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.