The efforts to reform state and local pension plans have followed a rather predictable path. Mounting unfunded liabilities and always increasing contribution requirements create the ever-growing need for additional funding, which usually has the effect of slowly crowding out the delivery of public services. Taxes may then be increased and/or municipal bonds issued. New—and lower—benefit tiers are added for new hires, and, because of the increasing pension debt, contribution rates still increase for employers and employees, even those in lower benefit tiers.
What’s missing from this entire progression is any thought of what is best for employees in the long run and how plan design meets employer workplace goals.
Over the last decade, many of the changes that defined benefit plans adopted have not produced the necessary financial gains and solvency outcomes desired. Only after these tweaks to use lower benefit tiers have come up short are fundamental changes to funding policy and benefit design for new hires typically considered.
The starting position for many considering pension reform is that the traditional defined benefit (DB) pension is the best type of plan for public workers as it provides lifelong income in retirement. But the need for change, the argument goes, will reluctantly have to override the ability to maintain this main feature. This attitude suggests an unfortunate tendency for policymakers to assume that in order to bring financial stability to the retirement system—employees —especially new hires, will have to settle for sub-optimal retirement outcomes.
In reality, the very idea that traditional DB plan designs are the only best approach for today’s state government workforce is nothing but arrogant and inaccurate on its face. While the traditional DB may turn out to work for some public sector employees, especially long-tenured workers, the majority of new hires will not have their retirement needs met by this type of plan.
As has been recognized in essentially all employment sectors—except state and local government—the nature of the modern workforce is dramatically different than it was a generation or two ago. Public employment has experienced the same evolution as all other employment sectors. Retirement plan designs need to evolve with the employee population, something that has not effectively happened in a number of sectors, but most broadly in state and local government.
The single biggest change in employment patterns that needs to impact retirement plan design is employment tenure. A generation ago it was common for state and local government employees to stay with one employer for their entire careers. There was an understood trade-off in play. If you worked in the public sector your salary was less than that of a comparable position in the private sector, but your benefits package was more generous, which often came in the form of a DB pension plan with a high income replacement rate.
Today, however, the disparity in compensation between the public and private sectors no longer exists and, perhaps most importantly, employees rarely remain with one employer for an entire career. The median employment tenure in state government today is just 5.8 years.1 This fact alone illustrates that traditional DB, with extensive vesting periods and high benefit eligibility ages, is not the right answer for a new generation of public sector employees.
Median private sector employment tenure is just under four years.2 In the private sector, DC plans that primarily focus on benefit portability and rapid vesting have been the primary retirement plan structure for some time. The plan designs, however, are just now beginning to appropriately recognize long term retirement goals. The public sector has the opportunity to avoid some of the private sector DC design growing pains.
Further evidence of the need for portable plan designs can be found on the state level. In Colorado, for example, only 35% of teachers/educators participating in the PERA system will remain with their employer for five years. In the state employee division under PERA only one-third of employees will stay to reach the same initial vesting period of five years. Similarly, in the South Carolina Retirement System, 62% of teachers are not expected to be employed beyond five years, and fully 73% will terminate employment within 15 years of hire.
Most participants in these systems, which are illustrative of many others, will leave employment with a return of employee contributions with, possibly, some token amount of interest and employer match. A minority will be lucky enough to just “break-even”, with the DB benefits catching up to the value of their own contributions. Adhering to this employment pattern, which is likely for workers in the current generation, will lead to grossly insufficient retirement assets following a full career in employment.
Another relevant aspect of this trend is the factual change in the importance/relevance of retirement benefits for younger employees. According to the 2016 Wells Fargo Millennial Study, the majority of adults between the ages of 22 and 35 prefer higher pay today to higher retirement benefits tomorrow. This essentially flips the preferences held by Baby Boomers. Furthermore, in the past few decades, the average number of jobs people pursue five to 10 years following their graduation has increased, according to the last year’s study done by the networking site LinkedIn.
Recognizing the reality of employment patterns today is critical in designing a retirement plan that meets employee retirement goals as well as employer workforce objectives, including recruiting and retaining 21st century employees. A retirement plan should not attempt to dictate employment tenure. Doing so only breeds resentment in employees and hinders retention for employers.
Rather, employers should maintain retirement plans that balance employer workforce goals with the reality of employee needs. Today there are DC-based plan designs that are focused on lifetime income, like DB plans, but recognize the mobility of the modern workforce. These plan structures meet the needs of today’s employees and enable effective recruiting and retention for employers. Importantly, these plans do not add to unfunded liabilities and provide complete budgetary predictability.
None of this is intended to suggest that DB plans are inappropriate for all public employees, current and future. Nor is it impossible to manage DB plans in a way that ensures proper funding. What is critical, however, is that if a DB plan is offered it must be properly designed with conservative, realistic assumptions and contribution rates sufficient to provide adequate retirement benefits for career employees.
Some states and jurisdictions are now starting to implement new plan designs that include choices for employees that enable them to utilize a plan design that will better meet their own financial situation and career progression. Arizona, Michigan and Pennsylvania are three that have recently made such positive reforms.
The benefits of a choice based system are clear: public sector employees that are aiming for long-term service can select DB plans while other public employees can instead choose a DC plan that aims to produce income in retirement and reflect many of the features of a DB plan while also providing portability.
For the sake of state and local government employees—as well as for the financial stability of the governments themselves—political leaders, labor leaders and everyone influencing the pension reform process must consider the realities of the modern workforce when designing solutions and not blindly adhere to ideologies that do not reflect today’s realities.
Richard Hiller is principal of Retirement Policy Consulting and a senior fellow at Reason Foundation. He has worked on income-focused retirement plan designs for more than 35 years.
Endnotes
1 Bureau of Labor Statistics, https://www.bls.gov/news.release/tenure.t05.htm
2 Ibid.
3 Reason Foundation Pension Integrity Project analysis based on PERA actuarial analysis and CAFR.
4 Ibid.
5 Reason Foundation Pension Integrity Project analysis based on SCRS actuarial analysis and experience studies.
6 LinkedIn, “Will This Year’s College Grads Job-Hop More Than Previous Grads? (blog post),” April 12, 2016.