PUBLIC PENSIONS: CHOOSING BETWEEN
DEFINED BENEFIT AND DEFINED CONTRIBUTION
PLANS
Jonathan Barry Forman*
T ABLE OF CONTENTS
INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
I. BACKGROUND ON PUBLIC PENSIONS . . . . . . . . . . . . . . . . . .
II. SOME KEY ISSUES IN CHOOSING BETWEEN DEFINED BENEFIT
PLANS AND DEFINED CONTRIBUTION PLANS . . . . . . . . . . . .
A. Funding and Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
B. Influence on Worker Behavior . . . . . . . . . . . . . . . . . . . .
1. Defined Benefit Plans Tend to Favor Older
Workers (Backloading) . . . . . . . . . . . . . . . . . . . . . .
2. Defined Benefit Plans Penalize Mobile Employees
(Lack of Portability) . . . . . . . . . . . . . . . . . . . . . . .
3. Defined Benefit Plans Push Older Workers Out of the
Work Force . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4. Work Force Management Issues . . . . . . . . . . . . . . .
C. Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1. Preretirement Inflation . . . . . . . . . . . . . . . . . . . . . .
2. Postretirement Inflation . . . . . . . . . . . . . . . . . . . . .
D. Investments and Risks . . . . . . . . . . . . . . . . . . . . . . . . . .
E. Leakage and Distributions . . . . . . . . . . . . . . . . . . . . . . . .
F. Administrative Expense and Complexity . . . . . . . . . . . . . .
G. Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
H. Hybrid Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1. Cash Balance Plans . . . . . . . . . . . . . . . . . . . . . . . .
2. Other Hybrid Approaches . . . . . . . . . . . . . . . . . . . .
I. Transition to a Defined Contribution Plan or Hybrid Plan . .
III. GENERAL RECOMMENDATIONS AND CONCLUSIONS . . . . . . .
A. Expand Coverage and Preserve Retirement Savings until
Retirement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1. Have a Short Vesting Period . . . . . . . . . . . . . . . . . .
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* Copyright 2000, Jonathan Barry Forman. Professor of Law, University of
Oklahoma; B.A. 1973, Northwestern University; M.A. (Psychology) 1975, University of Iowa;
J.D. 1978, University of Michigan; M.A. (Economics) 1983, George Washington University.
Delegate to the 1998 National Summit on Retirement Savings. The author wishes to thank
Cynthia L. Moore, Jay Toslosky, and Stanley C. Wisniewski for their comments on earlier
drafts. Research assistance was provided by Melissa French.
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3.
4.
B.
Accrue Significant Benefits for Every Worker . . .
Preserve Retirement Savings Until Retirement . . .
Encourage Workers to Remain in the Work Force
Longer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Pay Retirement Benefits in the Form of an Annuity . . .
[1:187
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INTRODUCTION
More than fourteen million state and local government workers and
retirees are covered by pension plans.1 The overwhelming majority of these
workers are covered by defined benefit plans,2 perhaps with a supplemental
defined contribution plan.3 Recently, however, a number of state and local
governments have reconsidered their pension obligations and are considering
shifting away from their traditional defined benefit plans and toward defined
contribution plans.4
In fact, a number of states and localities
1. See Irene Khavari, Employee Benefits: Choices for a Secure Retirement, AM. CITY
& COUNTY , Aug. 1998, at 41.
2. See U.S. G EN . ACCT. OFF., PUBLIC PENSIONS: STATE AND LOCAL GOVERNMENT
CONTRIBUTIONS TO UNDERFUNDED PLANS 2 (GAO/HEHS-96-56, 1996); Ann C. Foster, Public
and Private Sector Defined Benefit Pensions: A Comparison, 2 COMPENSATION AND WORKING
CONDITIONS, Summer 1997, at 37.
Defined benefit plans typically provide each worker with a specific annual retirement benefit
that is tied to the worker’s final average compensation and number of years of service. See id.
For example, a plan might provide that a worker’s annual retirement benefit is equal to 2% times
years of service times final average compensation (B = 2% x yos x fac). See id. Under this
formula, a typical worker with thirty years of service would receive an annual retirement benefit
equal to 60 percent of her preretirement earnings (B = 60% x fac = 2% x 30 yos x fac). See id.
Final average compensation is typically computed by averaging the worker’s salary over the
three years immediately prior to retirement. See id.
3. Under a typical defined contribution plan, the employer simply contributes a
specified percentage of the worker’s compensation to an individual investment account for the
worker. For example, contributions might be set at 10% of annual compensation. Under such
a plan, a worker who earned $30,000 in a given year would have $3,000 contributed to an
individual investment account for her. Her benefit at retirement would be based on all such
contributions plus investment earnings thereon.
4. See generally Nat’l Council on Tchr. Retirement, Preservation of Defined Benefit
Plans: a Compilation of Detailed Research and Other Materials Presented at an NCTR
Workshop (Nov. 19, 1996); CYNTHIA L. M OORE , RESOURCE BOOK ON THE PRESERVATION OF
DEFINED BENEFITS [NATIONAL COUNCIL ON T EACHERRETIREMENT] (3d ed. 1999); Kelly Olsen
& Jack VanderHei, Defined Contribution Plan Dominance Grows Across Sectors & Employer
Sizes, While Mega Defined Benefit Plans Remain Strong: Where Are We & Where We Are Going,
in EMPLOYEE BENEFIT RESEARCH INSTITUTE, SPECIAL REPORT AND ISSUE BRIEF NO. 190, 27-29
(Oct. 1997); Defined Contribution Plans in the Public Sector, SEGAL COMPANY: GOVERNMENT
E MPLOYEES BENEFITS UPDATE , Jan. 1997, at 1; Ronald K. Snell, Report to the National
Association of Legislative Fiscal Officers, St. Louis, Mo. (July 30, 1996); Jeff A. Taylor, States
1999]
Public Pensions
189
have already made such shifts.5 Michigan, for example, recently created a
new defined contribution plan for all new state employees,6 and Michigan State
Treasurer, Douglas B. Roberts has been one of the most vocal advocates of
a shift away from defined benefit plans and towards defined contribution
plans.7
In the private sector, the shift away from defined benefit plans has been
going on for years.8 In fact, there has been a worldwide trend towards defined
Show Workers The Money, INV. BENEFITS D AILY, June 5, 1997, at A1; Public Sector Eyes
Defined Contribution Plans, 7 FUND ACTION 6 (1996); Curtis Vosti, Governments Look at
Defined Contribution, PENSIONS & INV., May 11, 1992, at 3; Christine Williamson, DC
Providers Ready to Go to School, PENSIONS & INV., Sept. 15, 1997, at 39; State Legislators
Advised on Plan Design, Investments, Unfunded Liabilities of Plans, 12 BNA PENSION &
BENEFITS REP . 1139 (1985). With respect to particular states, see, e.g., Christine Williamson,
California Funds Fear Asset Drain; Defined Contribution Bill Brouhaha, PENSIONS & INV., June
24, 1996, at 1; Public Plans: Oregon Task Force Recommends Cut in Excessive Pension
Benefits, BNA PENSION & BENEFITS DAILY, June 22, 1994; Sponsor Update: Washington State
Retirement System, DEFINED CONTRIBUTION INVESTING, Sept. 30, 1996, at 9; David Kaplan,
Public Retirement Systems Lean Toward Defined Contribution, T HE BOND BUYER (Oakland
County, Mich.), Apr. 9, 1996, at 14A; Dan Tracy, Orlando Rethinks Generous Pension; with
Retirees Living Longer, Taxpayers Could Have to Makeup Shortages of Money, ORLANDO
SENTINEL, Oct. 12, 1997, at A1.
5. See Christine Williamson, Washington Teachers Enroll in New DC Plan, PENSION
& INV., Mar. 3, 1997, at 22; Defined Contribution Plans in the Public Sector, supra note 4, at
7 (W. V., Wash., Colo., and Mich.).
6. See 1996 Mich. Pub. Acts 487. Under the law, new state employees and teachers
are covered by a new I.R.C. § 401(k) (1998) defined contribution plan. Under the plan, the state
contributes 4% of each employee’s annual compensation to her account, and the state matches
additional employee contributions of up to 3% of salary. Vesting occurs in four years, as
opposed to ten years under the traditional defined benefit plan. See also, Aaron Baar, Trends
in the Region: Michigan Pension Plan Borrows Idea from Private Sector, T HE BOND BUYER,
Mar. 12, 1997, at 30; David Franecki, Michigan Legislature Begins Defined-Contribution
Debate, DOW JONES NEWS SERV., Dec. 4, 1996; Robert Kleine & Lisa D. Baragar, Michigan
Governor Proposes Retirement Changes to Save State Dollars, 96 ST. T AX NOTES 222-16
(1996); Sally Roberts, Michigan Overhauls Retirement Benefit Plans, BUS. INS., Jan. 20, 1997,
at 6; Dick Vendenbrul, Letters to the Editor, PENSIONS & INV., July 21, 1997, at 12; see also
Christine Williamson, Defined Contribution Last-Minute Legislation Expected from Michigan
GOP, PENSIONS & INV., Nov. 25, 1996, at 8.
7. See Douglas B. Roberts & Matthew J. Hanley,Others’ Views: Defined Contribution
‘Right’ for Public Plans, PENSION & INV., Mar. 31, 1997, at 12.
8. See, e.g., [EMPLOYEE BENEFIT RESEARCH INSTITUTE], RETIREMENTPROSPECTS IN A
DEFINED CONTRIBUTION WORLD (Dallas Salisbury ed., 1997); WHATIS THEFUTURE FOR DEFINED
BENEFITPENSIONPLANS: AN EBRI-ERF ROUNDTABLE [EMPLOYEE BENEFITRESEARCH INSTITUTE]
(1989); Roundtable Discussion: Defined Benefit/Defined Contribution Trends, in T HE FUTURE
OF P ENSIONS IN THE U NITED STATES 102 (Ray Schmitt ed., 1992); see also Gregory S. Alexander,
Pensions and Passivity, LAW & CONTEMP . PROBS., Winter 1993, at 111, 118 (1993) (arguing that
defined contribution plans are more consistent with the democratic model of pensions than are
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contribution plans that seems to be affecting both private pensions 9 and
national social security programs.10 However, traditional defined benefit plans
are far from disappearing in the private sector.11 In fact, there is a good deal
of debate about how and whether government policies should be changed to
stem the “erosion” in traditional defined benefit plans.12
The debate over whether or not to shift away from defined benefit plans
and toward defined contribution plans is now also squarely before state and
local government policymakers.13 With literally trillions of dollars at stake, 14
defined benefit plans).
9. See, e.g., Kevin Dent & David Sloss, The Global Outlook For Defined Contribution
Versus Defined Benefit Pension Plans, 12 BENEFITS Q. 23 (1st Q. 1996).
10. See, e.g., WORLD BANK, AVERTING THE OLD AGE CRISIS: POLICIES TO PROTECTTHE
OLD AND PROMOTE GROWTH (1994). The national debate about how to reform the beleaguered
Social Security system is also largely a defined-benefit-plan-versus-defined-contribution-plan
debate, which pits proponents of a privatized individual accounts system against the supporters
of the more traditional defined benefit approach of the current Social Security system. See, e.g.,
Jonathan Barry Forman, Whose Pension Is It Anyway? Protecting Spousal Rights in a Privatized
Social Security System, 76 N.C. L. REV. 1653, 1660-64 (1998) and sources cited therein.
11. See PBGC Study, Consultants Concur, Plans Will Not Vanish in Future, 17 BNA
PENSION & BENEFITS REP . 2103 (1990) [hereinafter PBGC Study] (discussing a Pension Benefit
Guaranty Corporation study that shows that almost all of the recent decline in defined benefit
plans can be attributed to structural shifts in the economy rather than conscious decisions by
plan sponsors to switch from defined benefit plans to defined contribution plans).
12. See, e.g., ADVISORY COUNCIL ON EMPLOYEE WELFARE AND PENSION BENEFITS , U.S.
DEP ’T OF LABOR, REPORT ON THE WORKING GROUP ON THE M ERITS OF DEFINED CONTRIBUTION
VERSUS DEFINED BENEFITPLANS WITH AN EMPHASIS ON SMALL BUSINESS CONCERNS (1997); Sue
Burzawa, Defined Benefit vs. Defined Contribution Plans—Current State of the Debate and
Future Influences, 51 EMPLOYEE BENEFITPLAN REV. 10 (1997); Christopher Conte, Retirement
Prospects in A Defined Contribution World: A Report on EBRI’s April 30, 1997, Policy Forum,
18 EBRI NOTES 1 (1997); see also PENSION BENEFIT G UARANTY CORP ., PUB. NO. 1007, A
PREDICTABLE, SECURE BENEFIT FOR LIFE (May 1998).
13. See, e.g., Keith P. Ambachtsheer, Others’ Views: Dedicated Governance A ‘WinWin’ Solution, PENSIONS & INV., Aug. 4, 1997, at 14; Fred Williams, NCPERs Feeling DC
Pressure: Speakers Discuss ‘Attack’ on Funds, PENSIONS & INV., June 9, 1997, at 24; Gerald
W. McEntee, Others’ Views: The Public Interest and the Switch to DC Plans, PENSIONS & INV.,
June 23, 1997, at 12; Cynthia L. Moore, Why Defined Benefit Plans Will Remain Important for
Teachers: Opinion, P LAN SPONSOR, June 1995, at 68; Marsha Richter, Counterpoint: Mistaken
Rush to Change Public Plans to DC, PENSIONS & INV., June 9, 1997; Roberts & Hanley, supra
note 7; Andrew Sollinger, Defined Contribution Plans: In the Public Interest?, 27 INST. INVESTOR
159-60, 163-64, 166 (June 1993); see also U.S. GEN. ACCT. OFF., STATE PENSION PLANS :
SIMILARITIES AND DIFFERENCES BETWEEN FEDERAL AND STATE DESIGNS (GAO/GGD-99-45);
OLIVIA S. M ITCHELL ET AL., DEVELOPMENTS IN STATE AND LOCAL PENSION PLANS (Pension
Research Council Working Paper No. 99-4, 1999); Girard Miller & Joseph J. Jankowski, Jr.,
Public-Sector Defined Contribution Plans: Lessons from Seven Governments, 6 G OV’TFIN. REV.
29 (1998).
14. See Khavari, supra note 1, at 41 (indicating there is already $2 trillion in state and
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191
this debate should prove interesting for all concerned.15 The purpose of this
article is to consider the major issues that are involved in that debate.
Specifically, this article discusses the principal issues that state and local
governments should consider in choosing between defined benefit plans and
defined contribution plans for their workers.16 Part I of this article provides a
little background on state and local government pensions.17 Part II of this
article discusses some of the key issues in choosing between defined benefit
plans and defined contribution plans. Finally, Part III of this article offers some
general recommendations about how to improve state and local government
pension plans.18
I. BACKGROUND ON PUBLIC PENSIONS
T he overwhelming majority of state and local government workers are
covered by defined benefit plans.19 For example, 91 percent of full-time state
and local workers participated in defined benefit plans in 1993-94, while 9
percent participated in defined contribution plans that year.20 All in all, 96%
of full-time state and local government workers were covered by at least one
retirement plan in 1993-94.21
local government pension funds. That number does not even count unfunded accrued liabilities
or the future benefit accruals of state and local government workers. Not surprisingly, Wall
Street is following this issue closely).
15. See, e.g., Laura Jereski, TIAA-CREF’s Expansion Plans Include State-Run Pension
Funds For Teachers, WALL ST. J., Aug. 11, 1997, at A2; Ellen E. Schultz, California Plan: A
Mutual Fund Bonanza?, WALL ST. J., June 28, 1996, at C1.
16. See also NAT’L CONF. OF ST. L EGIS., PUBLIC PENSIONS: A LEGISLATOR’S GUIDE
(JULY 1995); NAT’L EDUC. ASS’N, UNDERSTANDING DEFINED BENEFIT AND DEFINED
CONTRIBUTION PENSION PLANS (1995).
17. Throughout the remainder of this article, the terms “public pensions” and “public
pension plans” will be used to refer only to state and local pensions. Specifically, these terms
will not be used to refer to Social Security or to federal civilian or military retirement plans.
18. See Jonathan B. Forman, Address at the Oklahoma Teachers’ Retirement System
Task Force (Dec. 5, 1997).
19. See U.S. GEN. ACCT. OFF., supra note 2, at 2; Foster, supra note 2, at 37; OLIVIA
S. M ITCHELL & RODERICK CARR, STATE AND LOCAL PENSION PLANS (Nat’l Bureau of Econ.
Research Working Paper No. 5271, 1995); KAREN STEFFEN, STATE EMPLOYEE PENSION PLANS
(Pension Research Council Working Paper No. 99-5, 1999).
20. See Foster, supra note 2, at 37.
21. See id.
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This contrasts sharply with the private sector where less than 60% of
workers are covered by pension plans,22 and only about 40% are covered by
defined benefit plans.23 At the same time, however, while Social Security
coverage is almost universal in the private sector, more than 20% of state and
local workers are not covered by Social Security.24
It is also significant to note that unlike private-sector pension plans, state
and local government plans are not subject to regulation by the federal
government under the Employee Retirement Income Security Act of 1974
(ERISA).25 Instead, state and local pension plans are created and governed
by state and local laws which often have less stringent funding, vesting, and
other requirements.26 The federal tax rules governing state and local pensions
are also less stringent than the rules that apply to private plans.27
22. See William J. Wiatrowski, On the Disparity Between Private and Public Pensions,
M ONTHLY LAB. REV., April 1994, at 3.
23. See id. at 4.
24. See Foster, supra note 2, at 37-38; see also Kristen Phillips, State and Local
Government Pension Benefits, in T RENDS IN PENSIONS: 1992 (John A. Turner & Daniel J. Beller,
eds., 1992); Latest BLS Data on Employee Benefits in State and Local Governments, SEGAL
COMPANY: GOVERNMENT EMPLOYEES BENEFITS UPDATE , Sept. 1996, at 1; Bradley R. Braden
& Stephanie L. Hyland, Cost of Employee Compensation in Public and Private Sectors,
M ONTHLY LAB. REV., May 1993, at 14.
25. Employee Retirement Incme Security Act of 1974, Pub. L. No. 93-406 § 4(b), 88
Stat. 829, 839-40. Congressional efforts to extend ERISA-like protections to public pensions
have been unsuccessful. See, e.g., JOHN H. LANGBEIN & BRUCE A. WOLK, PENSIONS AND
EMPLOYEE BENEFIT LAW 82 (2d ed. 1995).
26. See U.S. GEN. ACCT. OFF., supra note 2, at 3-5; but see Public Plans: Teacher
Pension Plans Highly Regulated, Report Says, BNA PENSION & BENEFITS REP ., May 11, 1998,
at 1117 (reporting on a study by the National Council on Teacher Retirement). State and local
plans are also subject to state and federal Constitutional rules. See, e.g., Terry A. M. Mumford
& Mary Leto Pareja, The Employer’s (In)ability to Reduce Retirement Benefits in the Public
Sector, Sept. 11, 1997, available in WESTLAW, SC14 ALI-ABA 27.
It is also worth noting that the National Conference of Commissioners on Uniform State
Laws recently approved a new uniform Management of Public Employee Retirement Systems
Act (UMPERSA). See, e.g., Washington Update: Could a Uniform Pension Law Be Headed
Your Way from the State Legislature, SEGAL COMPANY: GOVERNMENT EMPLOYEES BENEFITS
UPDATE , Oct. 1997, at 7-9; Bronislaw E. Grala, Pension Plan Investments: Confronting Today’s
Issues, May 1998, available in WESTLAW, 415 PLI/Tax 439; Steven L. Willborn, Public
Pensions and the Uniform Management of Public Employee Retirement Systems, 51 RUTGERS
L. REV. 141 (1998).
27. In particular, the federal vesting and nondiscrimination rules applicable to
governmental plans are much more relaxed than the rules applicable to private plans. See, e.g.,
I.R.C. §§ 401(a)(5)(G) (1994) (coverage), 411(e)(1)(A) (1994) (vesting). Of course, state and
local government plan participants are subject to state vesting laws, which are often more
stringent than federal law. Also, one reason that state and local government plans are not
subject to the usual federal nondiscrimination rules may is that plan provisions are debated in
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193
II. SOME KEY ISSUES IN CHOOSING BETWEEN DEFINED BENEFIT PLANS
AND DEFINED CONTRIBUTION PLANS
This Part discusses some of the key issues for a government to consider
in choosing between a defined benefit plan and a defined contribution plan.
A. Funding And Cost
Defined contribution plans are always fully funded. On the other hand,
defined benefit plans are often underfunded. Nowhere is this distinction more
obvious than in the public sector. In fact, a recent survey of 451 state and
local pension plans found that 75 percent of them were underfunded, and 38
percent were less than 80-percent funded.28 For example, Oklahoma’s
teacher’s retirement pension system is only about 43-percent funded and has
an unfunded liability of approximately $4.7 billion.29
Defined benefit plans accumulate significant funding obligations as a
result of employee service over time. The employees earn the right to future
benefits as they work, but the employer does not always fully fund its accruing
pension liabilities. Moreover, a defined benefit plan can easily become
underfunded because of a decline in value of the pension fund’s investment
portfolio or even because of changes in the employer’s work force (such as
increasing life expectancies).30
Since the enactment of ERISA in 1974, private employers have had
relatively little leeway to avoid their funding obligations.31 On the other hand,
public pensions are not governed by ERISA, 32 and, as previously mentioned,
states are frequently guilty of underfunding their defined benefit plans.33 The
a public setting–the legislature; consequently, manipulation of plans by highly compensated
workers would be quite difficult. Personal Interview with Cynthia L. Moore, Oct. 1999.
28. See U.S. GEN. ACCT. O FF ., supra note 2, at 1-2; see also NAT’L EDUC. ASS’N,
CHARACTERISTICS OF 100 LARGE PUBLIC PENSION PLANS: WITH SPECIAL EMPHASIS ON PLANS
COVERING EDUCATION EMPLOYEES 50-57 (1998).
29. OTRS T ASK FORCE FINDINGS AND RECOMMENDATIONS 3 (1998).
30. One of the primary reasons why so many public pension plans are in financial
trouble is that people are living longer and retiring earlier. Of course, it’s great that we are all
living longer, and it’s great that we can expect to have long and leisurely retirements, but it has
led to many of the current funding problems faced by public pensions. Cf. Jonathan Barry
Forman, Reforming Social Security to Encourage the Elderly to Work, 9 STAN. L. & POL. REV.
289 (1998).
31. See ERISA § 302, 29 U.S.C. § 1052 (1994); I.R.C. § 412 (1994).
32. See ERISA § 4(b), 29 U.S.C. § 1003(b) (1994).
33. See U.S. GEN. ACCT. OFF., supra note 2, at 2; Cris Carmody, Trends in the Region:
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funding of state and local pension plans has improved substantially since the
1970s, but problems remain, and underfunding may present future problems for
many public pensions.34
Alternatively, it is worth noting that “a defined contribution system is
never underfunded.”35 The employer’s funding obligation is completed when
the employer makes the appropriate contributions to individual accounts, and
subsequent events have no impact on the employer’s funding obligations. In
short, under a defined contribution plan, the employer’s cost is known in
advance and can be included in the budget.
B. Influence on Worker Behavior
Pension benefits accrue differently under traditional defined benefit plans
and traditional defined contribution plans. In particular, under a defined benefit
plan, benefit accruals increase significantly the closer a worker gets to
retirement. On the other hand, under a defined contribution plan, benefits
accrue at a constant rate (e.g, 10% of annual compensation). Consequently,
defined benefit and defined contribution plans result in different incentives that
can affect employee decisions about work and retirement.36
In particular, defined benefit plans typically penalize workers who change
jobs frequently, create large financial incentives for workers to stay on the job
States Trying to Patch the Leaks of Unfunded Pension Plans, T HE BOND BUYER, May 15, 1996,
at 30; see also Olivia S. Mitchell & Robert S. Smith, Pension Funding in the Public Sector, 76
REV. ECON. & STAT. 278 (1994); OLIVIA S. M ITCHELL & PING LUNG HSIN, PUBLIC PENSION
GOVERNANCE AND PERFORMANCE (Nat’l Bureau of Econ. Research Working Paper No. 4632,
1994); Paul Zorn, Public Pensions, 57 (4) PUB. ADMIN. REV. 361 (July 1, 1997); Richard W.
Johnson, Pension Underfunding and Liberal Retirement Benefits Among State and Local
Government Workers, NAT’L T AXJ. 113 (1997); Laura S. Rubin, The Fiscal Position of the State
and Local Government Sector: Developments in the 1990's, 82 FED. RESERVE SYS. 302 (1996).
34. See U.S. GEN. ACCT. OFF., supra note 2, at 2.
35. See Baar, supra note 6 (quoting Michigan State Treasurer Douglas Roberts).
36. See, e.g., RICHARD A. IPPOLITO , PENSION PLANS AND EMPLOYEE PERFORMANCE 1017 (1997) [hereinafter IPPOLITO , PENSION PLANS]; RICHARD A. IPPOLITO , PENSIONS, ECONOMICS
AND P UBLIC P OLICY 133-50 (1986) [hereinafter IPPOLITO , P ENSIONS]; J OSEPHF. Q UINN ET AL.,
PASSING THE T ORCH: T HE INFLUENCE OF ECONOMIC INCENTIVES ON WORK AND RETIREMENT
(1990); LAWRENCE T HOMPSON, OLDER & WISER: T HE ECONOMICS OF PUBLIC PENSIONS 71-83
(1998); ALAN L. GUSTMAN & T HOMAS L. STEINMEIER, PENSION INCENTIVES AND JOB M OBILITY
(1995); Michael D. Hurd, Research on the Elderly: Economic Status, Retirement, and
Consumption and Saving, J. ECON. LITERATURE 565 (1990); Alan L. Gustman et al., The Role
of Pensions in the Labor Market: A Survey of the Literature, 47 INDUS. & LAB. REL. REV. 417
(1994).
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195
at least until they are eligible for early retirement, and push workers out of the
work force once they reach the plan’s normal retirement age.
1. Defined Benefit Plans Tend to Favor Older Workers
(Backloading)
One of the most obvious features of defined benefit plans is that they tend
to disproportionately favor older workers. The primary reason for this
backloading is that the value of benefit accruals typically increases a s a
percentage of compensation as employees approach retirement age. 37 Indeed,
most public pensions count on this so-called backloading – they expect to pay
a pro rata portion of full retirement benefits to just 30 or 40% of workers.38
Unfortunately, this backloading can discourage talented young workers from
coming into public service, and it can leave millions of former workers without
meaningful pensions.
2. Defined Benefit Plans Penalize Mobile Employees (Lack of
Portability)
Because defined benefit plans are backloaded, they reward long-tenure
employees and penalize more mobile employees. For example, Table 1 shows
the magnitude of this financial penalty on the mobile worker.39 Table 1
compares the retirement benefits of four workers. These workers all have
identical thirty-year pay histories (6% annual pay increases starting at $20,000
and ending at $108,370), and all their employers have identical defined benefit
plans (1.5% times years of service times final pay). The only difference
among these workers is that the first worker spent his entire career with one
employer, while the other workers divided their careers over two or more
employers. Nevertheless, the long-tenure worker would receive an annual
benefit of $49,000 at retirement, while the worker who holds five jobs would
receive just $27,000 per year.
In short, the mobile worker covered by a defined benefit plan will suffer
large benefit losses each time she changes jobs. Moreover, even greater
37. See generally IPPOLITO , supra note 36, at 41-60.
38. For example, California’s public employee pension system (CALPERS) expects
that 70% of the people in its system will leave the system before they receive a retirement
benefit. See Taylor, supra note 4.
39. Michael Falivena, Pension Portability: No Easy Solution, PENSIONS & INV., Feb. 5,
1990, at 15, reprinted in LANGBEIN & WOLK, supra note 25, at 85; see also Olsen & VanderHei,
supra note 4, at 11-12.
196
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[1:187
financial penalties can result if a worker changes jobs without vesting. For
example, under Michigan’s historical defined benefit plan, 45% of the state
employees did not vest in the program before leaving under that system.40 All
in all, the typical defined benefit plan penalizes workers who change jobs
frequently.
At the same time, however, the typical defined benefit pension plan
creates large financial incentives for workers to stay with a firm, at least, until
they are eligible for early retirement. This is the so-called “golden handcuffs”
phenomenon.
Few such benefit losses occur under defined contribution plans. Instead,
a mobile employee can typically roll over any defined contribution plan
accruals and accumulate a large account balance for retirement.41 Moreover,
defined contribution plans tend to have shorter vesting periods (or immediate
vesting) and an easily defined transfer value (the value in the account).42
Indeed, portability is one of the most important advantages of defined
contribution plans.43 Moreover, the lack of job security in today’s workplace
makes such portability and the resultant asset accumulation increasingly
important, especially for women.44
40. See Roberts, supra note 6. On the other hand, as a means of enhancing pension
portability, many state pensions allow employees to purchase pension credits to reflect prior
out-of-state service. See M OORE , supra note 13, at 16.
41. See, e.g., I.R.C. § 402(c) (1998). Of course, with defined contribution plans, there
is always the danger that employees will dissipate their retirement savings through early
withdrawals, lump-sum distributions, and loans. See infra Subpart II.E.
42. See Dent & Sloss, supra note 9. Of course, not all defined contribution plans have
short vesting periods. For example, the only major teacher plan that is a defined contribution
plan is the West Virginia TDC, and it has a 12-year vesting schedule. NAT’L EDUC. ASS’N,
supra note 28, at 11.
43. See GARY I. GATES, M ILBANK M EMORIAL FUND, PENSION PORTABILITY FOR STATE
AND LOCAL G OVERNMENT (1996); Peter J. Ferrara, The State Factor: Pension Liberation: A
Proactive Solution for the Nation’s Public Pension Systems, 23 AM. LEGIS. EXCHANGE COUNCIL
STATE FACTOR PAPER, NO. 4 (1997) (touting both the portability advantages of defined
contribution plans for state and local workers).
44. Anna Rappaport , The Aging Society and Retirement Benefit Strategy, 45 PROFIT
SHARING 8 (1997).
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197
TABLE 1. NON-PORTABILITY OF DEFINED BENEFIT
PLANS45
Worker
Employe
r no.
Yearly
accrual
rate
Years of
service
Final year’s
pay
Total
pension
1
1
1.5%
30
$108,370
$49,000
2
1
1.5
15
45,219
10,174
2
1.5
15
108,370
24,383
35,000
3
1
1.5
10
33,791
5,069
2
1.5
10
60,513
9,077
3
1.5
10
108,370
16,256
30,000
4
1
1.5
6
26,765
2,409
2
1.5
6
37,967
3,417
3
1.5
6
53,856
4,847
4
1.5
6
76,396
6,876
5
1.5
6
108,370
9,753
27,000
3. Defined Benefit Plans Push Older Workers Out of the Work
Force
Defined benefit plans typically push older workers out of the work force
at normal retirement age. Once a worker is eligible to receive full retirement
benefits, delaying retirement can actually be quite costly. Those who delay
retirement lose current benefits, and the increase in benefits that can result
45.
85.
Falivena, supra note 39, at 15; reprinted in LANGBEIN & WOLK, supra note 25, at
198
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[1:187
from an additional year of work rarely compensates for the benefits lost.46
Table 2 provides a numerical example of these financial penalties for delaying
retirement for a worker under a typical private-sector defined benefit plan.47
Table 2 assumes a thirty-year worker who could retire at age sixty-five with
a $3,000 a year pension and a fifteen-year remaining life exepectancy. As is
common in private-sector defined benefit plans, the worker does not receive
additional service credit for work after age sixty-five but is permitted to retain
the current wage in the pension formula. Moreover, in this simple example, the
pension is not actuarially increased for delayed retirement. Consequently, the
real value of the pension annuity drops from $45,000 at age 65 ($45,000 =
$3,000 x 15 years from retirement until death at age 80) to $36,000 if the
worker delays retiring until age sixty-eight ($36,000 = $3,000 x 12 years of
retirement). Working until age seventy-two further reduces the value of this
pension to just $24,000 ($24,000 = $3,000 x 8 years or retirement).
All in all, defined benefit plans create “windows” of retirement
opportunity that typically range from the plan’s early retirement age through
the plan’s normal retirement age. 48
46. Additionally, those who work until they drop often leave nothing behind for their
estates.
47. See IPPOLITO , supra note 36, at 146 tbl.2.
48. Moreover, a number of studies suggest that employers can significantly influence
the timing of retirement by offering subsidized benefits for workers who elect to retire early.
See Robin L. Lumsdaine et al., Retirement Incentives: The Interaction Between EmployerProvided Pensions, Social Security, and Retiree Health Benefits, in T HE ECONOMIC EFFECTS OF
AGING IN THE UNITED STATES AND JAPAN 261 (Michael D. Hurd & Nashiro Yashiro eds., 1997);
Paul Fronstin, Employee Benefits, Retirement Patterns, and Implications for Increased Work
Life, EMPLOYEE BENEFIT RESEARCH INSTITUTE ISSUE BRIEF NO. 184, Apr. 1997.
1999]
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199
TABLE 2. IMPLICATIONS OF “LATE” RETIREMENT FOR
PENSION WEALTH 49
Retirement
Age
Present Value
of Pension
Percent of Pension
Lost From Retiring
“Late” (Percent x 100)
Pension Loss As a
Percent Of Wage
(Percent x 100)
65
$45,000
-0-
-0-
68
36,000
20.0
90.0
72
24,000
46.6
210.0
Note:
Assumptions embedded in calculations: pension paid as annuity equal to $3,000
per year; annuity is indexed to inflation; the real rate of interest is zero; normal
retirement age is sixty-five; death occurs at age eighty; the wage is $10,000 (real)
per year.
Defined contribution plans can also influence the timing of the decision to
retire, but their effects are typically less dramatic.50 Their impact results
largely from the “wealth effect” of enabling workers to accumulate enough
money to be able to afford to retire.
4. Work Force Management Issues
As the preceding subpart has shown, defined benefit plans and defined
contribution plans can be designed to influence employee decisions about work
and retirement. Just which type of plan is best for a given employer depends
upon the human resources objectives of that employer and the demographics
of its work force. 51 Some employers may value younger workers who will
stay for short periods of time. Presumably, they would want to have defined
contribution plans.52 On the other hand, high training costs may cause some
employers to make retention of staff a high priority, and defined benefit plans
are better at rewarding long-tenure employees. Defined benefit plans also
49. See IPPOLITO , supra note 36, at 146.
50. See id.
51. See Richter, supra note 13.
52. For example, in the private sector, service and high tech firms typically prefer
defined contribution plans as a way of attracting younger, more mobile workers. See, e.g.,
PBGC Study, supra note 11.
200
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provide much greater flexibility in providing early and normal retirement
incentives.
C. Inflation
1. Preretirement Inflation
When it comes to inflation, the typical defined benefit plan has a serious
deficiency. Under the typical plan, benefits accrued by employees who
terminate employment before they retire are not indexed for inflation occurring
between the date of termination and the retirement date. Indeed, that is why
the mobile employees in Table 1 end up with smaller retirement benefits than
the employee who stayed with the same employer throughout her career.
There is a straightforward solution to this problem. Index a worker’s
accrued benefits for the inflation that occurs from the termination of
employment until retirement.53 This would preserve the real value of the
retirement benefits earned by mobile employees.
2. Postretirement Inflation
Another problem with both defined benefit and defined contribution plans
is that inflation after retirement can erode the value of accrued pension
benefits. Table 3 illustrates this problem.54 Post retirement inflation is always
a problem for defined contribution plans. On the other hand, many public
sector defined benefit plans provide for automatic or periodic increases in
benefits paid to retirees.55
D. Investments And Risk
53. See, e.g., Congressional Symposium on Women and Retirement: Hearing before the
Subcomm. on Retirement Income and Retirement of the House Select Comm. on Aging, 102d
Cong., 2d Sess. 134 (1992) (Statement of Ed Burrows, pension plans).
54. PRESIDENT’S COMMISSION ON PENSION POLICY, COMING OF A GE : T OWARD A
NATIONAL RETIREMENT INCOME POLICY 32 (1981).
55. See Zorn, supra note 33, at 361. According to that study, 70% of the plans
surveyed provided an inflation adjustment in 1994, averaging 2.81%. See id. See also CYNTHIA
L. M OORE , FIGHTING INFLATION: HOW DOES YOUR COLA COMPARE ? A COMPILATION OF COSTOF LIVING A DJUSTMENTS FROMSTATE T EACHER RETIREMENT SYSTEMS [American Association of
Retired Persons] ( 1999); Stanley C. Wisniewski, Informed Pension Choices in a Public Higher
Education Institution: Defined Benefit and Defined Contribution Plans, EMPLOYEE BENEFITS J.,
Sept. 1999, at 29.
1999]
Public Pensions
201
One of the biggest problems with defined contribution plans is that
individuals, rather than professional money managers, control investments.
Unfortunately, individuals tend to invest too conservatively, certainly toward
the end of their working careers.56 Additionally, many individual investors are
unsophisticated, and some may even end up being bilked by con artists.
TABLE 3
REAL VALUE OF RETIREMENT INCOME
BASED ON INITIAL REPLACEMENT RATE OF 100
PERCENT 57
Years in
Retirement
No Inflation
3% Annual
Inflation
5% Annual
Inflation
10% Annual
Inflation
0
100
100
100
100
5
100
86
78
62
10
100
74
61
39
15
100
64
48
24
20
100
55
38
15
25
100
48
30
9
Another problem with defined contribution plans is uncertainty. Financial
planning is difficult because the value of the ultimate benefit is unknown, and
the employee bears all of the investment risks. In particular, unlike defined
benefit plan benefits, retirement income bears no specific relationship to preretirement pay, so it is possible for there to be a significant change in living
standards at retirement. And, because of stock market volatility, workers who
retire when the market is up will have higher pensions than those who retire
when it is down.58
On the other hand, defined benefit plans are able to pool investments and
achieve superior returns and efficient fee structures by using professional
managers.59 Unlike individual investors, pension fund managers invest for the
56.
57.
58.
59.
See McEntee, supra note 13, at 12.
PRESIDENT’S COMMISSION ON PENSION POLICY, supra note 54, at 32.
See Richter, supra note 13.
See id.
202
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[1:187
long haul, and do not panic when the market becomes volatile. 60 In 1994, for
example, the average public pension had 40.6% of its assets invested in
domestic stocks and 36.7% in domestic bonds. 61
At the same time, however, there may be problems of political pressure
on public defined benefit plans.62 For example, there is a danger that public
pension funds may undertake imprudent investments for political reasons.
There is also some risk that politicians will manipulate or “raid” public pensions
to balance government budgets.63 Finally, many analysts are concerned about
the increasing power of public pensions to interfere with normal market
activity.64
E. Leakage and Distributions
Another major problem with defined contribution plans is that they are
leaky. While defined benefit plans typically provide lifetime annuities for
retirees and their spouses, defined contribution plans typically make lump sum
distributions to departing workers. Unfortunately, a significant portion of these
distributions end up being dissipated long before retirement. For example, a
recent study suggests that 60% of lump sum distributions made to job changers
from large plans are not rolled over into Individual Retirement Accounts
(IRAs) or other retirement savings plans.65
Defined contribution plans also often allow individuals to borrow against
their accounts.
Recent federal legislation suggests that Congress is
increasingly willing to let defined contribution plan savings be used for
nonretirement purposes (i.e., to purchase homes or to pay for college
education).66 Under a defined contribution plan, the responsibility for
60. See, e.g., Brendan Coffey, Nation’s Largest Public Pensions Unfazed by Equity
Plunge, DOW JONES NEWS SERV., Sept. 1, 1998, available in WESTLAW, Allnewsplus
database.
61. See Zorn, supra note 33.
62. See,e.g., Roberta Romano, Public Pension Fund Activism in Corporate Governance
Reconsidered, 93 COLUM. L. REV. 795 (1993); ROBERTA ROMANO, THE M ANHATTAN INSTITUTE,
POLITICS AND PUBLIC PENSION FUNDS (1994); Taylor, supra note 4.
63. See David L. Gregory, The Problematic Status of Employee Compensation and
Retiree Pension System: Resisting the State, Reforming the Corporation, 5 B.U. PUB. INT. L.J.
37 (1995); Ridgeley A. Scott, A Skunk at a Garden Party: Remedies for Participants in State and
Local Pension Plans, 75 DENV. U. L. REV. 507 (1998).
64. See Holman W. Jenkins, Jr., Business World: The Rise of Public Pension Funds,
WALL ST. J., Apr. 16, 1996, at A15.
65. Paul J. Yakoboski, Large Plan Lump Sums: Rollovers and Cashouts, EMPLOYEE
BENEFIT RESEARCH INSTITUTE ISSUE BRIEF NO. 194, Apr., 1997.
66. See, e.g., I.R.C. § 408A (Roth IRAs) (1998).
1999]
Public Pensions
203
purchasing an annuity is borne by the individual worker. Unfortunately, there
is just not much of a market for private annuities, and the costs are often
prohibitive. 67
Another problem with defined contribution plans is the longer life span of
women. Because women tend to live longer than men, they are more likely
to outlive their retirement savings.68 That is not as much of a problem with
defined benefit plans because distributions usually take the form of an
annuity.69
F. Administrative Expense and Complexity
Defined benefit plans can also be costly to administer.70 They have
complicated benefit structures, they are subject to complicated accounting
requirements and tax rules, and actuaries must be employed to determine
funding obligations. There are economies of scale, however, so it can be
relatively inexpensive to administer a large defined benefit plan, such as a
state-wide teacher retirement system.
In any event, defined contribution plans are always relatively simple to
administer. They operate like a bank account and are easy to explain to
employees.71
G. Summary
Table 4 summarizes many of the differences between traditional defined
benefit and defined contribution plans.
67. T HOMPSON, supra note 36, at 162-64.
68. Cf. Janet C. Boyd, When is a Girl Not a Girl and a Boy Not a Boy, T AX NOTES,
Aug. 10, 1998, at 729 (discussing a similar problem when defined benefit plans are allowed to
make lump sum distributions in lieu of annuity payments).
69. See id.
70. See Dent & Sloss, supra note 9; see also PBGC Study, supra note 11.
71. See Dent & Sloss, supra note 9.
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TABLE 4. SUMMARY COMPARISONS BETWEEN
TRADITIONAL DEFINED BENEFIT AND
DEFINED CONTRIBUTION PLANS
DEFINED BENEFIT PLANS
DEFINED CONTRIBUTION PLANS
! Benefits determined by set formula
! Benefits determined by contributions
(e.g., 2 percent times years of service
times final average compensation)
and
investment earnings (e.g., 10
percent of
annual compensation)
! Funding flexibility
! Possible discretion in funding
! Reward older and longer service
! Significant accruals at younger ages
employees (backloaded)
! Employees face financial penalties
! No disincentives for working past
for
normal
working past normal
retirement age
retirement age
! Long vesting period (e.g., 10 years)
! Often a short vesting period
! Employer bears the investment risk
! Employee bears the investment risk
! Employee has no investment
! Employee has investment discretion
discretion
! Often not portable
! Portable
! Require actuarial valuation
! Does not require actuarial valuation
! Relatively low employee
! Relatively high employee
understanding
understanding
and appreciation
and appreciation
! Unfunded liability exposure
! No unfunded liability exposure
! Provide benefits targeted to income
! Does not provide benefits targeted to
replacement level
! Usual form of benefit payment is
monthly income (annuity)
! Employees cannot borrow
income replacement level
! Usual form of benefit payment is lump
sum distribution
! Employees may be able to borrow
1999]
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205
H. Hybrid Plans
As the above discussion has shown, both defined benefit and defined
contribution plans have their advantages and disadvantages. Perhaps a better
approach may be found by looking at so-called “hybrid” plans that mix the
features of defined benefit and defined contribution plans. In particular, state
and local governments may want to seriously consider the merits of cash
balance plans.72
1. Cash Balance Plans
A cash balance plan is a defined benefit plan that looks like a defined
contribution plan. The plan accumulates, with interest, a hypothetical account
balance for each participant. The individual account balances are determined
by the plan’s benefit formula and consist of two components: an annual cash
balance credit and an interest credit. For example, a simple cash balance plan
might allocate 5% of salary to each participant’s cash balance account each
year, and credit the account with 7% interest on the balance in the account.
Cash balance account statements are issued to participants each quarter
and may provide benefit projections at retirement age. Cash balance
statements look like defined contribution plan statements and are generally
easier for participants to understand than a traditional defined benefit plan
formula. Cash balance plans may pay out account balances in the form of a
lump-sum distribution or as an annuity, but some sponsors encourage the
s election of an annuity by specifying a favorable actuarial basis to convert
accounts to annuities. Table 5 provides an example of a simple cash benefit
plan.73
72. See generally Sharyn Campbell, Hybrid Retirement Plans: The Retirement Income
System Continues to Evolve, EMPLOYEE BENEFIT RESEARCH INSTITUTE SPECIAL REPORT AND
ISSUE BRIEF NO. 171, Mar. 1996; Olsen & VanderHei, supra note 4; NAT’L EDUC. ASS’N,
UNDERSTANDING DEFINED BENEFIT AND DEFINED CONTRIBUTION PENSION PLANS, supra note
16, at 15-16, 25-26; Rose Darby, New Menu for Public Funds, PLAN SPONSOR, May 1995, at
28-30, 32-34; Carol Quick, An Overview of Cash Balance Plans, 20 EBRI NOTES 1 (1999);
Robert R. Mitchell, Cash Balance Pension Plans, 6 J. OF PENSION BENEFITS 25 (1999); Alvin
D. Lurie, Cash Balance Plans: Enigma Variations, T AX NOTES, Oct. 25, 1999, at 503; Hope
Viner Samborn, Now You See It, Now You Don’t, ABA J. 34 (Nov. 1999); Jon Forman, Cash
Balance Pension Plans, J. R ECORD (OKLAHOMA CITY) , Sept. 8, 1999, at 5; Jon Forman, Saving
the Teachers’ Retirement System, J. RECORD (OKLAHOMA CITY), Oct. 6, 1999, at 5, reprinted
as Jonathan Barry Forman, Saving a Public Fund, PENSIONS & INV., Dec. 13, 1999, at 14.
73. See Lawrence T. Brennan & Dennis R. Coleman, Cash Balance Pension Plans, T HE
206
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Like other defined benefit plans, employer contributions are based on
actuarial valuations, and the employer bears all of the investment risks and
responsibilities. Cash balance plans have been adopted by the Bank of
America, Bell Atlantic, Bell South Corporation, Chemical Bank, IBM, and
dozens of other companies. A traditional defined benefit plan can be
converted to a cash balance plan, but some transitional benefits would be
needed for employees nearing retirement.
2. Other Hybrid Approaches
Another approach might be to offer a target benefit plan. A target benefit
plan is a defined contribution plan which establishes a “target” benefit for each
participant using a defined benefit formula. The employer contributions for
each participant are actuarially determined to achieve this goal, but this
“target” benefit is not guaranteed. Instead, a worker’s ultimate retirement
benefit is based on the actual balance in the worker’s account.
Still another approach would be to offer a combination of defined benefit
and defined contribution plans. For example, a public pension might provide
for a defined benefit plan funded by employer contributions and a separate
defined contribution plan based on employee contributions. The State of
Washington recently adopted a teachers’ retirement system along these lines.74
HANDBOOK OF EMPLOYEE BENEFITS , VOL. 1,(Jerry S. Rosenbloom ed., 3d ed. 1992), reprinted
in Campbell, supra note 72, at 8.
74. See Williamson, supra note 5.
1999]
Public Pensions
207
TABLE 5. CASH BALANCE PLAN EXAMPLE 75
This example illustrates how an employee’s cash balance account grows over
five years. A new employee in this example earns $30,000 per year. Each year the
employee will earn cash balance pay credits equal to 5 percent of $30,000, or $1,500,
and an interest credit of 7 percent.
For purposes of this example, assume that each year’s pay credit earns one-half
of the annual interest credit rate in that year (i.e., 3.5 percent), since pay credits
normally will be credited throughout the year.
The balance after the first year would be $1,552.50 ($1,500 + 3.5 percent of
$1,500). To determine the interest credit for the second year, add 7 percent of the
balance at the beginning of the year ($108.67) to 3.5 percent of the pay credit for the
year ($52.50) to arrive at $161.17. Continuing in this manner, at the end of five
years, the account value will be $8,928.01, or almost 30 percent of annual pay (see
table below).
Account Value
Year (Beginning of Year)
$
0.00
1,552.50
3,213.67
4,991.13
6,893.00
1
2
3
4
5
Annual
Pay
Pay Credit Interest Credit
(5 percent) (7 percent)/a/
$30,000
30,000
30,000
30,000
30,000
$1,500
1,500
1,500
1,500
1,500
Account
Value
(End of Year)
$ 52.50
161.17
277.46
401.87
535.01
$1,552.50
3,213.6733
4,991.134
6,893.005
8,928.01
/a/ Pay credits assumed to receive one-half of the annual interest credit.
I. Transition to a Defined Contribution Plan or Hybrid Plan
Finally, it is worth noting that it would not be easy to shift from a
traditional defined benefit plan to a new type of retirement plan.76 Converting
a defined benefit plan into another type of plan can be an “arduous task,” and
it can be expensive to do because it involves consultants, actuaries, lawyers
and plan providers.77 Moreover, it would be unlikely that any revenue would
actually be saved in that process. In all likelihood, generous transition rules
75.
76.
77.
Brennan & Coleman, supra note 73, reprinted in Campbell, supra note 72, at 8.
See Dent & Sloss, supra note 9.
See Khavari, supra note 1.
208
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would be required, at least for workers close to retirement.78 With these
concerns in mind, Table 6 suggests some plausible approaches for a transition
from a traditional defined benefit plan to a new defined contribution or hybrid
plan.
TABLE 6. POSSIBLE TRANSITIONS FROM A TRADITIONAL
DEFINED BENEFIT PLAN TO A NEW DEFINED
CONTRIBUTION OR HYBRID PLAN
•
Keep the Defined Benefit Plan and Add a Supplemental Plan
•
•
Offer Both a Defined Benefit Plan and a New Plan
•
•
Under this approach, the employer would continue to operate its
current defined benefit plan but also add a supplemental defined
contribution plan for those employees who want to save
additional amounts for their retirement.
Under this approach, the employer would offer both its current
defined benefit plan and a new defined contribution or hybrid
plan, and employees would choose the plan in which they would
participate.
Close Entry to the Defined Benefit Plan and Add a New Plan
•
Under this approach, the employer would continue to operate its
current defined benefit plan for all existing participants, but all
new employees would be required to participate in a new
defined contribution or hybrid plan.
78. For example, if an existing defined benefit plan has an unfunded accrued actuarial
liability, that unfunded liability will not just disappear, even if the plan is terminated. Instead,
it is more likely that the employer would not only pay off that unfunded liability, but also
provide generous transitional benefits to protect long-service workers. Otherwise, those longservice workers would see a sharp reduction in their ultimate retirement benefits as the
employer shifted from a traditional (backloaded) defined benefit plan to an equal-cost defined
contribution plan.
1999]
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209
TABLE 6 cont.
•
Close Entry to the Defined Benefit Plan, Add a New Plan, and
Shift Unvested Employees to the New Plan
•
•
Freeze the Defined Benefit Plan at Current Salary Levels and
Add a New Plan
•
•
Under this approach, all new employees and unvested employees
would be shifted to a new defined contribution or hybrid plan.
Alternatively, all new employees and all employees under the age
of, for example, fifty would be shifted to the new plan.
Under this approach, each employee’s benefit accruals would be
frozen at the employee’s current salary level. Each employee
would continue to accrue benefits on earnings up to that salary
level until retirement. Salaries in excess of that cap would be
covered under a new defined contribution or hybrid plan, and all
new employees would be covered only under the new plan.
Terminate the Current Defined Benefit Plan and Replace It
With a New Plan
•
Under this approach, the current defined benefit plan would be
replaced with a new defined contribution or hybrid plan that
covered all new and existing participants. Existing accrued
benefits would be converted to initial individual account balances.
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III. GENERAL RECOMMENDATIONS AND CONCLUSIONS
Whatever pension system a state or local government chooses to provide for
its workers should be designed to help ensure that retirees and their spouses
will have adequate incomes throughout their retirement years. The pension
system should also be designed to attract and retain qualified workers, and it
should not discourage them from remaining at work after normal retirement
age. To help meet these goals, the pension system should strive to expand
coverage, preserve retirement savings until retirement, and pay retirement
benefits in the form of a lifetime annuity.
A. Expand Coverage and Preserve Retirement Savings until Retirement
To ensure an adequate retirement income, every worker needs to save
early and often for their own retirement, and those retirement savings must
remain untouched until actual retirement. There are a number of things that
state and local government pensions can do to help meet these goals.
1. Have a Short Vesting Period
First, state and local government pensions should have a short vesting
period. The ten-year vesting period that is still common among state and local
government defined benefit plans is just too long. At the very least, States
should strive for the five-year cliff vesting approach applicable to most privatesector plans.79 An even better approach would be to have vesting after no
more than one or two years.
2. Accrue Significant Benefits for Every Worker
Second, state and local government pensions should be designed to ensure
that every worker accrues a significant retirement benefit during each year of
work. In short, state and local government plans should minimize backloading.
This happens automatically in defined contribution plans. As for defined benefit
plans, state and local governments should seriously consider indexing benefits
for inflation from the time that a worker leaves employment until she actually
starts drawing her benefits at retirement.80
79.
80.
See ERISA § 203, 29 U.S.C. § 1053 (1994); I.R.C. § 411(a) (1994).
See supra Section II.C.1.
1999]
Public Pensions
3. Preserve Retirement Savings Until Retirement
211
Third, state and local government employers also need to be concerned
about employees dissipating their retirement savings through early withdrawals,
lump-sum distributions, and loans. But plans can easily be designed to minimize
this leakage and, consequently, to preserve retirement savings until retirement.
4. Encourage Workers to Remain in the Work Force Longer
Fourth, employers need to be concerned about keeping employees in the
work force longer. The fact of the matter is that public-sector workers simply
cannot expect to work thirty years, retire at age fifty-five, and have a taxpayerfunded pension that will support them for the next thirty years–yet that is how
many public pensions are currently designed. Most public pensions need to be
redesigned to raise the normal retirement age and to eliminate any financial
penalties for working past that age.
B. Pay Retirement Benefits in the Form of an Annuity
Finally, public pensions should be designed to ensure that all retirees and
their spouses have adequate incomes throughout their retirement years.
Consequently, it may also be appropriate to impose significant limits on pension
distributions after retirement. This goal could perhaps best be accomplished by
paying at least a basic portion of benefits in the form of a lifetime annuity,
perhaps even an indexed-for-inflation annuity. Beyond that basic annuity,
however, more relaxed distribution rules might apply.
For example, it could make sense to design a basic public pension benefit
that, together with Social Security (if any), would provide the equivalent of an
indexed annuity that is targeted to, say, at least 125% of the poverty level. 81
In 1999, the poverty level for a single individual was $8,240, and the poverty
level for a married couple was $11,060.82 Consequently, assuming a 125%-ofthe-poverty-level target, a single individual retiring in 1999 would have needed
the equivalent of an indexed annuity that paid $10,300 that year ($10,300 =
125% x $8,240) and appropriately inflation-adjusted amounts in future years.
For many public employees, Social Security would provide a good chunk
of this minimum 125%-of-the-poverty-level benefit, leaving only the balance
81. Cf. Forman, supra note 10, at 1682-83; Jonathan Barry Forman, Universal
Pensions, 2 CHAPMAN L. REV. 95, 123-24 (1999).
82. Annual Update of the Health and Human Services Poverty Guidelines, 64 FED.
REG. 13,428 (Dep’t Health & Human Serv. 1999). These numbers are adjusted for inflation
each year.
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to be made up from the worker’s pension. Specifically, the basic pension
benefit accrued for a retiring public employee might be made available under
just three options:
1. A 100% payout to purchase an indexed annuity that, when coupled with Social
Security, results in sufficient annual income to meet the 125%-of-the-poverty-level
standard.
2. Distributions as desired with only one constraint: the amount remaining in the
account after withdrawal must always be at least 110% of the amount necessary to
purchase an annuity guaranteeing the 125%-of-the-poverty-level standard.
3. A combination of 1 and 2.
Similarly, distributions for married couples might be geared towards purchasing
an indexed, joint and survivor annuity (i.e., paying $13,825 this year [$13,825 =
125% x $11,060] and appropriately inflation-adjusted amounts in future years).
Finally, as already mentioned, more relaxed rules could apply to
distributions in excess of the basic amounts needed to meet the 125%-of-thepoverty-level standard.