Over the past 20 years, private sector employers have shifted sharply towards "defined contribution" 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 private sector employees in such plans soared from 11 million in 1975 to 43 million in 1995, an increase of about 300%.
By contrast, traditional defined benefit employer plans have stagnated. Under these plans, the employer promises a specified retirement benefit and saves and invests the funds in a common 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. More private sector workers are now in defined contribution plans than defined benefit plans.
A trend is now developing among the states to begin to shift public employer pensions towards defined contribution plans as well. Michigan adopted a comprehensive defined contribution system for state workers in 1996. California adopted an option for some of its workers that year as well. Ten states have now adopted defined contribution reforms for a portion of their workers. Legislation extending such reform to more workers is now pending in 20 states, and formal legislative studies regarding possible reform are under way in 12 other states.
Florida is now poised to become the leader in this national movement. House Budget Committee Chairman Ken Pruitt (R) has introduced comprehensive, pathbreaking legislation giving all government employees in the Florida Retirement System the option of a personal defined contribution retirement plan instead.
The effort in the Florida Senate, led by Locke Burt, would raise current benefits, cut the vesting period to five years, and raise pensions for law enforcement. It also has a defined contribution element, which is being considered in the Committee on Governmental Oversight and Productivity, chaired by Senator Jack Latvala. This report will focus on the House version, however, and will be updated when a final bill reaches the desk of Governor Bush.
Pension reform would provide important benefits for both workers and taxpayers. For workers, the defined contribution plan would be fully portable. Workers would be 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 they do under the current Florida Retirement System. 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. With full, unbiased, market returns on their retirement account investments, short- and medium-term workers employed by the government for less than 15 to 20 years would get higher benefits through the personal account defined contribution system. Indeed, even longer-term workers may well earn higher benefits than promised in the state\’s current defined benefit plan. Finally, such reform provides workers with broader freedom of choice.
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. This promotes certainty and stability in budgeting. In addition, the simple defined contribution plan saves the state 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.
Basically, the defined contribution plan privatizes the investment function of the public employee pension system, producing these and other benefits. For all of these reasons, the movement towards defined contribution reforms in public employment pensions is called pension liberation
This report will present the case for adopting pension liberation reform in Florida. It will first describe the Florida public employee retirement system. It will then explain the reform proposed by Chairman Pruitt. It will then discuss in more detail the advantages of such a defined contribution option for both workers and taxpayers. The following section will respond to various criticisms. Finally, the report will summarize the reforms adopted and proposed in other states.
The Florida Retirement System for Public Employees (1)
The Florida Retirement System (FRS) is a standard defined benefit plan. It 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.
Close to 90% of workers and beneficiaries are in the standard, Regular Class of system participants. A separate Special Risk Class includes law enforcement officers, firefighters and correctional officers. About 9% of workers and 5% of beneficiaries are in this class. Still another class, the Elected Officers Class, includes elected state and county officials, state Cabinet officers, state judges and state attorneys. Less than 1% of workers and retirees fall in this class. Another special group is the Senior Management Service Class, which consists of the senior managers of state, county and city governments, state universities, community colleges, school districts, and legislative and judicial staffs. This group also covers less than 1% of workers and retirees. The smallest group is the Special Risk Administrative Support Class, which includes former Special Risk Class members who moved to non-risk administrative positions in their agencies.
Workers pay no contributions to the Florida Retirement System. All contributions are paid by the government employer. The current employer contribution rate for Regular Class employees is 9.21% of wages for retirement, survivors\’ and disability benefits. Another 0.94% of wages is paid for the Retiree Health Insurance Subsidy, for a total employer contribution rate of 10.15% for Regular Class employees. Contribution rates for the other classes run higher because of the riskier benefits paid to them.
Benefits vest for Regular Class members and the Special Risk Classes after 10 years. However, for Elected Class members, benefits vest after 8 years, and for the Senior Management Class, benefits vest after 7 years.
Except for those with special-risk service, workers in the FRS can start receiving full benefits at age 62, as long as they are fully vested. They can also receive full benefits after 30 years of service, regardless of age. Those in special-risk employment can retire with full benefits at age 55 with 10 years of special-risk service, or at any age with 25 years of special risk service. Workers can take early retirement at any time after they are fully vested, but their benefits will be reduced by 5% for each year their age is below the normal retirement age.
The benefit amount is calculated as a percentage of average final compensation (AFC). AFC is simply the average of the five highest years of wages in covered government employment. For Regular Class workers, the percentage for those retiring at the normal retirement age (62 or 30 years of service) is 1.6% times years of service. So a worker retiring at age 62 with 20 years of service would receive 32% times AFC. A worker retiring with 30 years of service would receive 48% times AFC.
Regular Class workers retiring at age 63 or with 31 years of service receive 1.63% times years of service. Those retiring at age 64 or with 32 service years receive 1.65% times years of service. Those retiring at age 65 or with 33 years of service receive 1.68% times years of service.
The percentage now for workers in the Special-Risk Class is 3% times years of service, but varying amounts between 2% and 3 % are provided for years of service before 1993. For those in the Special-Risk Administrative Support Class who have 10 years of special-risk service, the percentages are the same as for the Regular Class, except they start with age 55 or 25 years of service as the normal retirement age. Elected officers receive 3% times years of service, except for judges, whose percentage is 3.33% per year. The Senior Management Service Class gets 2% per year.
The FRS provides a flat 3% annual cost of living increase for retirees each July. At retirement, workers can choose to reduce their benefits under various options in return for a continued benefit after their death for a surviving spouse or other beneficiary.
If a worker dies while acting in the line of duty, the surviving spouse will receive a survivors\’ benefit equal to one half of the deceased\’s salary for the rest of the survivor\’s life. The benefit will continue for any unmarried children below age 18 if the surviving spouse dies.
Survivors\’ benefits are also available for the death of a worker before retirement outside the line of duty, if the worker has 10 years of service. For a surviving spouse or other adult beneficiary, the benefit is equal to the retirement benefit the deceased worker would have received if he or she had retired on the date of death, payable for the rest of the beneficiary\’s life. A child named as the beneficiary would receive the deceased\’s retirement benefit until the child reaches 25, unless the child is disabled at that time, in which case the benefit continues as long as the disability continues. Apart from a death in the line of duty, no survivors\’ benefits are payable today for current workers who die with less than 10 years of service.
Disability benefits are payable to workers who become totally and permanently disabled and unable to work. Current workers must be vested with 10 years of service to receive disability benefits, except for disability incurred in the line of duty, for which benefits are available upon employment. For regular disability, the minimum benefit is 25% of AFC. For in line of duty disability, the minimum benefit is 42% of AFC. If the worker\’s retirement benefit on the date of disability would be higher, then the worker receives that benefit.
FRS retirees also receive a health insurance subsidy to pay for health coverage costs. The subsidy amount is $5 per month for each year of service, subject to a maximum of $150 and a minimum of $50.
Workers who leave covered government employment before vesting, again 10 years for the great majority of workers, receive nothing from the current FRS. All employer contributions paid for such workers are then diverted to the longer-term workers. Workers who leave covered employment after vesting still cannot take their retirement funds with them. They can only wait until they declare retirement and then take the retirement benefits for which they are eligible based on their limited period of service. No survivors\’ or disability benefits are payable for those who have left covered government employment.
The FRS achieved fully funded status in 1998. That means the system has enough funds on hand on an actuarial basis to pay all earned benefits. The system holds total assets of about $110 billion, with about 70% invested in domestic and foreign equities. Assets have been growing at about 20% since 1995, reflecting double-digit investment returns. The average annual retirement benefit paid by the system is only about $10,700.
A few government employees in Florida already have a defined contribution alternative to the FRS. State university faculty and administrators can choose the Optional Retirement Program in place of the FRS. The university employer pays into a personal investment account for the worker the same amount that it would have paid to the FRS. These funds fully vest to the worker immediately upon payment to the account.
The worker then chooses an investment management company from a list approved by the state, which then invests the funds for the worker. Part of the worker\’s contribution pays for private life insurance to provide survivors\’ benefits. The worker can make additional tax-free contributions to the account up to the amount contributed by the employer.
About 10,000 workers participate in this alternative program. It was established to create a more desirable, fully portable system to help the state attract the best possible university faculty and administrators. This program consequently shows recognition of the problems of the FRS for workers.
Indeed, another defined contribution option is available to a small number of additional employees. The Senior Management Service Optional Annuity is available in place of the FRS to workers in the state Senior Management Service, selected managerial staff of the state legislature, the Auditor General and his managerial staff, the Executive Director of the Ethics Commission, senior managers of the State Board of Administration, and selected managerial staff of the Judicial Branch and the Department of Military Affairs.
This program is virtually identical to the Optional Retirement Program for university faculty and administrators. It was again explicitly adopted to enable the state to attract the best possible top managers, effectively recognizing once more the problems with the FRS for workers.
The Proposed Florida Reforms
Budget Committee Chairman Pruitt is advancing legislation to provide all government workers in the FRS with the freedom to choose a personal account defined contribution alternative for their retirement. His comprehensive, well-thought-out plan is supported by Gov. Jeb Bush (R). If enacted, their plan would make Florida the leader in the pension liberation movement.
The Pruitt proposal would allow government workers covered by the FRS a 90-day period during which they could choose to switch to the personal account defined contribution plan for their retirement benefits in place of the FRS. In the future, all new employees would have the chance to choose the new personal account option during their first 180 days of employment. The proposal offers all workers a one-time choice during these periods. Once they have made that choice, they can\’t switch to either the personal account option or the older FRS plan later. The state will provide education programs to workers during these 90-day periods to help them make their choice.
For workers who choose the personal account plan, their government employers would pay the same as they do for the FRS plan. The employer would continue to pay the health insurance subsidy contribution, currently 0.94% of wages, into that system. A portion of current FRS contributions, about 0.5% of wages, would continue to be paid into the FRS for disability benefits. The rest, about 9% of wages, would be paid into the workers\’ personal accounts to finance their future retirement benefits.
Workers would make no contributions to these accounts, whether voluntary or mandatory. Workers would be able to contribute additional tax-free dollars to retirement on a voluntary basis through Section 457 deferred-compensation plans offered by their employers.
Each worker with a personal account will choose investments for that account from a list approved by the state government through the State Board of Administration (SBA). The list will include a diversified mix of mutual funds offering equities and/or bonds and a range of fixed investments. Workers would exercise their choice of these investments through a third party administrator (TPA) for the program, leaving the worker with one simple point of contact. The TPA would charge no administrative fees, and the worker would bear only the minimum institutional fees charged by the chosen investment instrument.
The SBA will also enter into a contract with an education provider for the system. This provider will conduct the education programs for employees choosing between the defined benefit and defined contribution plans. In addition, all educational materials to be distributed to workers by others to help with this decision would first be reviewed by this provider, and subject to approval by the SBA before distribution. For those workers choosing the personal account program, the provider will conduct continuing educational programs and review and pre-approve before distribution all marketing materials for the investment options available to workers.
The defined contribution plan includes a vesting requirement of only one year. After that time, workers would have full property rights in the personal account funds and can take those funds with them to any other job. Past service in the FRS for current employees counts toward this one-year requirement. The legislation would also reduce the vesting requirements for the Regular Class in the defined benefit FRS program to eight years.
Current workers with 8 years of service who choose the personal account option can transfer to the account the present value of the accumulated defined benefit obligations they have earned in the current FRS based on past service. They will basically receive on a present value basis a proportion of future expected benefits equivalent to the proportion of expected lifetime contributions that have been on their behalf. As a result, they will start the new plan with a considerable sum already deposited in their personal accounts.
Employee contributions and all investment earnings in the accounts would be tax-free to the worker until benefits are withdrawn. In retirement, the worker can take the personal account benefits in the form of an annuity paid through the TPA 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.
Disability benefits in the defined contribution plan would be the same as in the current defined benefit plan. Employers could use the portion of the contribution for these benefits to self-insure or to purchase private group coverage. Workers in the personal account defined contribution plan would also receive the same health insurance subsidy benefits in retirement as those in the current defined benefit FRS plan.
A survey of Florida government workers by Watson Wyatt found them about evenly split in preference between the current defined benefit plan and the new proposed personal account defined contribution plan. This indicates that about half of current workers may well move to the new personal account option. As experience grows with the new personal accounts, preference for them among workers would likely grow as well. Moreover, much of the support for the current system came from those in the classes with the richer defined benefits, such as the Special Risk Class.
Finally, and perhaps most importantly, a clear majority of workers supported the idea of allowing them the choice of the alternative they preferred, whether defined benefit or defined contribution. That is the essence of the reform offered by Pruitt.
Advantages of the Defined Contribution Reforms
The personal account defined contribution reform plan proposed by Pruitt would produce enormous advantages for the government workers and taxpayers of Florida.
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. After the minor one-year vesting period, all contributions to the account would immediately become the worker\’s direct property. When a worker leaves government employment for another job, he or she can then take this individual retirement account with them. This account would include all past employer contributions plus full market investment returns. Consequently, the defined contribution plan provides for full portability.
The current defined benefit FRS plan, by contrast, has no real portability. When a worker leaves, he or she cannot take anything with them. For those workers with less than 10 years of service, all past employer contributions and market investment returns for the worker are left behind in the system, and the worker gets nothing. Moreover, even those who stay longer than 10 years cannot take any funds with them. They can only wait to receive the benefits that the defined benefit plan will later pay them.
This lack of portability is highly damaging to medium-term as well as shorter-term workers. Shorter-term here means those working less than about 15-20 years in state employment. For reasons discussed fully below, the current FRS plan, like defined benefit plans generally, does not provide good benefits for younger workers who stay less than 15-20 years or so in service. The system is skewed to favor the longest-term workers. As a result, not only can these workers not take anything with them when they leave, they are not offered good benefits if they just wait to receive what the system will later pay them. These workers would do much better if they could just invest the employer contributions through their own personal accounts.
While specific data was not available for Florida, 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 government workers end up not getting any significant benefits from a typical defined benefit retirement system. They just end up leaving before they can vest or qualify for significant benefits. In California, which has defined benefit plans for their government workers similar to the FRS, 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 receive no benefits under the old defined benefit system.
Vesting. The personal account defined contribution plan also greatly reduces the vesting requirement to a minor period of 12 months. In contrast, the current defined benefit system denies any benefits to all employees working for Florida government for less than 10 years. Consequently, the personal account defined contribution plan is highly beneficial for these shorter-term workers. Over half of current government workers in Florida covered by the FRS have less than 10 years of service.
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 FRS as well, in several standard ways.
First, of course, the vesting requirements eliminate benefits for those working less than 10 years under current law, with the funds devoted to benefits for those working longer-term.
Secondly, the benefits are a percentage of average salary, which tends to be much higher for those who 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 five years of salary will probably be the highest for the worker\’s period of public employment, and will be used to calculate the worker\’s benefits at retirement. This will be the salary during the years when the worker is 33-37. 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. Suppose as well that both are Regular Class employees. As compared to the first worker, the second employee\’s benefits will naturally equal an additional 1.60% of salary for each additional year worked past age 37, which fairly gives the worker credit for the additional years worked. But the 1.60% per year for all years will be taken against the five years of salary during ages 58-62, 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 Regular Class worker who also works 15 years for the government. 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 1.60% of final salary for each of the 15 years of service, or 24%, times the average salary at ages 58-62. The average salary at these ages will incorporate an additional 23 years of salary increases as compared to the average salary at ages 33-37, which is used to calculate the benefits for the first worker. That worker will receive 24% times this lower average salary. So the older worker will receive much higher benefits even though he worked the same number of years as the younger worker.
Thirdly, granting the same percentage of final salary for each year worked 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 continue to earn investment returns for many years after he leaves government employment. Yet, this worker will only get the same 1.60% of salary for each of his 15 years of government employment as other workers. Consequently, the worker will get no additional benefits for all the years of investment returns after he leaves employment on the contributions made for him. 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 (assuming he works more than 12 months). 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 average 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 or vehicle that will best serve them in the private competitive market, within reasonable limitations to ensure safety, soundness and integrity. Workers 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 personal account, defined contribution plan, because of all the factors discussed above. However, even the longest-term workers could get better benefits from the defined contribution plan as well.
This is shown in the accompanying Table. The Table assumes that 9% of salary is paid into the defined contribution system each year for retirement benefits. The retirement contributions are assumed to be invested and to earn a 5% real rate of return over the long run. In fact, over the last 75 years, going back before the Great Depression, the composite real rate of return on all stocks in the Standard and Poors 500 was 8.0%.(2) The composite real rate of return on smaller company stocks on the New York Stock Exchange over this period was even higher, at 9.2%.(3)Over the long term, the real return paid by investment quality corporate bonds has been 3-4%.(4) So a 5% real return is a quite fair assumption allowing for some diversification of stocks and bonds, and quite ordinary investment performance, with a small proportion of the returns going to finance the institutional administrative costs for the personal account investments
Take a worker who enters government employment at 22, works for 10 years, and then leaves for the private sector. Assume he earns $25,000 per year after inflation during his period of government employment. Payments equal to 9% of salary are paid into his retirement account each year during his government employment, but all further contributions stop after that. However, the funds continue to be invested and earn investment returns over the years after government employment.
By age 62, the worker would retire with a fund of $128,460 in today\’s 2000 dollars, after inflation. That fund would finance an annuity of $13,000 per year for the rest of the worker\’s life, compared to benefits of $4,000 per year that would be paid by the current FRS. In other words, the benefits paid by the defined contribution personal account would be more than three times as large as the benefits that would be paid by the current FRS system. The relative results are the same for workers at $30,000 and $40,000 per year.
A large advantage for the defined contribution system is similarly maintained if the worker remains in government employment for 20 years. A worker earning $30,000 each year after inflation would retire at 62 with about $250,000 in today\’s dollars. That fund would finance an annuity of over $25,000 each year for the rest of the worker\’s life, compared to $9,600 per year that would be paid by the current FRS. In other words, the benefits paid by the defined contribution personal account plan would be over 2-1/2 times the benefits paid by the current FRS. The relative results are the same for a worker earning $25,000 or $40,000 per year.
A major advantage remains as well for the defined contribution plan for a worker who continues government employment for 30 years. A worker earning $30,000 per year would reach retirement at 62 with over $300,000 in today\’s 1999 dollars. Such a fund would finance an annuity of over $31,000 per year for the rest of the worker\’s life, compared to $14,400 paid by the current FRS. In other words, the personal account defined contribution plan would pay over twice what the current FRS would.
Finally, the defined contribution plan outperforms the defined benefit plan even for the longest-term workers. At $30,000 per year in average salary after inflation, after 40 years of government employment the worker would retire with a fund of about $340,000 in today\’s dollars. That fund would finance an annuity of almost $35,000 per year, compared to $19,200 paid by the current FRS. In other words, the personal account defined contribution plan would pay 80% more than the current FRS plan. Similar results again prevail for a $25,000 or $40,000 worker.
The reasons for the advantage of the defined contribution plan for the shorter-term workers were discussed above. But how can the advantage for the longer-term workers as well be explained? Workers just do not seem to be getting the most for their money in defined benefit plans. A worker earning just standard market investment returns, with the help of a major investment firm investing the account funds, would still get better benefits through the defined contribution plan. Some of the returns to the defined benefit plans seem to get siphoned off to benefit the employer or others, and generally across the country these plans do not maximize returns for workers sufficiently.
Advantages 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 FRS, 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 through the government simply make a specific contribution to the accounts of the workers each month. The taxpayers are 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 FRS, there is always a strong danger of political giveaways by shortsighted 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 draw supposedly excess funds out of the pool in one way or another, perhaps by replacing an over funded 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 less than competent handling of the funds by bureaucrats who lack the incentives, competitive pressures, and expertise of private investment managers. Attempts to insulate the funds from political and bureaucratic control by contracting out to private investment managers may not be entirely successful. The investment managers can still be subject to political pressure, political mandates in their contracts, or even counterproductive legislative mandates.
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, 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 FRS, 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, 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 of 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 greater certainty and predictability in budgeting. There is no possibility that taxpayers will be surprised with a large, unexpected unfunded liability requiring increased taxes.
Reduced Costs. A defined contribution plan will also significantly reduce costs. Defined benefit plans have substantial 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 and his investment company take over administration of the account after that.
Improved Employee Recruitment. Finally, because of the advantages to employees noted above, defined contribution plans can help state and local governments attract 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 one job for another. Moreover, workers would favor the freedom of choice, personal control, and possibly higher benefits that they could get through defined contribution plans. Florida already has recognized these advantages by adopting narrow defined contribution plans for certain positions where the competition for highly talented workers is intense.
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 reform plan proposed by Pruitt is carefully structured to avoid this problem. Workers simply pick from a range of sophisticated investment funds designated and approved by the state government. These would include major mutual funds and other highly reliable pooled vehicles. Through these vehicles, highly sophisticated investment managers would then be picking the individual stocks, bonds and other investments, not the workers. This model has worked well for workers in a broad range of contexts, domestically and internationally.
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 apparently 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.
But 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 adult 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, then it will have the money saved in its common trust fund to pay the departing workers. 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 a newly offered, local, 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. (5) Similarly, while 42% of the government workers in Oakland County, Michigan, chose a 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. (6)
Since the FRS is fully funded, defined contribution reforms should not create transition problems for the two plans.
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, to obtain the extensive benefits of such reform discussed above. At the forefront of this reform has been Michigan, which adapted a comprehensive plan in 1996 proposed by Gov. John Engler (R).
Under that reform, all newly hired employees enter 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 two years, 75% after three 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 were able to switch to the new defined contribution 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 defined benefit plan were transferred to the defined contribution plan. In addition, for workers who were vested in the defined benefit plan, an amount equal to the present value of their accumulated retirement benefits was transferred to their defined contribution account as well. Prior service in the old defined benefit plan is counted toward the four year vesting requirement of the defined contribution plan.
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. State Street Global Advisors, the third party administrator for the plan and one of the largest pension investment firms in the world, maintains 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 switched 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 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 defined benefit plan.
The state Department of Management and Budget estimated that Michigan saved almost $100 million in the first year alone because of the new defined contribution 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 will now be 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 defined contribution 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 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.
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 would allow 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 California Public Employees Retirement System (CalPERS) and State Teachers Retirement System (STRS) plans, which hold $165 billion in vested assets.
A limited version of Kaloogian\’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 include 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). Colorado, Vermont, Arizona, North Dakota and Montana have enacted a defined contribution option for limited numbers of government workers in the past few years. Legislation to provide for such options for more government workers is pending in Texas, California, New York, Illinois, Ohio, Montana, South Carolina, Colorado, Georgia, Hawaii, Iowa, Kansas, Maryland, Maine, North Carolina, New Hampshire, Pennsylvania, Oklahoma and Arizona, as well as Florida. About a dozen states also have studies under way to consider such reform.
Florida should adopt the defined contribution reform plan proposed by Chairman Pruitt. That plan would offer state and local government workers the choice of a defined contribution retirement plan in place of the current FRS defined benefit plan. Such a defined contribution option offers great advantages for both workers and taxpayers. In enacting the well-crafted, comprehensive Pruitt proposal, Florida would be the leader of the national movement for pension liberation.
Table 1: Defined Contribution Retirement Benefits
Defined Contribution Plan vs. Defined Benefit Plans: 10 Years of work

Annual Salary
Total Investment Fund Accumulated by Retirement
Annual Annuity Benefit
Replacement Rate
Annual Cash Benefit
Replacement Rate
Defined Contribution Plan vs. Defined Benefit Plans: 20 Years of work
Annual Salary
Total Investment Fund Accumulated by Retirement
Annual Annuity Benefit
Replacement Rate
Annual Cash Benefit
Replacement Rate
Defined Contribution Plan vs. Defined Benefit Plans: 30 Years of work

Annual Salary
Total Investment Fund Accumulated by Retirement
Annual Annuity Benefit
Replacement Rate
Annual Cash Benefit
Replacement Rate

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

Annual Salary
Total Investment Fund Accumulated by Retirement
Annual Annuity Benefit
Replacement Rate
Annual  Cash  Benefit
Replacement Rate
Note: All figures are in constant 2000 dollars and assume a 5% real rate of return on investment. The worker is assumed to enter public employment at 22 and retire at age 62. The defined benefit plan column states the retirement benefits that would be paid under the current FRS.

  • The information in this section comes from Florida Retirement System, Annual Report, July 1, 1997 – June 30, 1998, Division of Retirement, State of Florida, May 1999; Florida Retirement System, A Retirement Guide for the Regular Class, Division of Retirement, State of Florida, 1999 Edition.
  • Stocks, Bonds, Bills and Inflation, 1999 Yearbook, (Chicago, Ill., Ibbotson Associates Inc., 1999)
  • Ibid.
  • Calculated from Moody\’s Investor Services, Industrial Manual, Bond Survey
  • Peter J. Ferrara, Pension Liberation, American Legislative Exchange Council, State Factor, 1996
  • Ibid.