Pension Reform Heats Up

Following unrealistic promises and unsustainable funding gaps, states and municipalities may need to make greater use of defined contribution plans.  

Now that federal tax reform has passed, state and local governments likely will face continued pressure to rethink the retirement benefits they promised their workforce. After all, their pension contributions already eclipse what employees are contributing (see Chart 1), employees are retiring later and living longer, and investment returns in many cases have fallen short of required funding levels for defined benefit (DB) plans.  

A number of plan sponsors, particularly in states with serious fiscal issues, have already asked their employees to assume more responsibility for their retirement via defined contribution (DC) plans with institutional features such as auto-enrollment and auto-escalation (whereby the contribution level is automatically increased at regular intervals, until it reaches a preset maximum), and, in some cases, a variety of payout options.  

With state and local taxes no longer deductible on federal tax returns (and limits on mortgage interest and property tax deductions), the risk of pension reform becoming a more contentious issue is bound to increase. Take Kentucky, for example, where Governor Matt Bevin repeatedly has pushed a proposal that would shift new hires into 401(k)-style plans, freeze cost-of-living increases for retirees for five years, and require public employees to contribute an additional 3% of their salary to retiree health plans.  Retirees have mounted strong opposition, claiming that the current reform process is opaque and controlled by just a few people. Last November, 1,000 teachers rallied on the front steps of the Kentucky state capitol in Frankfort.¹  The issue is sure to heat up as lawmakers await an actuarial analysis.

Chart 1. Employers Are Contributing Much More to Public Pension Plans Than Employees
U.S. pension contributions per person*


Source: Nelson A. Rockefeller Institute of Government. *State- and locally administered plans.

DBs versus DCs
An aging population has been one of the main driving forces behind the wave of pension reforms in recent years. The Organization for Economic Co-operation and Development (OECD) warns that the so-called demographic “old-age dependency ratio” will more than double by 2075. In 2015, there were 28 individuals aged 65 and over for every 100 persons of working age (ages 20–64), on average, across all OECD countries, which includes the United States, where the old-age dependency ratio continues to be problematic. By 2075, there are expected to be 58 individuals 65 and over for every 100 persons of working age.

According to the OECD, DB plans are provided by the public sector in 18 OECD countries. DC plans are compulsory in 10 OECD countries. In the latter, contributions flow into an individual account. The accumulation of contributions and investment returns is usually converted into a pension-income stream at retirement.

In the United States, state and local governments whose retirement plans were hard hit by the global financial crisis of 2008–09 have been torn between guaranteeing lifetime pension benefits for longstanding employees in DB plans and establishing more manageable (and less costly) DC plans.

According to the National Association of State Retirement Administrators (NASRA), nearly all employees of state and local government are required to contribute toward the cost of their retirement, and in many states, budget challenges and rising pension costs made employee-contribution increases a central part of pension reform.²

“While public pension changes have taken different forms throughout the country, reforms generally kept those core features known to balance retirement security, workforce management, and economic efficiencies sought by stakeholders,” a NASRA report said.  Those reforms included increased employee-contribution rates, reduced pension benefits, mandatory participation, pooled and professionally managed assets, targeted income replacement, and lifetime benefit payouts.

As the shift toward DC plans continues, we believe a closer look at the structure of the investment menus and plan design features may be a prudent next step for plan sponsors. Although many public plans are non-ERISA (Employee Retirement Income Security Act of 1974), many of them are starting to view the world through the lens of behavioral finance that focuses on the behavior of participants and the health of various plans. This in turn should pave the way for DC specialists to cultivate the public space more than they have  in the past.

Altered States
While many states still rely on DB plans, other states have explored plans that combine elements of traditional pensions and individual account plans, such as 401(k)s.

Since 2009, for example, Michigan, Utah, Rhode Island, Virginia, and Tennessee have created combination plans that include a DC feature.  Rhode Island created a hybrid plan, and so did Connecticut, albeit it was optional for higher-education employees with employee contributions 3% higher than the rate paid by most current members. Arizona and Oklahoma closed their traditional pension plans, and placed newly hired workers into individual DC plans, NASRA said.     

In 2017, Pennsylvania’s pension reform included two hybrid plans and a third option where all of an employee's retirement savings would be invested in 401(k)-style accounts. The Pew Charitable Trust said the changes were “the most comprehensive and impactful reform any state has implemented.”

California Public Employees’ Retirement Association (CalPERS), the nation’s largest pension fund (which includes six DB plans and three DC plans), increased employee contributions, revised benefit formulas, and lengthened retirement eligibility requirement. In 2010, and again in 2012, CalPERS increased the required employee-contribution rates and added new benefit formulas with reduced benefits and lengthened retirement eligibility requirements. New employees enrolled in DC plans assume investment and longevity risks. The savings at retirement depend on contributions and investment returns. Higher contributions and investment returns lead to higher savings, and lower contributions and investment returns lead to lower savings.

In the University of California Retirement System, employees first hired after June 30, 2016, who choose the DB plan are subject to a cap on DB covered compensation equal to the cap mandated by California’s Public Employees’ Pension Reform Act (PEPRA), which is equal to $118,775 for 2017. These employees also must participate in a supplemental DC plan. Supplemental DC plan contributions for employees would be 7% on covered compensation; employer contributions for faculty would be 5% on all covered compensation, up to the federal limit; for staff, the employer contributions would be 3% on covered compensation.³

In Illinois, which is saddled with massive pension debt, the minimum employee contribution to the DC plan is 4%; the employer contribution to employees’ DC accounts is between 2–6%.

Clearly, the role of DC plans for state and local government employees is evolving. DC plans have played a useful role as supplemental saving vehicles, but have a long way to go before they become the primary income-replacement resource.⁴   That may change as more and more baby boomers (the demographic cohort born between 1946–64) retire and the ranks of millennials (1978–96) grow, but most don’t know how much they will need to save for a comfortable retirement; and to make matters worse, about 25% of state and local employees are not covered by Social Security, according to the Center for State and Local Government Excellence.

Legal Challenges
While pension reforms to date are expected to generate billions of savings for various state, school, and local agency plans, there have been a number of legal challenges, most notably in California, where courts have long held that not only that retroactive reductions in pension benefits are impermissible but also that the state is prohibited from prospectively changing accrual rates for any current employees.⁵

Whether that legal doctrine holds up in the current political and economic environment is another matter.

As Amy Monahan, an associate professor at the University of Minnesota Law School, put it in a 2012 article in the Iowa Law Review:

“This California Rule, adopted by many other states, improperly infringes on legislative power by holding that a legislative contract exists without ever evaluating whether there is clear and unambiguous evidence of legislative intent to form a contract. Even in the absence of a legislative contract, long-standing precedent protects earned pension benefits under the theory that earned compensation is protected by an implied contract, but there is no such basis for protecting future accruals absent an explicit agreement. Protecting such future accruals absent an explicit agreement to do so is inconsistent with contract theory, economically inefficient, and simply forces the state to make other changes to the terms and conditions of public employment that may be less desirable to employees, less effective at stabilizing public pension funds, and potentially more damaging to the state and its citizens.”⁶

Since then, two appellate courts in California ruled that lawmakers may change retirement benefits for current employees so long as they still receive “reasonable” benefits. Now the state supreme court is considering what may be the most significant public employee pension case in nearly three decades.⁷

Other states will be watching that case closely. Oral arguments are expected to begin in early 2018.⁸

¹ Jack Brammer, “It’s 2018, and there’s no sign of a pension overhaul bill in Frankfort,” Kentucky.com, January 2, 2018.
² Keith Brainerd and Alex Brown, “Spotlight on Significant Reforms to State Retirement Systems,” National Association of Retirement Administrators, June 2016.
³ Source: Selected Approved Changes to State and Selected Local Public Pension Systems, NASRA, July 2017.
⁴ Paula Sanford and Joshua M. Franzel, “The Evolving Role of Defined Contribution Plans in the Public Sector,” a joint research project of the Arthur N. Caple Foundation and the National Association of Government Defined Contribution Administrators, conducted by the Center for State and Local Government Excellence, September 2012.
 ⁵  Amy B. Monahan, “Statutes as Contracts? The ‘California Rule’ and Its Impact on Public Pension Reform,” Iowa Law Review, 2012.
⁶ Ibid.
⁷ “Brown Comes to Taxpayer Defense on Pension Reform,” editorial, San Jose Mercury News, November 27, 2017.
⁸ Randy Diamond, “Appeals Court Hearing Sets Stage for California Rulings on Altering Pension Benefits,” Pensions & Investments, December 13, 2017.

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Defined benefit plan. A defined benefit retirement plan provides employees with guaranteed retirement benefits that are based on a benefit formula. A participant’s retirement age, length of service, and pre-retirement earnings may affect the benefit received. In the private sector, defined benefit plans are typically funded exclusively by employer contributions.

Defined contribution plan. A defined contribution retirement plan specifies the level of employer and employee contributions (retirement savings) and places those contributions into individual employee accounts. Retirement benefits are based on the level of contributions, plus earnings, that have accumulated in the account at the time of retirement.

Employer matching contribution. The employer matches a specified percentage of employee contributions. The matching percentage can vary by length of service, amount of employee contribution, or other factors.

A 401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.