Let’s stack the deck

By Cate Long
May 17, 2011

Deficits at state-pension funds are the real monsters threatening municipal stability. Estimates of shortfalls at these funds range from $1 trillion from the Pew Center on the States to $3 trillion from Orin Kramer, the former chairman of New Jersey’s State Investment Council.

There are numerous strategies that individual pension-plan sponsors are using to stabilize their funds, including:

  • Reducing benefits
  • Increasing employee contributions
  • Making additional public contributions to “top up” the fund
  • Trying to increase returns for the fundby increasing investment risk
  • Changing to a defined contribution plans

The excellent graphic above, provided by the Pew Center on the States, shows how many states are adopting the first and second strategies listed above. The upside of these methods is they stabilize fund assets immediately.

As most pre-existing pension plans are defined benefit plans (think standard public pension), the fifth strategy of changing to a defined contribution plan (think 401K) has been the focus of much discussion. Unfortunately, this change shifts almost all of the risk for providing benefits to the retiree.

An excellent report from the Center For Retirement Research defines the risks:

The defining characteristic of defined contribution plans is that they shift all the responsibilities and all the risk from the employer to the employee.

In terms of responsibilities, the employee must decide whether to join the plan, how much to contribute, how to allocate those contributions among different investment options, how to change those allocations over time, and how to withdraw the accumulated funds at retirement.

Under a defined benefit plan, the sponsor retains these responsibilities.  The plan requires participation, sets contribution rates, invests the assets, and pays an annuity at retirement.

Leaving the responsibilities in the hands of employees means that they are exposed to the risks of saving too little, losing funds when financial markets fluctuate, seeing the value of their retirement income eroded by inflation, and outliving their resources since payment is generally not in the form of an annuity.

Not to be harsh, but generally people with low incomes lack experience in managing financial assets and can be misled easily by complex financial product disclosures. Or, to put it more simply, they are easy prey for Wall Street.

The most interesting idea I have read comes from the Center on Retirement Research report cited above and proposes a “stacked” benefit plan. This would provide a base defined benefit for income up to $50,000 and then “stack” a 401(k)-type program on top for higher-earning employees.

A better approach to limiting taxpayer risk is to cap the income covered by the defined benefit plan.  Such a cap would prevent the situation where the typical taxpayer, earning $50,000, is forced to pay higher taxes when the stock market plummets to cover benefits for highly-paid public employees, such as university presidents.

Therefore, the proposal would be to limit coverage under the defined benefit plan to earnings below, say, $50,000 (indexed for inflation). Many public sector workers would still be covered in full under the defined benefit plan.

In the last few years Georgia, Michigan, and Utah have adopted such “stacked” plans for new hires, and nine more states are discussing adoption. See the Center on Retirement Research report for more details.

2 comments

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A defined contribution plan need not shift the full responsibility to the employee (as stated in the article). The employer can contribute a portion of salary to a fund managed by the employer/fiduciary. That portion could be provided solely by the employer, mandated to come from the employee (as Virginia proposed)or be voluntary. In addition to contributions, growth of the fund may be based on an the stock market or an index like the yield of the 30 yr. Treasury yield.
In addition to the added risk, the employees payout is based not on their highest years of earnings as is typical in defined benefit plans, but instead based on earnings over time and a contribution rate that could change in the future.

Posted by kenvolvo | Report as abusive

Having 50 different state pension plans with 50 different approaches to funding/investment management of state employee pensions will surely lead to major disasters in several of them. The public will end up footing the bills anyway.

So, perhaps the stacking should be composed of moving a portion of each state’s pension into Social Security based on earnings up to $50,000. The funds to support this should also be moved over to the Social Security trust in the amount that would have been attributed to the workers, had they been covered by Social Security up to the first $50k of salary. This will lead to a consistent safety net across all states, and funding consistent with how it works for the rest of us.

The remaining portion of the pensions should be converted to a defined contribution plan at the state level funded by the state worker. This way, state employees look like the rest of us and would be subject to the same risks. There is no good reason that a state employee should be in a more privileged position that ordinary American workers when it comes to pension benefits … that only leads to the financial problems that have ultimately emerged with all of these state pension plans.

Posted by Mangojulie | Report as abusive