By Josh Elliott-Traficante

October 2011

With mounting unfunded liabilities in their pension systems, made worse by the recent economic turmoil, many states have begun looking at other retirement benefit options. In recent years, policy makers in a number of states have turned away from the pure pension model, instead opting for plans that are not only fair to the employees but also free the taxpayers from being left with the bill for huge deficits. Given the scale of the pension funding crisis, several reform minded states have instituted a variety of systems to replace their pension systems, which are outlined in the following paper.

Defined contribution systems however, come in a number of varieties and the basics of plans currently used by other states are laid out below:

Pure Defined Contribution System:

A pure defined contribution system functions in the same way as a private sector 401(k) functions. Money is contributed by the employee and generally matched by the employer, up to a certain percentage of the employee’s salary. Under this setup, as the employee gets closer to and passes the age of retirement, the ratio between stocks and bonds in the portfolio declines, reducing risk in exchange for greater stability. Under this set up, all of the risks and rewards of the fund is placed on the employee. There is no governmental liability once the contributions have been added.

States with mandatory defined contribution systems:

Alaska, The District of Columbia, Michigan (state employees), Utah (must choose between defined contribution plan or Hybrid plan)

States with open optional defined contribution systems:

Florida, Montana, Colorado, Ohio (all but Police &Fire), South Carolina (all but Police &Fire), North Dakota (non-classified employees)

Benefits:

-          Potential for employees to realize greater returns

-          No liabilities for the taxpayers

-          Greater portability

Disadvantages:

-          All of the investment risk falls on employees

Member Direction:

In all of the states offering defined contribution plans, the employees have a say in the investment direction. While employees do not get to pick what particular stocks or bonds to buy as they would with a brokerage account, they do pick the fund. Alaska, for example, offers a selection of funds for their employees to choose from ranging from Target Date Funds to Treasury Bond funds and everything in between.[i] Among states that offer DC plans, this is a standard practice.

Variations: In House vs. Contracted Out

When discussing the possible implementation of a defined contribution system the question arises of whether to manage the assets of these plans in house, or let an investment company such as Charles Schwab or ING manage the funds. Both options are currently being exercised in other states. In Alaska’s plan for example, assets are managed by number of firms including Black Rock and T. Rowe Price, while in Utah the assets are managed in house.

Implementations and Important Considerations:

No two states are exactly alike, so what simply taking what one state has done and doing it here in New Hampshire without modification would be unwise. For New Hampshire to switch over to a defined contribution system, changes would be need to be made to Group II (Police and Fire) to ensure equity between the two groups. Currently Group I employees pay into Social Security while working and receive benefits when they retire. It functions similarly to a pension plan in that it provides a regular and guaranteed payment. Group II however, neither pays into, nor receives Social Security (in part this is why they pay higher contribution rates currently.) In order to give Group II retirees the same assurances their Group I counter parts have, there are two potential options, either require Group II members to enroll in Social Security or create a version of a Hybrid Plan, which combines a pension and a 401k scheme that is only open to Group II.

The Hybrid System:

Hybrid System, combines a reduced pension and with a supplemental 401(k) for retirement benefits. The idea, similar to that of social security, is to give retired state employees some sense of stability in their retirement income, while not also burdening the tax payers with large pension liabilities. In the example of a hypothetical Hybrid System, the employee’s and employer’s contribution total 10% of the salary of the employee. This 10% contribution is then divided between a pension fund and a 401(k) fund. Each year the contribution rate for the pension portion is assessed, so as an example for Utah the 2011-2012 year the rate was calculated by actuaries to be 7.59%. The remaining 2.41% was contributed to the 401(k) portion.[ii]

The above model is only one way for a hybrid model to function. For example, under Georgia’s plan, the employee pays 1.25% towards the pension portion and the state contributes a portion set by actuaries (7.42% for 2011-2012 year). The employee contributes mandatory 1% to the 401(k) plan, with the state matching 100% for the first 1% and 50% for the next 4%. In simpler terms, the state’s maximum contribution to the 401(k) portion is 3%[iii]

States with mandatory Hybrid systems: Washington State (Teachers), Georgia

States with open optional Hybrid systems: Ohio, Oregon, Indiana, Washington State (All but Teachers), Michigan (Teachers), Utah (must choose between defined contribution plan or Hybrid plan

Benefits:

-          Investment risk spread between tax payers and employees

-          Combination of potential greater return and stability

-          Portability of 401(k) portion

Disadvantages:

-          Taxpayers still liable for short falls, albeit smaller than normal pension plan

Variations: COLAs

It is important to note that the contribution rates for Utah take into account cost of living increases (COLA) to the pension portions that are based on the Consumer Price Index. COLAs are capped at 2.5% per year. COLAs in the Georgia plan are at the discretion of the retirement board but not specifically built into the plan.

Variations: Institutional vs. Member Direction:

For the 401(k) portion of the hybrid plans, there is states have taken different routes in terms of who dictates the direction of the investments. In states such as Utah, Oregon and Georgia, for example, all of the investment direction is done in house by the respective retirement systems. In contrast, Ohio’s system allows for employees to choose between different in house managed funds.[iv]

Variations: Parallel Hybrid vs. Stacked Hybrid[v]

Parallel Hybrid:

This is the type of hybrid plan now in effect for the all of the states mentioned above. The employee receives a split DC/DB plan at all income levels. Though pensions would be smaller in comparison to a pure defined benefit plan, there is no cap.

Stacked Hybrid:[vi]

This type of plan, proposed by the Center for Retirement Research at Boston College, flips the parallel hybrid plan on its side. Rather than a split plan at all income levels, an employee is given a pension, based on a capped salary, for the sake of argument, $45,000. For those who make less than this amount, they and the employer only make contributions for a pension. For those who make more, say $60,000, the employees and employers would make contributions to the pension portion on the first $45,000, while any contributions made on salary over that amount would be placed into a 401(k).

Implementations and Important Considerations:

In the case of the stacked hybrid plan, suggested as an alternative to the parallel plan, what the cap is on the pension can vary. The proponents of the plan at the Center for Retirement Studies at Boston College proposed having the cap set at the average salary for the resident of the state, which is then indexed to inflation going forward.[vii] This cap could be set at any level, average state salary, median state salary, or just a round number, like 45,000, which is then indexed in some way to the growth of inflation so as to retain its intended value.

The contribution rates and ratios between the 401(k) and pension portion of the hybrid plans expounded on in this paper should not be taken as specific policy suggestions; they have been merely used to illustrate how other states administer similar systems. I am not, nor do I purport myself to be an actuary so I do not know, nor would I venture a guess as to what contribution rates would work for New Hampshire for the system to remain solvent.

Ohio Option:

Offering the greatest variety of choices to their public employees is Ohio. Under the Ohio Public Employee Retirement System (OPERS) employees are given the option of joining a traditional defined benefit plan, a hybrid plan, or a defined contribution plan.

Plan details:

Pension

Multiplier: 2.2% x Final Three Years Average Salary x Years of Service

If the years of service is 30 or over, the multiplier is 2.5%

Employee Rate: 10-11.1%

Hybrid

Multiplier: 1.1% x Final Three Years Average Salary x Years of Service

If the years of service is 30 or over, the multiplier is 1.25%

Employee Rate: 10-11.1%

Member Directed

Rates: Employee 10%, Employer 14%: Normal Cost 8.73%, Health 4.5%, Mitigation, .77%

Note: Plan stipulates that if Pension System needs financial shoring up, employer assessments on Member Directed Plan employees may be required. This mitigation rate is set at .77%

Conclusion:

There has been a slow, but gradual shift in the past twenty years to move state retirement benefits plans from pensions to 401(k)s or hybrid plans in an effort to either eliminate the future liabilities of the state or to at least share the financial risk between the state and the employees.

While there will be no silver bullet to fix the current short falls of the system, establishing a plan that does not leave the taxpayers on the hook will ensure the future fiscal health of the state.


[i] http://doa.alaska.gov/drb/dcrp/financial/dcrp-investment-options.html

[ii] https://www.urs.org/pdf/AnnualReport/2010/annualReport.pdf

[iii] http://www.ers.ga.gov/plans/ers/formspubs/GA%20ERS%206-30-2009%20Valuation%20Report%20Final.pdf

[iv] https://www.opers.org/members/combined/index.shtml

[v] Image taken from “A Role for Defined Contribution Plans in the Public Sector” released by the Center for Retirement Research at Boston College.

[vi] http://crr.bc.edu/briefs/a_role_for_defined_contribution_plans_in_the_public_sector.html

[vii] http://crr.bc.edu/briefs/a_role_for_defined_contribution_plans_in_the_public_sector.html

 

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2 Responses to “Defined Contribution Models in Other States”
  1. 1Dr. Joseph Dittmer on Oct 5, 2011 at 2:59 pm:

    With some study, readers will discover that the defined benefit far outperforms the hybrid or defined contribution plans. That is why if a state changes from DB to DC plan they discover that the same dollars bring only about 50% the benefits of the DB plan did. The only winners are the employers who can then slash their costs by 50% and have no legacy responsibilities in the future. The way the stock market has performed, retirees will be hard put to realize the same standard of living as current retirees.

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