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Hybrid Pension Plans Attracting More States, Cities

Unable to continue making payments on traditional retirement benefits, officials are trading in the old model and looking for a more efficient option.

Riled-up citizens in San Diego and San Jose, Calif., have spoken: This spring, they voted overwhelmingly to shrink retirement benefits for current city employees as well as new hires.

Fiscally worried state officials have taken action too. As of July 1, Rhode Island cut retirement benefits for all state workers, including retirees.

And crisis-wary legislators are working to preclude potential disaster. Last year, Utah’s legislators not only set up a hybrid for new employees, but also capped the state’s contribution to their defined-benefit plan. If the plan’s costs are higher than the cap, employees make up the difference.

There’s a public pension crisis out there. Defined-benefit (DB) plans -- the stalwart of public pension systems -- are in trouble, both financially and politically. The $757 billion in unfunded liabilities that the plans now carry are a threat to the well-being of states and localities and their taxpayers. Meanwhile, the private sector has been shedding its DB plans for decades, replacing them with defined-contribution (DC) plans in the form of 401(k)s. That has left those employees with pension envy. As voters, they are no longer willing to bankroll benefits for public employees that they no longer get themselves.

To address the growing problem, jurisdictions have implemented or proposed a number of changes. Some are revising the defined-benefit plan itself -- raising the retirement age or suspending cost-of-living adjustments. Some are looking at a more radical approach: doing away with the defined-benefit plan for new hires and offering them a defined-contribution plan only. But the middle ground -- and a trend that seems to be growing -- is to have a little of both: a defined-contribution plan backed up by a lower-level defined-benefit plan. Alternatively, some are opting for a cash balance program that combines aspects of both defined-benefit and defined-contribution approaches.

These are hybrid plans. While the trend may be fairly new, hybrids have been around for years. Indiana has had one since the 1950s. At last count, about a dozen states and a handful of cities have joined Indiana’s ranks, offering their employees -- usually just their new hires -- hybrid plans.

The main impetus is to keep costs in check. States and localities see the unfunded liabilities of traditional defined-benefit plans as a threat to their budgets and credit ratings. If their employees had defined-contribution accounts instead -- a version of 401(k)-style plans -- they would eventually be relieved of that burden.

But a DC plan alone raises uncomfortable questions about retirement security for employees. Depending on how they are structured, DC accounts may have the same pitfalls as 401(k) plans have had in the private sector. Individuals are left to navigate the perils of the investing world on their own and could end up retiring in a down market, losing a big chunk of their nest egg. “We need to think of pensions not as wealth accumulation, but as old-age poverty insurance,” says Keith Brainard, research director of the National Association of State Retirement Administrators.

It is a point Richard Hiller, senior vice president of the government market for the financial services organization TIAA-CREF, makes as well. In fact, Hiller objects to equating DC plans with 401(k)s in the first place. That “scares people who saw the losses suffered in 401(k) plans during the recession,” he says. “But a properly designed DC plan should protect itself from those kinds of wild swings.”

By “properly designed,” he means one that provides a limited menu of low-cost investment choices that focus on generating adequate retirement income. Some of those choices would be annuities and life-cycle funds whose allocation changes over time as the member ages.

A proper DC plan also distributes income differently than a 401(k), he notes. Payouts can be designed to last for life rather than taken in a lump sum. In that way, it is “much more tightly designed to be a true retirement plan,” Hiller says. Consequently, “the emphasis is on income replacement rather than on asset accumulation.”

However well the DC plan is designed, there is still a need for a DB plan that provides a predictable level of retirement income -- albeit one that is less generous than today’s traditional plans. Maintaining a DB plan as part of a hybrid plan is particularly important in the public sector, Hiller notes. “When the government is the plan sponsor, what you don’t want is people getting to retirement without adequate assets -- then looking to the state to be their safety net.”

A cash balance plan is an alternative to maintaining both DB and DC plans. It combines elements of both in a single plan. Like a traditional DB plan, contributions from employees and employers are pooled and professionally managed. But unlike a DB plan, the benefit is based on the amount accumulated in the account -- not on a formula based on salary and years of service. Members get a guaranteed rate of return, but it’s likely to yield lower yearly payouts than a traditional DB plan. In effect, the cash balance plan eventually converts the savings in the individual’s account into an annuity, with a minimum rate of return guaranteed by the employer. Though they are on the hook for guaranteeing the return, the cash balance approach greatly lowers future liability.

Nebraska, which started out with a DC plan for most state workers (teachers and some other public employees are in DB plans), switched to cash balance in 2003. The plan is mandatory for new hires and optional for existing employees.

Where some states see a cash balance plan as downsizing their pension plans, Nebraska “improved our benefit by going from a DC to a cash balance plan,” says Phyllis Chambers, who runs Nebraska’s Public Employees’ Retirement System. For Nebraska, cash balance is a necessary improvement over the straight DC system.

“Cash balance offers a good, stable retirement income with a guarantee,” Chambers says, “so nobody’s benefit goes down.” After all, investing is not only tricky -- even for the expert -- it also leaves the person about to retire at the mercy of the market. With a DC “it’s all about timing,” Chambers points out, and timing was terrible for workers who wanted to retire in 2008-09. A number of Nebraska’s DC members were forced to postpone retirement, Chambers says, because their account values had plunged by half. But that didn’t happen to participants in the cash balance plan who receive a guaranteed 5 percent minimum return. When investment returns are above 5 percent (as they were for the first five years of the plan), members get a dividend. When returns drop below 5 percent (as in recent years), the state makes up the difference.

Even with the state on the hook for that guarantee, it adds up to a much lower potential liability than the teacher’s defined-benefit plan. In order to meet those payouts now and in the future, the pension plan operates on the premise of an 8 percent assumed rate of return. When the portfolio doesn’t meet that return, the shortfall becomes an obligation of the state.

All in all, Chambers says the cash balance form of a hybrid plan has worked out well for fiscally frugal Nebraska. Recently Louisiana and Kansas decided to follow suit and adopt cash balance plans for future employees.

Most hybrids are so new that it’s hard to tell how well or poorly they’re working -- especially since they apply only to new hires in most states.

But Indiana has a long hybrid history. Its combination plan has changed little since its inception in 1955. It includes a modest DB component funded by the employer. On the DC side, employees (alone or in combination with the employer) must contribute at least 3 percent of their salary, with the option to kick in more. Employees, who also participate in Social Security, choose how to invest the DC funds from a limited number of options and assume the investment risk.

There is one unusual feature to the lineup of investment options available to employees: They can opt to invest their money with the state’s defined-benefit portfolio. “They get what the DB portfolio earns, and that is a higher rate of return than they could get in any other plan,” says Teresa Ghilarducci, a former public trustee with the Indiana fund (and currently chair of economic policy analysis in the Department of Economics at The New School for Social Research).

Although the system is healthy (the plan is 81 percent funded), the state wants to add a non-hybrid, DC-only option for new state employees. The state’s objective, according to Steve Russo, executive director of Indiana’s public employees’ retirement fund, is to improve the management of risk and offer workers more choice. “We’re keeping an eye on the future,” Russo says. “We’re trying to prevent a crisis so we don’t have to act out of desperation.”

Under the proposed DC-only option, the state would contribute funds into each employee’s account equal to what would have gone into the DB portion of the hybrid. But members would assume all the investment risk and there would be no DB backup. New hires may prefer the DC-only option, Russo says, because the existing DB piece has a 10-year vesting period.

One of the selling points of a DC-only option is to give employees more leeway in choosing plans and investment options. “Giving people a choice is always better,” Russo says. “But along with that comes the obligation to educate them before they make those choices.”

He is referring to helping new employees choose between the state’s current hybrid plan and the optional DC-only plan that the state hopes to implement. But the “obligation to educate” also applies to helping workers in a DC plan figure out how to invest.

As officials in Nebraska can attest, many employees are unsophisticated in that department and often make inappropriate or poor choices. Plan administrators can’t dispense investment advice, so they may work with financial professionals by arranging seminars, webinars and individual counseling sessions as well as by providing general information in print and on websites.

The education effort is uncharted territory for many systems that are just getting started with the DC component of their plans. “It’s so new -- that’s part of the problem,” says David Daly with the National Pension Education Association. “Everybody’s trying to decide how to handle it.” To that, Daly adds that educating members “is something we’ll certainly be looking at as more systems switch to hybrids and DC plans.”

Ready or not, like it or not -- hybrids are coming. Many state and local officials consider them a decent -- even good -- compromise for sharing the pain of the current era.

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