A Third Way for Public Pensions: Adjustable Pension Plans

Defined-benefit plans put all the risk on states and localities; defined-contribution plans put it all on employees. Now there's a new approach to risk sharing.
May 16, 2013

For employees, there's nothing like it. A defined-benefit (DB) plan guarantees them their prescribed stipend no matter how much it rains or shines on the pension portfolio's investments. For states and localities, on the other hand, a defined-contribution (DC) plan places the burden of investment risk on the employee -- not on them.

No matter what side you're on, it is no wonder that the current trend in state and local government is to switch new employees to DC plans. That trend, however, has its problems for employers: They may not provide their employees with an adequate retirement, forcing the government to step in down the road, and they also may create two tiers of employees earning vastly different benefits for the same job and salary.

This is where a new approach -- an adjustable pension plan (APP) -- comes in to play. An APP is a defined-benefit plan with a key difference: The benefit received each year is adjusted from an original multiplier based on the previous year's investment performance. In this way, investment risk between employees and employers is shared. There's also a floor to the plan -- a minimum guarantee of income.

In the last two years, APPs have started making headway in the private sector. A multi-employer plan, the Greater Boston Hospitality Employers Local 26 Trust Funds, moved from a 401(k) plan to an APP in January 2012. The Consumers Union in Yonkers, N.Y., adopted it to replace a DB plan as did The New York Times Company for its employees in the newspaper guild.

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Three adoptions does not a trend make, but it does raise a question: Would an APP be a viable alternative for a state or local pension plan? That's what Maine wants to find out. I talked to Sandy Matheson, executive director of the Maine Public Employees Retirement System, about why her state is looking into APPs and more. Here's an edited version of our conversation.

Why is Maine looking into APPs?

Maine is in a minority situation. We are a non-Social Security state, which means our current pension plan is a qualified replacement plan under the IRS. Two years ago, the legislature requested that a [task force made up of] employers, members and the executive director of the pension plan look at moving into Social Security and design a supplemental plan to go along with that. The legislature had a set of criteria for that. In addition to [what employers would pay] for Social Security, the legislature wanted to limit long-term costs for employers to an average of 2 percent of payroll. We were also tasked with creating a plan that would help with recruitment or retention of employees. The task force also set down a set of principles for themselves that any plan or program would have to meet. One of the more critical principles was that the plan create retirement income security versus wealth accumulation. That is, we wanted the plan to offer lifetime retirement income security and to be equivalent to old benefits so workers side by side would have an equivalent benefit.

We started looking at designs and were intrigued with the APP because of the risk-limiting aspect. We were trying to balance a benefit that could be counted on but that had risk limitation and risk sharing with employee and employer.

What did you end up recommending?

The recommended plan has a 1 percent contribution from the employer toward the APP, 1 percent toward a defined-contribution plan and an employee contribution of 4.6 percent to the APP. Between the three elements, the task force plan created a benefit that was the equivalent to the current plan that we have. From the legislature's perspective, it accomplished what we were charged with doing. The plan was based on Social Security, it improved portability and limited risk. It also met the task force's criteria of a predictable income stream [for retirees].

The APP is not a one-for-one trade with a defined-benefit plan, but it is generally equivalent. The defined-benefit is replaced by Social Security plus the APP plus the 1 percent employer contribution to a 401(a) plan. The 401(a) defined-contribution plan is designed to encourage employees to annuitize. We also added a 457 deferred compensation plan for optional or lifestyle savings you might want in retirement. We felt that it met everyone's needs and was a good recruitment and retention tool. It gave some retention and some flexibility for turnover. The DC plan is good for portability and the APP is good for retention.

Where does the task force's recommendation stand now?

[It is with the legislature now, so they can] discuss it formally. It doesn't look like it will happen this session, but it's in the queue.

I should add something to be clear: When we turned in the original report for this, we had two employee groups and two employer groups on the task force. It was a unanimous decision, but we were careful to indicate that we selected this plan based on criteria the legislature set out and the principles the group set out. Each of the individual groups have retained the right to have an opinion on it. So when it actually comes up for discussion, they may be for it [or they] may not be.

You've said that Maine's situation is somewhat unique. Would other states find an APP a possible solution to pension plan problems?

If people are looking for new ideas, this is a great one to explore. It shares risk and provides a predicable income stream for employees.

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