary to a personal 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.

Those already in the work force at the time of the reform were able to switch to the new DC plan only during an "open season" in the first four months of 1998. For those who made the switch, all past employee contributions to the DB plan were transferred to the DC plan. In addition, for workers who were vested in the DB plan, an amount equal to the present value of their accumulated retirement benefits was transferred to their DC account as well.

Investment options are structured for workers to make investing easy. 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. 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 DC 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.
Those already in the work force who switched to the DC plan will receive the same retiree health benefits as under the old DB plan. For new workers in the DC plan, the state will pay 3% of the cost of retirement 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 made no change in the benefits of current retirees. Moreover, there was no change in benefits as well for employees who choose to stay in the old DB plan.

The state Department of Management and Budget estimated that Michigan saved almost $100 million in the first year alone because of the new DC plan, due to savings on employer contributions and administrative costs. Yet, 45% of state employees who effectively received no benefits under the old plan because they left state employment too early are now able to benefit under the new system after state employment of only two years, with fully vested benefits after only four years.

In addition to the state, four major counties in Michigan have switched to DC plans for their workers. These include Oakland County, Saginaw County, Washtenaw County and Wayne County. The state capital, Lansing, has switched as well, and the city of Kalamazoo has a partial DC plan.

In Nebraska, all state employees hired since Jan. 1, 1964, have been covered exclusively by the state's DC plan. For the first $19,654 in wages each year, the employer contributes 6.75% of salary and the worker contributes 4.3%. For salary above that level, the employer contributes 7.5% and the worker contributes 4.8%. The worker can choose from among 11 investment fund options for his or her contributions, and any combination of three funds for the employer contributions. These alternative investment funds are all operated by private investment management firms. At retirement, the worker can choose to take the DC benefits as a lump-sum payment, a schedule of partial withdrawals, a rollover to another tax-qualified plan or IRA, or as a monthly annuity.

In West Virginia, all school employees hired since Jan. 1, 1991, are automatically enrolled in that state's exclusive DC plan for teachers. The employer contributes 7.5% of wages and the worker contributes 4.5%. The worker can choose among seven investment fund options, with each again operated by a private, expert investment manager. Retirees have very similar options for the DC plan benefits as in Nebraska.

Washington State now has a hybrid DB/DC plan for all state and public school employees. The employer contribution is 7.33% of wages to the system, and the workers' contribution varies from 5% to 15% among different plans with different agency employers. The worker can choose to self-direct the DC investments, or choose the investments made by the Washington State Investment Board. At retirement, the worker receives a DB plan benefit each month based on a formula providing 1% of salary for each year of service. The worker then receives additional benefits payable by the accumulated DC plan investments. Workers can receive these benefits as a lump-sum payment or through a variety of payment plans.

Indiana's PERF system has covered all state employees since its inception in 1945. The employer contributes 5.1% of wages to the plan and the state pays as well the 3% worker contribution. The worker can choose any five investment funds again managed by private investment companies. At retirement, the worker receives a DB monthly benefit based on a formula providing 1% of wages for each year of service. Workers can then use the DC funds to purchase an annuity provided by the state, or they can withdraw the DC funds as a one-time lump-sum payment.

Oregon has a peculiar hybrid system that allows workers to direct some of their funds in a DC investment system, and some of the benefits at retirement will depend on how these investments perform. The state pays 8.2% of wages for its employees, while local schools pay 9.93% and local government employers in the system pay 7.30%. Employees pay 6%. Workers can then exercise some control over how their retirement funds are invested, shifting among government and corporate bonds and stocks. Indeed, they can choose to invest up to 75% of the retirement funds in stocks. At retirement, however, the worker can choose the higher of the benefits payable by the DC system, or DB benefits calculated under a formula providing for 1.67% of final salary for each year of service. Workers hired before Aug. 21, 1981, can also choose to take the DC benefit payable by the worker's contribution and a DB benefit financed by the employer contribution based on a formula providing 1% of final salary for each year of service.

Montana recently adopted a DC option for all of its covered state and local and school employees similar to the Florida plan. Current workers have one year to choose the DC plan and all new employees can elect the DC plan within one year of being hired. For those who choose the DC plan, the employer contributes 4.53% to the worker's account, the same as for the state DB plan. The worker can then choose among different investment funds managed by private investment companies. The account funds can then be used for a range of different benefit options in retirement chosen by the worker.

Ohio has also recently adopted such a system for its state and local employees and schoolteachers. Current employees with less than five years of service, who are not vested in the current system, can choose the DC policy option within a 180-day window. All new employees can elect the DC plan within the first 180 days of employment. Employers and employees pay the same into the DC plan as in the old DB plan. Workers can choose among life insurance annuities, variable annuities, investment funds and other investment options approved for participation by the governing board.

In South Carolina, all public school employees hired after July 1, 2000, can choose the DC plan option within 90 days of employment. The same employer and employee contributions are again made to the DC plan as the DB plan. Those who choose the DC plan can select among investment funds offered by Citistreet, Aetna, American-General, and TIAA-CREF.

As mentioned above, twelve more states offer DC plan options to limited groups within the state. These are mostly college and university employees and temporary, seasonal and part-time workers. Twenty-five states overall also offer workers a supplemental DC plan option. In these plans, the worker contributes to an investment account on top of the DB plan, often with matching employer contributions. The worker then selects from a range of different investment funds managed by private investment firms, approved for participation in the program. In retirement, benefits financed by the accumulated DC account funds would be paid to the worker in addition to DB plan benefits.

The most notable and successful of such supplemental plans is the Federal Thrift Savings Plan for federal employees. Federal employees covered by the Federal Employee Retirement System (FERS) can each contribute up to 12% of their salary to their personal account in the system. The federal government as employer will match these contributions up to 5% of salary. The worker can then choose among five investment funds for this money, three stock funds and two fixed-income funds. A private investment firm, Barclay's Global Investors, manages the stock funds and the fixed-income fund invested in corporate bonds. It chooses the particular stock and bond investments for these funds. The thrift system itself manages the fixed-income fund invested solely in government securities. As noted above, 2.5 million federal employees, 85% of the total, now participate in the plan.

Overall, some form of DC plan is available in some degree to state and local employees and schoolteachers in 35 states.

Expanding Pension Liberation Opportunities

Recently passed federal legislation expands the opportunity to save and invest through DC plans. The annual contribution limits on supplemental DC plans, Section 457 or 401(k) plans, have been increased to $11,000 in 2002, $12,000 in 2003, $13,000 in 2004, $14,000 in 2005, and $15,000 in 2006. These limits are also indexed to increase with inflation in future years.

After age 50, workers can contribute additional "catch-up" funds to these DC plans. The maximum additional contribution is $1,000 in 2002, increasing by $1,000 per year until it reaches $5,000 in 2006. This allows workers who missed the opportunity to accumulate retirement savings earlier in life to make additional contributions now to try to make up for that to some degree.
The legislation also provides tax credits for contributions by lower-income workers to these DC plans. Single workers earning $15,000 per year or less, and married couples earning $30,000 per year or less, receive a 50% tax credit for their contributions. So a contribution of $500 to their DC plan account would reduce their income taxes by $250. Single people earning $15,001 to $16,250 for the year, and married people earning $30,001 to $32,500, would receive a tax credit of 20% for their contributions. Single people earning $16,251 to $25,000, and married people earning $32,501 to $50,000, would receive a 10% tax credit. This policy encourages contributions from low- and moderate-income workers, who participate in investment and stock ownership programs much less than higher-income workers.

The new law also increases the maximum annual contribution limits for traditional and Roth IRAs. The maximum contribution limit will now be $3,000 per year for 2002 through 2004, $4,000 per year in 2005 through 2007, and $5,000 in 2008. The limit is also indexed to increase with inflation in future years.

Conclusions and Recommendations

DC plans for state and local government employees are quite extensive. Moreover, they are not limited to supplementing old-fashioned DB plans. Seven states provide for DC plans in place of traditional DB plans, and three more have hybrid DB/DC plans. Moreover, 25 others also have extensive DC components in their overall systems.

Based on the analysis of the benefits of DC reform plans and the extensive experience with such plans discussed above, states should move aggressively on the following reform agenda:

1. States that do not even have a supplemental DC plan should establish them for their workers. These plans are very helpful to workers in achieving the necessary retirement security and in broadening stock ownership;

2. States should, at a minimum, establish DC plan options for college and university employees, elected officials and their staffs, political appointees, and temporary, seasonal and part-time workers. These employees tend to remain in state and local employment only over the short term, and are greatly benefited by a DC plan in place of a traditional DB plan; and

3. Over the long run, the DC plan option should be extended to all state and local employees and schoolteachers, to achieve all of the benefits discussed above.

These reforms would make full-scale pension liberation a reality.