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December 8, 2014

Boxed in by pension funding gaps, states must think outside the box

December 8, 2014

States and municipalities across the country have responded to growing funding gaps in their pension plans by cutting benefits or requiring employees to contribute more. These steps may improve plan finances, but they often backfire, undermining employees’ retirement security and making it harder for governments to attract and retain qualified workers. Instead of simple cost cutting, it’s time for policymakers to fundamentally rethink the retirement benefits provided to public employees.

Consider Pennsylvania, with some of the most troubled public pension plans in the nation. In 2010, to save money, it significantly cut retirement benefits for general state employees.

Beginning in 2000, state employees earned pensions equal to 2.5 percent of their final average salary multiplied by years of service, which they could begin collecting at age 60 or after they had completed 35 years of service. For employees hired after 2010, however, the benefit formula has been sliced to 2 percent, and pensions can’t begin until age 65 for those with fewer than 35 service years. Despite the benefit cut, Pennsylvania state employees must still contribute 6.25 percent of their salaries to the plan.

Because of these cuts, relatively few new hires get much out of the pension plan. Employees who begin working for the state today at age 25 must work 32 years before their future pensions are worth more than their required contributions. Those who separate earlier lose money in the mandatory plan. These employees would fare better financially if they could opt out of the plan and invest their contributions elsewhere.

There are better ways of reforming pensions that can provide public servants with secure retirements and still save taxpayers money. Some public employees in Nebraska, Texas, and Kentucky, for example, are enrolled in cash balance plans, which combine features of 401(k)-type plans and traditional pensions. Under these plans, employers contribute a set share of each employee’s salary each year to a retirement fund, which earns investment returns. Plan benefits are expressed as an account balance, as in a 401(k) plan, but investments are pooled and professionally managed, and often guarantee some minimum return. Additionally, cash balance plans allow participants to collect their benefits as lifetime annuities.

Another noteworthy reform option comes from Senator Orrin Hatch (R-UT), who introduced a bill that would, among other provisions, allow states and localities to fund annuities from private insurance companies for their employees. As in a cash balance plan, employers adopting Hatch’s Secure Annuities for Employees (SAFE) plan would contribute a portion of each employee’s salary each year. But instead of depositing those funds into the public pension plan, they would use them to purchase a deferred fixed-income life annuity contract each year for each employee.

Compared with traditional pension plans, cash balance and SAFE plans both provide more retirement security for employees who spend less than a full career in public service. Retirement benefits in traditional plans are frozen when employees separate, so their value erodes with inflation and lost interest while employees wait to collect. By contrast, deferred annuities and cash balance plan accounts continue to earn returns until employees retire, even after they’ve left public service. All employees, regardless of service length, benefit from these retirement plans.

As a result, cash balance and the proposed SAFE plans score well on our public pension report card, which rates public plans on funding, workforce incentives, and benefit adequacy. The SAFE plans do best. Unlike cash balance and traditional plans, it prevents governments from underfunding their retirement benefits, because insurance companies won’t accept IOUs when issuing deferred annuities. As an added bonus, SAFE plan participants don’t need to worry about receiving lousy annuities because they might retire when interest rates are unusually low, because the plan issues deferred annuities throughout participants’ careers, not all at once.

There’s no free lunch, of course. The added benefits that cash balance plans and the SAFE plan provide for relatively short-tenured employees are paid for by reducing benefits for long-tenured employees. And these reforms don’t offer solutions for the underfunded benefits already promised to public employees. But they represent the kind of bold thinking needed to address the pension challenges confronting state and local governments.

Want to learn more? Watch our webinar tomorrow and visit our public pension webpage.

Top Image from our interactive public pensions report card.

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