Public retirement plans need to evolve

Government retirement plans are meant to deliver secure post-employment income to retired public workers and to meet employer workplace needs of recruiting and retaining qualified employees in a financially viable way. Many wonder, however, how these public pension systems found themselves with growing unfunded liabilities (now $1.6 trillion and growing nationwide) and perpetual fights over cost-of-living adjustments (COLAs), assumptions, and benefits types.

The answers to these questions, as they often do, lie in the history of how public retirement plans started and how they have evolved over the last 40-plus years.

In the early 1980s, the significant movement in state retirement plans was the wave of public university systems moving to defined contribution optional retirement plans (DC ORPs). Public university systems in many states already had optional retirement plans, including the University of Michigan (the first ORP dating to 1918).

Optional retirement plan is a generic term for a portable DC-based retirement plan where the individual participant owns his or her assets and can control them through a career with multiple employers. The two most common types of ORPs are the ones that give an option for an employee to make a one-time choice between the defined contribution plan or a traditional pension and the type where eligible employees can only participate in the DC plan.

Through the 1980s and into the 1990s, optional retirement plans were enacted by legislative action for university systems in Florida, Georgia, South Carolina, Idaho, Montana, Colorado, and New Mexico, among others.

The main reason for enacting optional retirement plans was the need to recruit faculty and administrators from a nationwide talent pool, and universities recognized that a non-portable traditional pension hampered recruiting. Higher education employees, especially faculty, were one of the most mobile professions at this time. By the end of this wave of ORP implementations, all but a small group of states had mobile, defined contribution-based retirement plans in place for higher-education employees. Of note is that these plans, with their DC structure, were still focused on providing stable lifetime income to participants after a career of employment. In most cases, at the time, lifetime annuity income was the primary distribution method from these plans.

The big news in the 1990s was the seemingly never-ending upward movement of equity markets. As the decade advanced, many state legislatures began implementing substantial benefit formula increases in their state’s traditional pensions. These increases were the result of increasing political influence on public pension plans, including a desire among legislators to attract votes from public employees and significant pressure from public employee unions. While the funding status of most traditional public pension plans was strong because of market conditions, these benefit formula increases were often adopted without proper consideration of potential funding impacts. Once promised, these increases could not be revoked. 

These changes subjected the financing of these plans to a great deal of risk that did not exist before the benefit increases were rewarded. The contribution formulas at the time were designed based on the actuarial analysis of what was needed to meet the benefit obligations before these unfunded increases were implemented. The fact that funding statuses at the time were high was not sufficient logic to not fund the changes. These actions exhibited either a monumental lack of understanding of market behavior or an arrogance that ‘it will not happen to us. The market downturn would prove extremely damaging to these public pension plans. There was a broadly held belief, however, that markets would continue growing and never slow down. Alan Greenspan, then chairman of the Federal Reserve in 1996, called this “irrational exuberance.”  

DC-based retirement systems, including many ORPs, were not immune from changes brought about by the rise in equity markets. Participants began demanding more investment options and distribution methods other than lifetime annuities. In plans that had investment strategies geared toward long-term retirement savings and income production, these pressures spurred a movement away from the core objectives of retirement security. Many plans became focused on wealth accumulation rather than income production. Some plans wound up with hundreds of investment choices among multiple providers, putting the average, non-investment-sophisticated plan member in a difficult spot. While investment choice in and of itself is not necessarily a bad thing, this kind of unchecked choice came with a general move away from the central objective of secure lifetime income production. The variety of options unfortunately opened the door to a rise in unclear and inappropriate goals, like prioritizing wealth accrual over lifetime retirement security.

The tech bubble bursting and the inevitable large market downturn, followed by a prolonged period of war and overall economic instability, was a dramatic wake-up call for retirement systems, both traditional pensions and ORP-type public plans. Inadequately funded benefit increases led to wholly predictable unfunded liabilities. Many retirement systems tried to address the shortcomings by becoming more aggressive with the investment of system assets. This attempt to chase returns led directly to even deeper unfunded liabilities when the subprime mortgage crisis prefaced the great recession later in the decade. States and municipalities were forced to find revenues to adequately fund their retirement systems, resulting in impacts on other government-provided services.

While no unfunded liabilities could accrue to employers with DC-based plans, individuals that had invested in an overly aggressive manner found themselves with inadequate assets as retirement approached. In numerous cases, this resulted in delayed retirements and certainly necessitated changes in personal retirement planning. Many retirement plan systems at this point were being advised by third-party investment and benefits consultants whose experience was largely in the DC corporate world.

By and large, corporations had moved away from pensions but had not moved to defined contribution plans designed around lifetime income security. While the seeds were planted for redesigning these DC plans along the lines that ORPs originally were, the implementation of better designs was still years away.

During this time, employment patterns in the state and local government workforce continued to change. At one time, many government employees remained with one employer for a full career. That was no longer the case, with governmental employment patterns more closely tracking private sector employment tenure.  

The recovery from the Great Recession was slow, but corporate balance sheets began to improve steadily in the 2010s. Employment, however, lagged. State and local governments were revenue-strapped, and unfunded pension liabilities were wreaking havoc on government budgets while employment tenure continued to decrease. Government retirement, long a back-burner political issue, became front-page news. Taxpayers were pushing for public pension reforms, while unions were demanding protections for public employees. 

This environment called for significant action in public pension plans. It was clear that the unfunded liability situation could not continue. It was also becoming increasingly clear that the changing employment patterns in the public sector made traditional pensions ineffective for the vast percentage of new employees entering public employment. Public employers were also having trouble recruiting qualified employees. To address all these challenges, a move—for new employees only—to an ORP-like DC-based retirement system should have been obvious. This would have prevented the creation of new unfunded liabilities, would have met the needs of an increasingly mobile workforce, and would have aided in recruiting–just like ORPs had done for higher education.

A few state governments, including Alaska, Oklahoma, and North Dakota, did just that, closing outdated pensions and enrolling all new employees in defined contribution plans. More states, like Florida, Arizona, Colorado, Michigan, and several others, added and expanded upon optional defined contribution plans so new hires could choose for themselves which approach would best fit their career path.

Most state and local governments, however, did very little to modernize their retirement plans, leaving the majority of public workers in defined benefit pensions despite their inability to accommodate an increasingly mobile workforce.

Amidst the need to modernize retirement plans, as evidenced by the clear preference to do so in the private sector, public employers largely ignored growing risks and costs. Unions and other anti-reform groups continued to insist that traditional public pensions serve as superior recruiting tools despite only between 30% and 50% of public employees even qualifying for these benefits.

Today, there are even efforts to undo modernizing public pension reforms and to bring government employers back to the defined benefit pensions of the early 2000s.

Examining the history and evolution of public retirement plans, one can see that today’s situation is actually not much different than it was in the 1980s. While market conditions and employee needs have changed, secure lifetime retirement income after a career of employment remains the primary objective of any retirement plan, along with aiding employers in recruiting and retaining employees in a financially viable manner. Luckily, there is a wealth of tools available in the marketplace to craft low-cost plans that are efficient in managing risks and flexible enough to meet individual employee needs, which was not the case 40 years ago.

As the DC-based, income-focused retirement plan is the best design to meet the needs of governmental employers and employees today, stakeholders in public retirement plans, including employers, employees, unions, legislators, and others, should consider expanding and emphasizing this approach for new hires.

One key lesson that policymakers should learn from the last 40 years is that they must maintain a focus on retirement plan objectives. Losing that focus, as has happened in both traditional pension and defined contribution designs, will lead to suboptimal outcomes for both employers and their workers.