A quiet revolution for workers’ control and choice over their own retirement finances, and taxpayer relief, is beginning to take hold across the states. The issue involves reform of pension programs for state and local government workers. Because of the liberating effects of the budding reforms for both workers and taxpayers, the movement has been dubbed pension liberation.
Traditionally, state and local government pensions have involved "defined benefit" plans. Under these plans, the employer promises a specified retirement benefit and saves and invests annual contributions in a common pool to finance those benefits. The new reforms involve offering workers the choice of an alternative "defined contribution" plan. Under such plans, the employer pays a specified amount into an individual retirement account for each worker which becomes the worker’s private property. These funds are then invested over the years by private investment managers the worker chooses. In retirement, the account funds are then used to finance the benefits the worker chooses and the accumulated account contributions and investment returns can support.
Michigan has been the leader in the new trend towards defined contribution plans among the states, adopting a comprehensive plan proposed by Governor John Engler in 1996. California began adopting such a plan for some of its workers that year as well, and the reform process there continues. Ten states have now adopted defined contribution reforms for a portion of their workers. Legislation for such reform is now pending in 6 states, and formal legislative studies for such reforms are under way in 12 other states, including Virginia.
This new trend among the states follows a dramatic shift in the private sector towards defined contribution plans over the past 20 years. 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, defined benefit plans in the private sector have stagnated, growing over the same period by less than 10%, from 33 million covered workers to 36 million. More private sector employees now have defined contribution plans than defined benefit plans.
For workers, the defined contribution plan is fully portable. Workers are able to take the funds paid into their accounts wherever they go. Those who work for a few years in the public sector and then move on, as most now do, would not lose all of their employer pension contributions, as with typical defined benefit plans. 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 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 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.
This report will review these issues in more detail, and advance a pension liberation proposal suited to Virginia. It will first describe the Virginia public employee retirement system. It will then discuss the reforms being proposed and adopted in other states. The report will next outline a specific proposal for Virginia. The advantages of such reform for both workers and taxpayers will then be fully analyzed. The report will conclude by responding to potential criticisms.
The Virginia Public Employee Retirement System
The Virginia Retirement System (VRS) provides retirement, survivors and disability benefits for state workers from 234 state agencies, for the employees of 136 cities and towns in the state, for the teachers and other employees of 146 local school districts, for workers employed by 92 county governments, and for the employees of 138 other political subdivisions in the state.(1) Altogether, the plan covers about 84,000 state workers, 112,000 teachers, and 75,000 workers from the other political subdivisions.(2) It provides benefits to about 84,000 retirees and other beneficiaries.(3) These benefits are in addition to those provided by Social Security.
Separate defined benefit plans cover about 1,600 state police officers and about 400 state judges. The discussion below will focus on the predominant VRS plan.
The normal retirement age for workers in the VRS is 65. Workers with 30 years of service can retire with full benefits at age 55. For those with less than 35 years of service, full retirement benefits are equal to the average of the 3 years of highest pre-retirement compensation times years of service times 1.5% of the first $13,200 of average compensation and 1.65% of average compensation above $13,200. So, for example, take a worker with 25 years of public service and average compensation for the highest 3 years of $30,000. The worker’s annual retirement benefit would be 1.5% of $13,200 plus 1.65% of $16,800 times 25, or $11,880. For a typical state government retiree who retires after 21 years of government service, the average benefit is currently about $900 per month, or $10,800 per year.(4)
For those with more than 35 years of service, full retirement benefits are equal to the average of the 3 highest years of pre-retirement compensation times years of service times 1.65%. So, for example, take a worker with 35 years of public service and average compensation for the 3 highest years of $30,000. The worker’s annual retirement benefit would be 1.65% times $30,000 times 35, or $17,325.
Workers are eligible for early retirement at age 55 with at least 5 years of service, or at age 50 with at least 10 years of service if they worked for a public employer at any time after Jan. 1, 1994. But the full benefits calculated as above are reduced by 0.5% for each of the first 60 months of early retirement and 0.4% for each additional month after age 55. Benefits are reduced by 0.6% for each additional month of early retirement before 55. So, for example, a worker with 20 years of service and $30,000 of average compensation retiring at 55 would have the full annual benefit calculated under the formula above ($9,504) reduced by 54% (0.5% x 60 + 0.4% x 60), to $4,372.
If the worker is closer to achieving the service requirement of 30 years for full benefits at 55 than to the normal retirement age of 65, then the benefit reduction can be calculated based on the number of years short of the service requirement. For example, take a worker at 55 with 25 years of service and $30,000 average compensation. Instead of 10 years of calculated benefit reductions based on the normal retirement age of 65, the worker’s benefits would be reduced for just the 5 years short of the service requirement of 30 years for full benefits at 55. So the worker’s benefit would be the full retirement benefit ($11,880) reduced by 30% (o.5% times 60), or $8,316.
Workers may choose post-retirement survivors benefits under a range of different options, including continuation of 100% of the retirement benefit to the survivor, 50% of the retirement benefit, or some other chosen percentage. However, if these survivors benefits are chosen, the retirement benefit is actuarially reduced depending on the percentage of continuing benefits chosen and the age of the designated survivor beneficiary. Workers are also eligible for survivors benefits for death before retirement, in varying amounts depending on salary and length of service. Workers are eligible as well for disability benefits, which vary depending on salary, length of service, and other factors.
Once these retirement, survivors, or disability benefits begin, the VRS pays an annual cost-of-living increase equal to the first 3 percentage points of inflation measured by the Federal CPI-Urban index, plus half of each additional point up to 7% inflation. So the maximum COLA increase in any year is 5% (3% plus one-half of 4%).
Except for the disability benefits, the right to these benefits vests only after 5 years of employment. (Vesting is when workers become entitled to receive some benefits at some point, now or in the future.) Workers who leave or die in service before then receive back only the employee share of VRS contributions plus 4% annual interest. Even after 5 years, workers who leave cannot take the employer contributions or any investment returns with them. They can only take out the employee contributions plus 4% interest, and forego all future benefits under the system. Or they can wait until retirement and receive whatever retirement benefits they may be entitled to given their years of service.
The VRS is financed by contributions from both workers and employers. The employee contribution is 5% of wages, which the employer can agree to pay. In fact, Virginia state and local government employers agree to pay about 86% of these employee contributions overall.(5) Employers are required to pay varying amounts that designated actuaries determine as necessary to finance the promised benefits. In FY97, the state paid 4.18% of payroll for its VRS contribution as an employer, and school districts paid 6.41% of payroll on average. The contribution rates for other political subdivisions ranged from 29.92% of payroll down to 0%. These employer contributions cost state taxpayers over $800 million in FY 97 alone.
At the end of the last fiscal year, the VRS trust funds held about $25.5 billion in accumulated assets.(6) However, the system was still not fully funded, as these assets amounted only to about 80% of accrued benefit liabilities.(7)
Pension Liberation Across America
As previously mentioned, Michigan has adopted the most comprehensive defined contribution reform, doing so in 1996. Under that reform, current state employees can choose the new defined contribution plan or stay in the old defined benefit plan. All newly hired employees will be in the defined contribution plan. The reform originally committed to including all public school employees in the reform. But since the old defined benefit plan was not fully funded, this has been delayed to avoid transition funding problems.
Under the defined contribution plan, Michigan 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 Michigan employees could choose to switch to the new defined contribution plan only during an "open season" in the first four months of 1998. For those 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. Once a worker switched 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 did 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 these Michigan workers to make investing easy and reasonably secure. 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 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, 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 2 years, with fully vested benefits after only 4 years.
In addition to the state, four major counties in Michigan have switched to defined contribution plans for their workers. These include Oakland County, Saginaw County, Washtenaw County, and Wayne County. The state capitol, Lansing, has switched as well, and the city of Kalamazoo has a partial defined contribution plan.
The reform process in California began with legislation proposed in 1996 by Assemblyman Howard Kaloogian (R-San Diego). His bill would have authorized, but not required, state and local employers throughout the state to offer defined contribution plans as an alternative to their defined benefit plans. The defined benefit option would have to be maintained as well.
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 Kaloogians’s plan passed in 1996, providing for new defined contribution options for employees of the state’s colleges and universities. Kaloogian is continuing legislative efforts to expand this option to all government workers in the states. His most recent bill would expand the option to all employees of the state legislature.
Other states with defined contribution systems for some of their employees includes Ohio (university employees), Illinois (university employees), Washington (public school employees), Alabama (university employees), West Virginia (public school employees), South Dakota (university and some other employees), Colorado (public school employees) and Missouri (university employees). Legislation to provide for such plans for more government workers is pending in California, Colorado, South Dakota, Florida, Oklahoma, and Arizona. Twelve states also have studies under way to consider such reform–Connecticut, Iowa, Massachusetts, Missouri, Montana, New Mexico, North Dakota, Ohio, Oklahoma, Vermont, Virginia, and West Virginia.
A Defined Contribution Plan for Virginia
Virginia should offer its workers an alternative defined contribution retirement plan as well. This plan can be structured as follows.
Workers and employers would each pay the same amount into this defined contribution retirement plan that they pay for the current retirement system. Employers would be required to assume the employee contribution share for the defined contribution plan to the same extent that they do for their defined benefit plan. As the actuarially determined employer contribution for the defined benefit plan changes up or down in future years, the employer would be required to pay the same rate for the defined contribution plan. Workers can be allowed to voluntarily contribute additional amounts, up to a total of 20% of their wages counting the employer contributions, or any higher limit allowed by federal tax law.
All contributions to the defined contribution plan would go into an individual investment account for each worker. These contributions would immediately become the private property of each worker with no vesting period. The worker would then choose an investment company to manage his or her account and pick the particular investments for the account. The workers could choose from a wide range of different companies approved by the state. Companies that wanted to manage such funds would apply to the state for approval. The state would approve only reliable firms with established expertise, which would commit to comply with the state’s rules and regulations. Such companies would include major stock brokerage firms, banks, insurance companies, mutual funds and others. Workers could switch among these investment companies during an open season each year.
The investment companies would then determine what particular stocks, bonds and other investments to buy with the funds in each worker’s account. Highly risky and speculative investments would be prohibited. But the funds could be invested in domestic and foreign stocks and bonds, government securities, perhaps certain real estate vehicles, and other instruments. The Federal regulations currently applying to investments in Individual Retirement Accounts and 401(k) plans would be a good model to follow.
Investment returns to the accounts would be tax free over the years. Some of the contributed funds would be set aside to buy private life and disability insurance matching the survivors and disability benefits of the current defined benefit system. The investment company chosen by the worker would be responsible for obtaining such insurance. No withdrawals from the defined contribution investment account would be allowed before retirement.
The worker could retire at any age at which retirement is permissible under the current defined benefit system, which would be age 50 after 10 years of service, 55 after 5 years of service, or 65. Retirement benefits would equal what the funds accumulated in each worker’s retirement account could support. Workers could choose to buy a private annuity with some or all of the funds, which would guarantee specified benefits for the rest of the worker’s life. Or the worker could rely on periodic withdrawals from the accounts, which would be limited to ensure that workers would not run out of funds before a reasonable life expectancy.
Workers today who have already paid into the current defined benefit plan for any number of years would be free to switch to this new defined contribution plan. They would each receive a lump sum payment from the current defined benefit plan into their new defined contribution retirement accounts. This payment would be equal to their share of the assets in the current defined benefit plan set aside to finance their accrued retirement benefits. This should compensate them sufficiently for both the employer and employee contributions paid into the system over the years.
The new defined contribution plan would only be an option for all current and future government workers in the state covered by any of the current defined benefit plans. Each would be free to choose it or to choose to stay in the current defined benefit plan. Workers who remain in the defined benefit plan would continue to be free to choose the new defined contribution alternative during an open season each year.
Advantages of Defined Contribution Reforms
Such a defined contribution reform plan would produce enormous advantages for the state workers and taxpayers of Virginia.
Advantages for Workers
Portability. The clearest advantage for workers of the defined contribution plan is portability. The funds would be paid directly into each individual worker’s own account and immediately become the worker’s direct property. When a worker leaves state employment for another job, he or she can then take this individual retirement account with them. This account would include all past employer and employee contribution plus full market investment returns. As a result, the defined contribution plan provides for full portability.
The current defined benefit VRS plan, by contrast, has no real portability. When a worker leaves, he or she can take with them only the employee share of past contributions plus 4% interest. They must give up the employer contributions for all of their years of work, all investment returns on those contributions, and the full market investment returns on the employee contributions in excess of 4% interest.
This lack of portability is highly damaging to shorter term and younger workers. Shorter term here means those working less than about 15-20 years in state employment. For reasons discussed fully below, the VRS, 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, the shorter term workers cannot take anything but the employee share of past contributions plus nominal interest when they leave, and they are not offered good benefits if they just wait to receive what the system will later pay them. These workers can frankly do much better by just taking their own money out and investing it, rather than waiting for these future benefits from the system.
As a result of the lack of portability and the plan’s benefit structure, most state workers end up not getting any significant benefits from a typical defined benefit retirement system. They just end up leaving with their own money back. In California, which has defined benefit plans for their government workers similar to the VRS, 70% of state and local workers end up not getting any retirement benefits from the system. In Michigan, 45% of state workers and 65% of public school employees effectively received no benefits under the old defined benefit plan. Notably, the actuaries for the Virginia plan assume that 75% of workers who leave before age 50 will elect to simply take the employee contributions plus interest from the system, effectively receiving no benefits from the employer share of contributions.(8)
The defined contribution plan solves these problems with full and immediate portability. Under the plan proposed above, 100% of workers would get retirement benefits for the years they worked for state or local government. And they would take those benefits with them wherever they go. This would be highly beneficial for younger and shorter term workers who stay in public employment roughly 15-20 years or less. This probably constitutes the majority of people who work for state or local government for at least part of their lives.
Vesting. The defined contribution plan also eliminates any vesting requirement. The funds paid into the worker’s account immediately become the property of the worker and remain fully available to pay future retirement benefits. This includes the employer as well as employee contributions and all investment returns on those contributions. Under the current defined benefit system, by contrast, the 5 year vesting requirement eliminates any real benefit for workers who stay less than 5 years.
Consequently, the defined contribution plan is highly beneficial for these shortest term workers. A vesting requirement can be imposed on a defined contribution plan, as in Michigan, allowing workers to take permanent control of the funds in their own accounts only after the vesting period. But there is really no good reason for such a requirement in the defined contribution context. A vesting requirement in a defined benefit plan makes sense to eliminate small and relatively inconsequential benefit payments to numerous short term employees, and the burden of keeping track of the financing and payment of such benefits. But in a defined contribution plan, the government simply pays a proportion of the worker’s salary into the worker’s own account and leaves it to the worker after that. Eliminating any vesting requirement would allow all workers to receive retirement contributions for the years they worked for the government employer, without any significant administrative burden on the system.
Fair Benefits. Under traditional defined benefit plans, benefits are skewed to favor the longer term and oldest workers and disadvantage the younger and shorter term workers. This occurs in the VRS as well, in several standard ways.
First, of course, the vesting requirements eliminate benefits for those working less than 5 years, with the funds devoted to benefits for those working longer term.
Secondly, the benefits are a percentage of final salary, which tends to be much higher for those have worked the longest, and for older workers. Take the example of a worker who enters governmental employment at 22, continues that employment for 15 years, and then leaves for a private sector job. The final three years of salary used to calculate the worker’s benefits at retirement will be the years when the worker was 35-37. No salary increases for the next 25-30 years of the worker’s career will be counted. By contrast, suppose another worker starts employment at 22, continues working for the same government employer for 40 years, and retires at 62. As compared to the first worker, this employee’s benefits will naturally equal an additional 1.5% – 1.65% of salary for each additional year worked past age 37, which fairly gives the worker credit for the additional years worked. But this additional 1.5% – 1.65% per year will be taken against the final salary at age 62, which will include 25 years of additional salary increases. This gives the second worker more benefits for each year of work than the first worker.
Indeed, compare the first worker to an older worker who also works 15 years for the government. 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 1.5% – 1.65% for each of the 15 years of service, or 23% – 24%, times the average salary at ages 60-62. The average salary at these ages will incorporate an additional 25 years of salary increases as compared to the salary at ages 35-37 which is used to calculate the benefits of the first worker, who will receive 23% – 24% times this lower average salary. So the older worker will receive much higher benefits even though he or she worked the same number of years as the younger worker.
Thirdly, granting the same percentages 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, including the employer and employee contributions, continue to earn investment returns for many years after he leaves government employment. Yet, this worker will only get the same 1.5% – 1.65% of final salary for each of his 15 years of government employment as other workers. Consequently, the worker will get nothing for all the years of investment returns 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. Each worker also gets the full market investment returns on the contributions for every year thereafter, giving him the full value of those contributions, rather than redistributing some to others based on a calculated percentage of final salary. Finally, those investment returns over the years will also include an inflation compensation component, again giving the worker compensation for inflation for each year after the contribution is made.
Consequently, the defined contribution plan gives fair, undistorted benefits to each and every worker. Those who work longer get proportionally higher benefits to the extent they worked longer. But they do not get disproportionally higher benefits, skewed to favor them over other workers, and effectively redistributing funds from these workers to them.
Personal Control. In the defined contribution plan, the retirement funds for each worker are under the direct ownership of the worker in his or her own individual account. Workers can then pick the private investment manager that will best serve them in the private competitive market. They consequently no longer have to worry about adverse changes in their retirement plan or politicians failing to make good on their promises, at least for the years already worked, as the contributions for those years already belong to them in full.
Better Benefits. Younger and shorter term workers who work roughly 20 years or less in government employment would generally get much better benefits from the defined contribution plan, because of all the factors discussed above. However, even the longest term workers couldl get better benefits from the defined contribution plan as well.
This is shown in the accompanying Table. The table assumes that 10% of salary is paid into the defined contribution plan each year. Of this total, 15%, or 1.5% of payroll, is assumed to be devoted to financing pre-retirement survivors and disability benefits equivalent to those paid by the VRS. Current expenditures for these benefits seem to be running slightly less than this as a percent of payroll.
The remainder of contributions are assumed to be invested and to earn a 5.5% real rate of return over the long run. In fact, over the 70 year period from 1926 to 1996, going back before the Great Depression, the composite real rate of return on all stocks in the Standard and Poors 500 was 7.5%. (9) The composite real rate of return on smaller company stocks on the New York Stock Exchange over this period was even higher, at 9.5%.(10) A diversified portfolio of 75% large stocks and 25% small stocks would have earned a real return of 8%. Over the long term, the real return paid by investment quality corporate bonds has been 3-4%.(11) So a 5.5% real return is a quite fair assumption allowing for some diversification of stocks and bonds, reasonable administrative costs (which should be less than 50 basis points), and quite ordinary investment performance.
Take the example of a worker who earns $30,000 per year over his career after inflation. After 40 years of work, this worker would retire with a fund of about $350,000 in today’s dollars. Assuming retirement at the normal Social Security retirement age, that fund would finance an annuity paying the worker almost $50,000 per year each year for the rest of his life, or about 164% of pre-retirement income. The VRS would pay the worker only 66% of final salary, or $19,800 per year. The results are similar for workers earning $40,000 and $50,000 per year.
For those who work for 30 instead of 40 years, the table shows that for those who retire at the normal Social Security age the defined contribution plan would still pay much more than the VRS defined benefit plan. This would apply to a worker who started employment in his mid 30s and retired in his mid 60s. However, even for a worker who started employment at 25 and retired at the early retirement age of 55 under the VRS, the accumulated funds in the defined contribution plan would be sufficient to pay higher benefits than the VRS.
The table also shows the enormous advantage of the defined contribution plan for the shorter term workers. Take a worker who enters government employment at 25, works for 20 years, and then leaves for the private sector. Payments equal to 10% of salary are paid into the defined contribution plan each year during his 20 years of employment, but contributions stop after that. However, the funds continue to be invested and earn investment returns. A worker earning $30,000 per year after inflation would retire in the future with a fund of over $300,000 ($304, 634) in today’s 1998 dollars. That would finance an annuity about 4.5 times as large as the VRS would pay. The results are similar for workers earning $40,000 per year and $50,000 per year after inflation.
Or take a worker who starts government employment at 25 and works for 10 years before leaving for the private sector. Payments into the system stop after those 10 years, but the accumulated funds again continue to earn investment returns after that. A $30,000 per year worker would reach retirement in the future with a fund of almost $200,000 ($192,143) in today’s 1998 dollars. That fund would finance an annuity paying benefits equal to about 5.6 times what the VRS would pay.
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. While the VRS is currently earning fabulous returns ,like most investors right now, that likely won’t continue over the long run. Moreover, those high current returns are not reflected in the benefits promised to workers in any event. The current high returns in the VRS are being used to increase the funding ratio of the plan and reduce employer contributions. With a defined contribution plan, workers would be enjoying the full, current high returns themselves through their individual account investments. The analysis above shows that during normal times at standard long term returns, which are much less than what the market is providing now, longer term workers would still get better benefits investing the funds on their own rather than through the VRS defined benefit plan. The defined benefit plans are either not being managed to maximize returns for workers sufficiently, or some of the funds are being redirected to benefit the employer or others.
Advantage for Taxpayers
No Investment Risk. The most obvious advantage for taxpayers of the defined contribution plan is that it eliminates investment risk for them. With the government managing a common pool of investment funds under a defined benefit plan like the VRS, 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 government simply makes a specific contribution to the accounts of the workers each month. The government, and by implication 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 VRS, 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 draw supposedly excess funds out of the pool in one way or another, perhaps by replacing an overfunded plan with a new one, or reducing the government’s contributions. Or they may try to use the funds for short-term added benefits. Politicians and bureaucrats have been known even to siphon funds out of these plans improperly or illegally. These actions would again raise costs for taxpayers.
Government management of the funds also creates the risk of 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 VRS, 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 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.
Criticisms of Defined Contribution Plans
One of the major criticisms of defined contribution plans is that most workers are too unsophisticated about investing to handle the responsibility of directing their own retirement investments. This underestimates the capabilities of working people. Nevertheless, the plan proposed above was carefully structured to avoid this problem. Under this proposed plan, workers would simply pick from a range of sophisticated, highly reliable, investment management companies. These would include large banks, insurance companies, stock brokerage firms, and others. These highly sophisticated investment managers would then be picking the individual stocks, bonds and other investments, not the workers.
Probably the main criticism of defined contribution plans is that they shift investment risk from the employer to the worker. In a defined benefit plan, the worker receives the specified benefits regardless of investment performance, so the worker bears no investment risk. In a defined contribution plan, the worker’s benefits depend entirely on the investment performance of his retirement account, so the worker bears full investment risk. Poor investment performance leads directly to lower benefits.
What is not widely recognized is that while defined contribution plans leave workers subject to investment risk, defined benefit plans without inflation adjustments leave workers subject to inflation risk. As inflation rises, the specified benefit in an unadjusted defined benefit plan is worth less and less. Under a defined contribution plan, by contrast, the worker’s investments would rise along with inflation over the long run, providing a real, above inflation, market rate of return. This would tend to keep prospective long run benefits rising with inflation. The VRS has only a partial inflation adjustment, so it is partially subject to this inflation-adjusted problem.
Also not sufficiently appreciated is that workers can fully handle the investment risk posed by defined contribution plans, for several reasons. First, retirement investments are very long term. The worker is investing not only for his entire career, but, indeed, for his entire life, as the remaining retirement fund will continue to be invested to support benefits throughout retirement. With such a long term investment horizon, perhaps 60 years or more, workers can weather many ups and downs in investment performance, with the average return on a diversified portfolio very likely over the long run to close in on the average long term market return.
Secondly, workers can easily invest in simple, widely available, highly diversified pools of stocks, bonds and other investments, through mutual funds and other vehicles. Such diversified pools will track the general market investment returns discussed above over the long run. Indeed, with a sufficiently broad based investment pool, the worker would basically own a piece of the economy as a whole. If the entire economy collapses, state and local governments will not be able to support defined benefit plan promises either.
Thirdly, with professional investment managers handling the specific investments for workers, investment risk can be minimized in a sophisticated and reliable manner through diversification and other market strategies.
Workers, indeed, may be able to handle this investment risk better than state and local governments. For they can do so without all of the political risks discussed above.
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 the newly offered defined contribution plan, they took with them only 14% of the assets of the old defined benefit plan. The assets of that plan actually continued to increase through the transition, climbing from $80.7 million before the conversion to $86.4 million after the conversion.(12) 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.(13)
Because of this effect, the VRS should be sufficiently well funded to handle the adoption of a defined contribution option for workers. Moreover, the state is increasing the relative funding of the plan over time, increasing its ability to fund any transition. Finally, in any event, the reform could simply provide that workers leaving for the defined contribution plan would take with them only a proportion of the funds for their accrued benefits equal to the plan’s total proportion of full funding. So if the plan was only 80% fully funded, workers who chose the defined contribution plan would take assets from the defined benefit plan equal to only 80% of the funding for their accrued benefits.
Virginia should adopt the defined contribution reform plan advanced in this study. That plan would offer state and local government workers the choice of a defined contribution retirement plan in place of their current defined benefit plans. Such a plan offers great advantages for both workers and taxpayers.
Virginia Retirement System, Comprehensive Annual Report for the Fiscal Year Ended June 30, 1997, p.27
Ibid., p. 86
Ibid., p. 30
Ibid., p. 20
Ibid., p. 40
Virginia Retirement System, Comprehensive Annual Report for the Fiscal Year Ended June 30, 1997, p.71.
Stocks, Bonds, Bills and Inflation, 1997 Yearbook, (Chicago, Ill., Ibbotson Associates, Inc., 1997)
Calculated from Moody’s Investor Services, Industrial Manual, Bond Survey
Peter J. Ferrara, Pension Liberation, American Legislative Exchange Council, State Factor, 1996