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The Upside of a Little Progressive Pension Paternalism

With most public retirement systems seeing improved actuarial funding levels, there’s an opportunity to offer options that could make government compensation more competitive. But any impetus for change should come from pragmatic public employers, not partisans or lobbyists.

Today, for the first time in quite a while, the glass is more than half full for the public sector’s pension systems. Recent stock market gains, along with higher bond yields looking forward, will boost the actuarial funding levels of most systems when they post their upcoming reports, even though some are still far more underfunded than many Fortune 500 corporate counterparts.

Tight labor markets now place a premium on the value of a guaranteed pension for workers of all ages, making it a valuable fringe benefit that attracts some employees. There are public pension adversaries who disagree, citing the unfunded liabilities for paying benefits today to retired baby boomers who seldom paid an equitable share of the costs of their pumped-up pensions, but today’s competition for talent is the immediate challenge for public employers.

Since the 1990s, the defined-contribution (DC) retirement plan industry has been pitching the public sector with 401(a), 457 and 403(b) plans as a better alternative to traditional fixed pensions. Corporations went whole hog for the DC pitch to avoid balance sheet liabilities under evolving accounting rules. By likewise sidestepping unfunded liabilities and shifting stock market risk to public employees rather than taxpayers, the DC industry also enjoyed some limited popularity in scattered jurisdictions for more than a decade. But the 2008 financial crisis and market meltdowns of that era shed new light on the plight of a cohort of older firefighters and police officers who suddenly could not afford to retire because their defined-contribution savings accounts had abruptly lost half their value.

At the same time, many states enacted some sensible limits on the promises that public pensions could make on a go-forward basis, and those reforms now apply to about half of their workforces, so the policy misjudgments and benefits over-promises of prior decades are starting to wear off for many plans. (New York state is an exception: Lawmakers there just backslid by rolling back reforms enacted in 2012 and creating yet another new unfunded liability.) Pension hawks can still complain, but the wind has gradually been taken out of their sails.

Particularly for the public sector, the DC industry has therefore shifted strategy toward mostly pitching its programs as ancillary to the traditional defined-benefit (DB) pension plan, with marketing terms like “hybrid” and “supplemental” now in favor. As with Social Security, many newer employees understand that their now-reformed skinnier pensions alone may not be enough to fully fund a comfortable, active retirement lifestyle. Thus, a supplemental “side-pocket” DC program can enable them to achieve lifestyle aspirations that leaner post-reform taxpayer-funded pensions alone cannot offer. Those retirement packages are typically sweeter than the 401(k) plans offered by local private companies, so there is genuine recruitment value for some public sector jobs.

Even so, that hasn’t stopped advocates of the DC model from proselytizing. A recent Governing guest commentary argued the case that some younger workers expect to job hop and don’t plan to spend an entire lifetime in public service, so they’d prefer a portable 401-type plan. The DC proponents sometimes also complain about traditional pensions letting older public employees off into the retirement pasture too soon, although I don’t know if any of them ever met a 62-year-old firefighter with a wiped-out nest egg. And who doesn’t remember the doddering elder public school teacher who couldn’t afford to retire gracefully after spending decades educating ungrateful adolescents? Nor do the advocates face up to the higher embedded mutual fund fees of most DC plans and the commonplace investment underperformance of many naive employee-investors.

Discouraging Early Walkouts

Early retirements appear to be a nationwide phenomenon, hardly limited to public employees. But there are ways to address that. For example, where cushy early retirements are actually a problem, it’s reasonable for public agencies to negotiate a partial restructuring of their deeply underfunded retiree medical benefits promises to discourage pre-Medicare walkouts by civilian workers.

Likewise, cost-of-living pension increases for those who quit working before age 65 can be trimmed or eliminated for new civilian hires, which will also discourage early retirements in the future. Some public pensions already require an actuarial benefit reduction factor, similar to Social Security’s, for those who retire before the system’s standard retirement age for their occupational category. Both of these design tools are underutilized by many of the arguably over-generous systems.

Pension advocates have one more argument to add to their case, which is the growing realization that 401-style DC accounts, including those in the often cited Australian superannuation system, are now viewed as falling short of their intended purpose after several decades of operation. But then again, nobody can rightfully claim that America’s Social Security system is working perfectly, given its actuarial deficiencies. This is a debate prone to cherry-picking of statistics.

Peaceful Coexistence

Although the politics of pension reform often escalate to the state legislatures, the impetus for change would best come from public employers and not special interests, political gadflies and lobbyists. The truth is that both DB and DC retirement plan models can coexist if that’s what employers want to offer: Some may want to give new hires the option to participate in the traditional DB pension system by default or to actively choose instead to contribute to a portable 401(a) or 403(b) plan with comparable employer matching funds and quicker vesting.

The actuarial impact of such optionality on the pension fund and public employers would be negligible, giving up some of the modest contribution forfeitures that unvested participants leave behind in the system when they leave employment. That’s an almost trivial price for supportive employers to pay for the competitive labor-market advantage they may then enjoy by offering a DC option. Most prominent public-sector DC plan administrators will jump at the chance to serve an optional 401(a) plan with modest or no explicit administrative fees.

Any such two-track retirement plan option should provide extra precautions to warn new hires that their choices are irrevocable. Five or 10 years down the road, when their colleagues who went the DB route are getting promotions — and with them higher formula-based future pension benefits — and their go-go DC investments have lost 25 percent or more in a typical cyclical recession, there will inevitably be some vocal opt-out-blocked whiners who complain that “nobody told me I could end up worse off!” The DC plan administrators really must provide full-disclosure education sessions and not just flashy sales pitches. To minimize predatory selling, the enrollment agents should be salaried and not commission-compensated.

The Hybrid Option

For diehard pension advocates who just can’t get their heads around a DC-only replacement, there’s also the hybrid structure such as the one offered by the Washington state retirement system. It includes an elective half-and-half plan that provides a lower traditional pension benefit combined with a 401(a) savings component with optional contribution levels at the time of entry, plus super-low fees.

It’s what I’d call progressive pension paternalism. One notably attractive part of that plan is the employee’s option at the time of entry to squirrel away more dollars in their tax-advantaged investment account than the 5 percent minimum salary deduction. DC advocates point to this option package as resulting in lower employee turnover among teachers than the traditional pension.

Now might be the moment — with market returns edging most public pensions closer to actuarial health and the genuine progress toward financial sustainability that many of them have made over the past 15 years — for them to explore options that could give public employers a leg up in a tight labor market. Adding a DC option for new hires could be a recruitment positive while partially de-risking the taxpayers’ obligations and still demonstrating the value of public pensions for public service.

Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be considered investment advice. Disclosure: Girard Miller is a former president of ICMA-RC, now known as MissionSquare Retirement, which offered defined-contribution plan services including for the original Washington state DC plan conversion option described above. Now retired, he has had no professional affiliation with the corporation since 2003.
Girard Miller is the finance columnist for Governing. He can be reached at
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