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Commentary of the Day - March 3, 2005: The Myths and Realities of Public Employee Pension Plans.
The debate over Social Security reform has sharpened the focus on pension "reform" in general. Most K-12 teachers and other public school employees, as well as many public college and university instructors and employees across the country are members of public retirement systems. Most of these public retirement systems offer what are known as "defined benefit" plans. However, there has been pressure from some quarters recently to shift to "defined contribution" plans. The argument frequently is made that defined contribution plans are less costly, and provide a better retirement benefit to employees than defined benefit plans. In reality, defined benefit plans usually are less costly to the taxpayers; and, in most cases they offer a much better deal to retirees.
So what are "defined benefit" and "defined contribution" plans all about, and why should anyone care? Under a "defined benefit" plan the employer, in this case the public agency, guarantees to the retiree a benefit that is based on a formula that takes into account the employee's age at retirement, the number of years the employee has worked under the plan, and a factor related to the employee's highest salary in the years just before retirement. Defined benefit plans also often include cost of living adjustments, health benefits, and death benefits. The defined benefits plans are funded by an employer contribution (either a fixed percentage of salary as in the case of the California State Teachers Retirement System, or an actuarially determined variable rate as in the case of the California Public Employees Retirement System), and a required employee contribution (a fixed percentage of salary). The combined contributions of the employer (or employers in the case of a multi-agency fund like the California Public Employees Retirement System) are pooled in a large investment fund that is used to provide benefits for retired employees.
Under a "defined contribution" plan the employer provides a fixed contribution (again a fixed percentage of salary) to an individual retirement account for each employee. In most defined contribution plans the employee also is required to make a minimum contribution and may contribute more than the minimum. The employee then is given a choice of investment options for these funds. Choices may include fixed annuities, variable annuities, and a variety of mutual funds. The benefit that the employee receives at retirement basically is the value of the account at that time. No cost of living adjustment or health benefits are included in most of these plans although the retiree usually has the option of purchasing an annuity at retirement.
Both defined benefit and defined contribution plans have a vesting period, usually five years. Employees who leave before the five year vesting period get back only their own contributions with interest. After the five year vesting period there is a substantial difference between the two types of plans. An employee who is vested in a defined contribution plan who leaves before reaching retirement age can either cash out his account (including employer contributions) at its current value, or roll it over into another retirement account with his or her new employer or into an individual retirement account.
An employee who is vested in a defined benefit plan who has not reached retirement age has much different options. The employee in the defined benefit plan can either withdraw his or her contributions with interest, or the employee can leave the money in the fund until retirement age is reached. At that time he or she will be eligible to receive a retirement benefit that is formula driven. Although the retirement benefit will be much smaller than those received by workers who continued working for the agency until retirement, in most cases it still will include cost of living adjustments and death benefits but not health benefits.
The different treatment of vested employees in the two types of plans has huge impact on retirement benefits and costs. Younger employees frequently are not focussed on retirement, and they have a tendency to "take the money and run". Approximately 70% of CalPERS members leave agency employment before they retire, and they opt to take their money out of the system. But, the employer contributions for those employees remain in the retirement fund. On the other hand, members of defined contribution plans who cash out take with them both their own contributions and those of their employer with them. In fact, 50% of the employer contributions to defined contribution plans are spent before the employee reaches retirement age.
Because the employer contributions for the 70% or so of employees in defined benefit plans who leave early remain in the retirement fund, the benefits for the 30% in these plans who actually retire typically are worth much more at retirement. For example, an employee in a defined benefit plan (5% employer contribution, 5% employee contribution) that earns 8% per year who is hired at age 30 at $25,000, receives 5% annual pay raises, and retires at age 60 will have a retirement benefit worth approximately $732,000. For the defined contribution plan with the same assumptions, the amount available at retirement will be only approximately $498,000. Clearly, the person with the defined benefit plan receives a much better retirement benefit with no higher cost to his or her employer.
Now it is true that if a person with a defined contribution plan is an astute investor, he or she might do better than 8% over the long haul. However, the odds are not in the employee's favor. Large public retirement funds have the advantage of broad diversification and low investment costs. The investment costs for CalPERS has averaged about 18 cents per $100 invested for the last decade, while the average cost for investing in a mutual fund has been about $1.10 per $100. Large systems like CalPERS also are managed by investment professionals who understand both the risks and rewards of investing. Over the last decade (ending June 30, 2004) CalPERS averaged a 9.7% rate of return, which is in line with broad market indices such as the S&P 500. On the other hand, participants in defined contributions plans often make investment choices that produce below market results. This is not surprising since two-thirds of stock mutual funds do not perform as well as the S&P 500. Going back to the example in the previous paragraph, if an employee in a defined contribution plan achieved only a 7% rate of return over the long haul compared to the 8% return of the large defined benefit plan, his or her amount available at retirement would have been only about $426,000.
So what about costs? Are defined contribution plans really cheaper for the employer (in this case the taxpayers), than defined benefit plans? The answer in most cases is no. Remember that for a defined contribution plan the taxpayers always have to contribute a fixed percentage to each employee's retirement account. On the other hand, for a defined benefit plan the employer only has to guarantee the benefit. If the fund performs well and produces more income than is needed to pay benefits, the surplus can be used to help cover the employer's required contributions thus reducing the amounts that the taxpayers have to contribute. Conversely, if the plan performs very poorly the taxpayers may have to contribute more than the fixed percentage in order to guarantee the benefits. However, this very rarely is a problem. In the 22-year period from 1982 to 2004 CalPERS earned about $172 billion from its investment activities, employers (state and local agencies) and employees contributed about $30 billion to the fund, and $49 billion was paid out in benefits. During the last 10 years 75% of CalPERS income has been from investments, and employee contributions actually have exceeded employer contributions.
So why would anyone choose a defined contribution plan over a defined benefits plan? Basically, there are two reasons.
First, in a few cases, employers (state and local governments) have gotten too generous with the defined benefit formulas. Here in California the age at which many public safety employees could retire with full benefits was reduced from 55 to 50, and some other general retirement benefits were increased when it looked like the stock market was headed for infinity (not surprisingly this was a time when agencies were paying nothing into the system because investment results were so good). At the same time investment returns have come back to more normal levels, so agencies again have had to pony up their contribution (although as a percentage of payroll most agencies actually are paying less now than they did twenty years ago). Nevertheless, rising pension costs have prompted some agencies to look for alternatives that may appear to contain costs.
The second reason, and the one that really is the driving force, is political in nature. Public employee pension funds hold enormous amounts of stock in publicly held corporations. Most individual shareholders have little or no chance to affect the governance of these corporations; but, with their large stakes the public employee pension funds can tip the balance in a proxy fight to oust directors and managers who have not been acting in the best interests of their shareholders. In recent years many of these public pension funds have been outspoken in their demands for corporate accountability in the aftermath of scandals at companies like Enron, Worldcom, Tyco, and Adelphia. A switch to defined contribution plans would reduce the influence of the public pension funds on corporate governance. Much of the drive to switch to defined contribution plans is being funded by corporate interests that would prefer to avoid the scrutiny of the large public pension funds.
In the view of the IP the best way to deal with rising public pension costs is not to shift to defined contribution plans; but, rather to adjust the defined benefit formulas to ensure that the plans meet sound actuarial standards. For example, the minimum age for public safety employees to be able to retire with full benefits should be restored to 55. That would solve the cost problems for many local agencies. Likewise, the formulas for new employees should be adjusted periodically to take account of changes in longevity and other factors.
(In the interests of full disclosure, the IP currently receives retirement benefits from the California Public Employees Retirement System (CalPERS), which is the largest public retirement system in the country. In addition, the IP has been an active private investor for decades.)
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