Hybrid Vigor for Pension Evolution

A good option for new public employees is a "half & half" defined-benefit and defined-contribution plan.
by | September 9, 2010

It's election season, and public pensions have grabbed international, national and local headlines daily. There's Bell, California's scandalous pensions with CalPERS' complicit administrative idiocy, colossal underfunding problems in many of the major plans, turmoil over accounting rules, and taxpayer outrage over the disparities between public and private employee benefits levels. Political candidates are staking out their ground as pension reformers — whatever that means to their political base in their state.

Traditionally, the promotion of public pensions has been a Democratic party posture, with employee unions throwing their weight behind candidates who promote job and retirement security with defined benefit (DB) plans. Republicans were typically associated with free-market approaches and corporate solutions, aligning themselves with the Chamber of Commerce in support of 401(k)-like defined contribution (DC) plans. Nowhere is this demarcation more evident than in California. In the race for governor, Republican candidate Meg Whitman favors a 401-type defined contribution plan for new hires, whereas Democratic candidate Jerry Brown favors several much-needed pension reforms but fundamentally supports the idea that DB plans provide more retirement security. Neither has proffered a complete solution, as pundits have noted.

In other states, the debates are usually a variation on this theme, with differing proposals reflecting local in-state issues against the backdrop of individualism-vs-collectivism that reflects the two parties' ideological bases. Often, the candidates have decided to just avoid or ignore the pension issue and treat it like the untouchable "third rail" of Social Security reform at the federal level. Conventional political wisdom has it that nobody ever got elected by calling for higher taxes, deep sacrifices and reductions of benefits for retirees. Many candidates will do everything possible to sidestep the issue.

So, once you're elected, then what? Once the dust settles after November, however, many governors, state legislatures, mayors and county officials will arrive at or return to their desks to find that their jurisdictions' pension problems are growing worse every day, and they actually need to do something about it. As I have described in a previous column, the coming years in retirement plan finance will be ugly, as the problems are far deeper than many pension plans and public leaders have acknowledged. Long-term reforms and hard-nosed decisions will be necessary.

One option to consider is the establishment of a statewide or local option for all new public employees to participate in a hybrid half-and-half plan that combines the best of both worlds. That splits the risks and opportunities of long-term investing between the employees and the taxpayers. Elected leaders from both parties can find common ground with this bipartisan approach.

Working examples from Washington, D.C. to Washington State. The half-and-half approach has been adopted for federal employees nationwide, and by Washington State. The Federal Employee Retirement System pays a fixed pension of 1 percent times years of service, and then matches employee contributions up to 5 percent of pay in a defined contribution plan with a limited menu of indexed investment options. In Washington State, the optional hybrid plan's pension multiplier is also 1 percent, with the defined contribution rates of 5 percent and higher, depending on employer and employee decisions. Employees have a menu of investment options including a fund that mirrors the state pension fund's investment portfolio.

In an ideal structure, the new hires would be offered a traditional DB pension plan with slightly lower total benefits, or higher employee contributions to recognize that the employees bear no risks. Thus, the financial incentives would tilt employees toward the hybrid option. For example, if a hybrid plan offers a 1 percent pension multiplier and an equal match of the employee's 5 percent defined contribution, then the accompanying traditional pension plan should provide a multiplier no greater than 1 3/4 times years of service, with employees bearing one-half its ongoing cost. Actuarially, that is a sustainable, sufficient and lower payout than the hybrid would offer. It takes into account the employees' risk-free return on investment under the traditional pension plan since taxpayers bear the entire risk of financial markets underperforming their pension trustees' long-term expectations.

For employers who operate exempt from Social Security, the benefit and contribution levels for new hires under both plan types should be higher, of course. The good news for employers with hybrid plans is that if Social Security free-rider inequities are reformed, as I suggested last month, their adjustments will be painless.

An option that could be built into these hybrid plans would allow retiring workers to convert all or part of their defined contribution savings back into a pension. In essence, the retirement system would annuitize their DC savings account at a fair actuarial value based on their age at that time. Employees could elect to convert all or a portion of their savings into a life pension — and still invest a piece of it themselves for growth or to leave as an estate legacy for their children and other heirs. That kind of individual flexibility would indeed be the better of both worlds.

Here's the investment side: For hybrid plans, there are several options to consider. For large systems with proven investment performance, I like the Washington state model, which offers a clone fund that mirrors the pension fund portfolio with high-performing, low-fee investment managers. Alternatively, the plan could create a simple low-fee, no-brainer multi-asset-class index fund that resembles the pension fund portfolio's asset allocation. Target-date index funds could easily be added, to allow all employees to make age-appropriate investments and then migrate automatically toward more conservative portfolio positions as they approach retirement.

Whether the defined contribution accounts should be opened up to the entire smorgasbord of investment options usually offered in a 457 deferred compensation plan is a matter for local discussion. Remember, these are core retirement investments not "mad money," and I would lean toward a limited menu of choices rather than excessive complexity and boundless opportunities. Those tend to make a mess of workers' retirement nest eggs.

In a hybrid plan like this, the employees' money is immediately vested, and the employers' defined contribution shares are usually vested over time (usually 5 to 7 years) so that longevity in service is rewarded incrementally. The DB portion can vest in 10 years with employee contributions refundable if they leave sooner.

Alternatives in the hybrid world. There are many other types of hybrid plans. Actuaries like to promote "cash-balance" and "floor offset" plans, which I teasingly claim they prefer because they create more work for the actuaries, whereas the investment folks want to promote DC plans that invest in mutual funds — an honest but predictable difference in self-interests. Humorous rivalries aside, for those who are skeptical about their employees' ability to invest for themselves successfully and efficiently, hybrid arrangements can include a large, pooled investment fund.

The most taxpayer-friendly hybrid is a "collective defined contribution trust" in which the employer establishes a pension-like fund that is invested professionally with lower institutional fees as a collective trust fund. The employer and employees make defined contributions into the fund, and an actuary is retained at least biennially to determine what level of benefits the plan can afford given its recent experience. If investments are successful, the retirement benefit increases; if markets go sour, the employees and retirees get less. Everybody shares the market risks, longevity risks and actuarial risks of the plan. Retirees don't have to worry about outliving their money, as they get a lifetime pension even if the dollar level fluctuates over time. There are no unfunded liabilities for the employer to pay. Although it lacks portability, it's a worthwhile compromise to consider when designing the total compensation plan. Workers who leave before full vesting can take their contributions plus or minus accrued investment gains and losses. Pension traditionalists prefer this route over individual accounts.

Reflecting on my life experiences. For those who ideologically advocate a purely defined contribution system, I'd like to share some life wisdom as the former president of an organization devoted to serving governmental DC plans, and a former director of the industry's national defined contribution council. When investment markets turn sour, a 100 percent individual DC approach will push all losses on the employees — and that's not optimal either. Just take a look at some of the DC municipal police and fire retirement plans in Colorado (where they exempted themselves from Social Security) and you'll find some very unhappy elder public safety professionals who watched their 401(a) plans turn into 301(a) plans with the market meltdowns of the past decade. As much as I rant about 50-year-old retirees with unsustainable lifetime pensions, it's not in the public interest for police and firefighters or heavy road equipment operators to have to serve beyond 57 unless they are in shape to do so. Having grown up on a farm and worked the big machines in my early life, I'm over that hill personally and know the ravages of age combined with physical stress. Our retirement plans must enable these honorable public servants to find other gainful pursuits in second careers where they can continue to grow their nest eggs before playing golf, taking grandkids to Disney and fishing full time. A hybrid solution with shared risks works better than 100 percent of either a conventional DB or DC system.

Back to the politics and the policymaking process. Getting back to the political candidates, those who advocate policies that offer choice to employees, and a fair sharing of risks, responsibilities and returns are likely to find their message resonating with voters. A complete plan with more specific reforms to make the entire structure sustainable financially would set the stage for real progress — and minimize re-election risk in future years. My earlier column provides detailed suggestions for candidates seeking ideas.

And here's a great place to start: the legislators' own pension plans. A hybrid 50-50 percent DB-DC plan as outlined here would provide a reasonable defined contribution plan for term-limited officials and still provide a very modest longer pension term benefit for those whose adult lives are devoted to public service. By adopting a hybrid plan for the legislature, constitutional officers and key staff positions, the elected officials can send a strong message to the unions and the pension systems that what is good for the goose is indeed good for the gander.

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