Article

The Evolving Role of Defined Contribution Plans in the Public Sector

Authors:  Paula Sanford and Joshua M. Franzel

Editor’s note: InFRE was a reviewer for this joint research paper of the Arthur N. Caple Foundation and the National Association of Government Defined Contribution Administrators conducted by the Center for State and Local Government Excellence.  This is an excerpt from the complete report.

The role of defined contribution plans for state and local government employees is evolving. This change is being driven by several factors including flat government revenues, increased demand for services, economic uncertainties, concern about future benefit costs and risk exposure, and a wide range of related political debates. Traditional defined ben­efit public sector retirement plans are under pressure to make structural changes with governments mak­ing a range of changes that seek to reduce or control employer contributions and address unfunded liabili­ties. State and local government defined benefit plans have historically offered a reliable and adequate level of retirement income. Defined contribution plans have played a useful role as supplemental saving vehicles, but, with some exceptions, have not focused on becom­ing the primary income replacement resource.

The purpose of this report is not to suggest that defined contribution plans will or should replace tradi­tional defined benefit plans. Instead, it seeks to focus on the increasing role of defined contribution plans in state and local government and for employee retirement security.

The Current Environment
For the greater part of the last century through today, employer-provided,⁵ employer-provided retirement benefits have been a key element in the economic security of most⁶ full-time state and local government employees. Between 1909 and 1976,⁷ all 50 states had adopted some form of defined benefit pension plan for their general employees, which often covered local government employees as well. These retirement benefits have undergone unprecedented changes over the past decade; changes which have increased in scope and intensity in the wake of the 2008 stock market downturn and subsequent recession.

Today, for the vast majority of state and local government employees, the bulk of their retirement income comes from a defined benefit plan and Social Security, if eligible. Employees may also have supplemental savings from a defined contribution plan among other sources. But, continued fiscal pressures from the 2008 and 2009 economic downturn, an aging public sector workforce, and strains on state and local government revenues have led governments across the country to consider changes to the retirement benefits they offer to their employees.

Current Public Retirement Plan Participation
As of March 2011, 90 percent of all state and local government employees had access to a retirement benefit of some kind. Eighty-four percent of these employees had access to a defined benefit⁸ retirement plan with 78 percent participating. For state employees, 87 percent had access to a defined benefit plan with 78 percent participating. Eighty-three percent of local government employees had access to a defined benefit plan with 79 percent participating.⁹ These levels of participation have decreased some over the past few decades (for example, in the 1990s, the participation rates ranged from 91 to 87 percent).¹⁰ Thirty percent of state and local government workers also had access to a defined contribution plan with 17 percent participating. Defined contribution participation levels have almost doubled for all state and local government workers since the early-to-mid 1990s (when they were 9 percent).¹¹ While state and local government defined benefit coverage levels are relatively the same across the levels of government, there is more variation in defined contribution offerings. Forty-three percent of state workers have access to a defined contribution plan with 26 percent participation while 26 percent of local workers have access with 14 percent participation.¹²

While the vast majority of states continue to offer defined benefit plans as the primary retirement savings vehicle for employees, a few states have adopted a primary or core defined contribution plan. For example, state employees in Alaska and Michigan hired after a specific date participate in a primary defined contribution plan. Other states, including Georgia, Oregon, Rhode Island, Washington, and Utah have adopted combination defined benefit/defined contribution plans, often referred to as hybrid plans.¹³ Utah, Florida, and Ohio offer employees the option of participating in either a defined benefit or defined contribution plan. New York, Vermont, and North Dakota maintain a defined contribution plan for elected officials or other specific categories of shorter-tenured workers. Recently, Kansas and Louisiana adopted a cash balance plan for new hires. Reforms have not taken a “one-size-fits-all” approach. Although the redesign trend has been to keep defined benefit plans as the core benefit, changes made to these plans result in reduced income replacement. In the few instances where government employers have moved to a primary defined contribution arrangement, the focus of these plans should be on income replacement strategies rather than supplemental savings.

About one-third of state and local government employees—mostly public safety and education workers—do not participate in the Social Security system. General employees in Alaska, Colorado, Louisiana, Maine, Massachusetts, Nevada, and Ohio¹⁴ are also not covered by Social Security. Most states and localities that do not participate in the federal system compensate with a retirement benefit structure that replaces Social Security retirement and disability benefits.

Current Pension Reforms

Given these demographic, financial, and economic realities, state and local governments have implemented many pension changes over the past decade. Between 2009 and 2011, 43 states implemented substantial pension reform.²⁰ A 2012 survey of state and local governments conducted in early 2012 (with 82 percent of the respondents from local governments) reported that 37 percent had made changes to retirement benefits in the past year, an increase from 21 percent in late 2009.²¹ Most of these changes have been made to achieve financial sustainability and reduce employer risk. Other reasons for recently implemented changes include a workforce preferring the mobility of a defined contribution plan or elected and appointed officials seeking to equalize the types of benefits offered in the public and private sectors.

Plan changes fall into five categories:
• Increasing current and/or new employee contribution levels
• Increasing the age and/or length of tenure required to be eligible for normal retirement
• Reducing or eliminating cost-of-living adjustments (COLA) for new and/or current employees
• Changing the way pension formulas are calculated to reduce pension benefits
• Offering a hybrid and/or defined contribution plan instead of a traditional defined benefit plan.²²

Many of these changes, individually or in combination, will ultimately lead to lower levels of retirement income through traditional defined benefit plans for eligible public employees. In some cases, for public workers with short tenures, the changes will eliminate the opportunity to receive the benefit. With lower or no pension income, employees may face significant financial challenges, becoming more dependent on Social Security or other government programs and/or relying more on other retirement savings, such as defined contribution plans.

The Future of Defined Contribution Plans in the Public Sector
The current environment within which public sector retirement plans are operating suggests that changes will continue to occur with the responsibility for financing retirement benefits shifting more to employees. Some experts argue that defined benefit plans will replace less income in retirement due to increased employee contributions, higher vesting requirements, more years to calculate the benefit formula, and later retirement ages.²³ Cost-of-living increases and perhaps even benefit multipliers will decrease. These changes will, in many instances, reduce pension benefits, increase employees’ risk, and push more of the responsibility to employees to fund their retirement by contributing more money to supplemental defined contribution plans. At a minimum, supplemental defined contribution plans will play an increasingly important role in “filling the gap” created by changes to defined benefit plans. Though still legally supplemental and not mandatory in most cases, increased participation in defined contribution plans will be necessary for employees to maintain the standard of living in retirement they had while working. These additional savings become particularly important when governments reduce or eliminate cost-of-living increases for the defined benefit plan and when retirees need to pay for rising health care costs.

Rise of Hybrid Plans
The research of this report indicates openness toward hybrid pension plan design for state and local government employees.²⁴ A few respondents further argued that once hybrid plans are adopted, governments may then begin offering core defined contribution plans in order to further reduce liabilities.²⁵ The vast majority of hybrid plans have what is referred to as a “parallel” structure where employees contribute to both a defined benefit and a defined contribution plan from the first dollar earned.²⁶ However, some argue that a “stacked” hybrid model is more desirable.²⁷ The “stacked” plan provides a defined benefit up to a salary cap with a defined contribution portion applying to earnings above the cap. Employees with more modest earnings receive the full benefit of a defined benefit plan and have relatively less need to contribute to a supplemental defined contribution plan.²⁸ However, like traditional defined benefit plans, the “stacked” hybrid plan would be less portable for lower-earning employees than the “parallel” plan. While hybrid and even core defined contribution plans can provide sufficient retirement income that result depends on plan structure, funding and contribution levels, investment outcomes, and education.

These changes also need to be considered in light of public employees’ reliance on Social Security and potential future benefit changes.²⁹ While it is unlikely that Social Security will end, reduced benefits could have serious ramifications for the importance of individual savings and supplemental defined contribution plans.

Increased Role for Defined Contribution Plans in the Public Sector

With the trend toward an increasing role for defined contribution plans in the public sector, it is important to consider whether the purpose of a retirement benefit will be met with these reforms. Experts typically cite two goals for a retirement benefit: to attract and retain good employees and to allow employees to retire with adequate income on which to live.³⁶ The first goal focuses on the needs of the employer and implies a transaction between the employer and employee.

The second goal involves a workforce planning component to ensure an orderly transition of staff out of the workforce as well as a level of concern for employee well-being. This interest in employee welfare after they leave service could be considered beyond the scope of an employer’s responsibility. In the transactional model, an employer’s primary goal is to provide a compensation package that attracts and retains quality employees at the most efficient price. The quality of an employee’s life after he or she leaves the workplace may be beyond the interest or obligation of the employment contract. However, even if employers have no moral responsibility to fund employee retirements under this philosophy, retirement benefits are an important part of the compensation package and are necessary for employee recruitment and retention. One could argue that the traditional design of core defined contribution plans with employees having total control over the assets fit into this general model because responsibility for retirement income is borne by the employee.

So, can a defined contribution plan be successful in meeting the goal of attracting and retaining quality employees? The answer depends on a number of considerations including who the government is trying to attract. Research³⁷ and anecdotal evidence indicate that core defined contribution and hybrid plans can be very effective in attracting younger professionals known as the Millenials or Gen Ys. This generation expects to take on several different jobs in their careers and is attracted to the portability of a defined contribution plan. For example, Gwinnett County, Georgia found that the young professionals they were seeking to attract preferred a defined contribution plan.³⁸ This finding was an important consideration in the government’s decision to close its defined benefit plan and open a core defined contribution plan for new hires. In order for a defined contribution plan to be effective in attracting and retaining quality personnel, it needs to be competitive with other governments and (in some cases) with the private sector. Key factors include the employer contribution rate, vesting schedule, and investment results on which employees can build a secure retirement.

How have defined contribution plans fared in providing for an adequate retirement income? Many believe that defined contribution plans can support employees in reaching their retirement goals if they contribute early and diligently and are invested appropriately. Furthermore, plan structure can contribute to a positive outcome. Because of the importance of defined contribution plan structure to retirement income sufficiency, a substantial section of this report is dedicated to this topic.

An argument can be made that governments should be concerned with their employees achieving an adequate retirement income because of the community-wide consequences of residents with inadequate retirement resources. Retirees without sufficient income are unable to spend money which results in fewer sales tax dollars to state and local governments.³⁹ Given that many individuals retire in their home communities, having employees with sufficient retirement income can result in financially positive effects for the government. Furthermore, a large low-income elderly population leads to greater demands for social services such as food stamps and Medicaid.⁴⁰ To paraphrase one respondent, the government pays for its employees in retirement, either through a strong retirement benefit or through social services. Obviously, the former is a more desirable approach for both economic and moral reasons.

Examples of Structural Change
State and local governments have and are continuing to undergo pension reform. In some instances, these changes have resulted in hybrid plans, either as an option (e.g., Florida, Ohio, Utah) or mandatory (e.g., Georgia, Rhode Island) or core defined contribution plans (e.g., Alaska, Michigan) for employees. In most state and local governments, pension reform has entailed adjustments to the defined benefit plan, which has renewed interest in supplemental defined contribution plan participation. This section considers the issues and challenges of implementing new hybrid and core defined contribution programs, drawing on the experience of a few governments that have recently undertaken structural changes. This section looks at four governments: two states, one large urban county, and a small city. This diversity provides an opportunity to see whether implementing a defined contribution plan presents more challenges to one type of government or another.

As part of this research, administrators were interviewed¹⁵⁶ from the state of Georgia and a small city in the state, Fayetteville, which implemented hybrid plans for new employees in 2009 and 2012, respectively. This section also draws on prior research conducted by the Center for State and Local Government Excellence,¹⁵⁷ which included case studies on the state of Oregon and Gwinnett County, Georgia. Oregon began its hybrid plan in 2003 and Gwinnett replaced its defined benefit with a core defined contribution plan for new employees in 2007. The goals, impetuses, and processes for reform differ among the governments, reflecting political, financial, and social circumstances. All of the government and plan administrators interviewed for this report believe their pension reforms have been successful.

The following sections provide brief summaries of the reform plans.

State of Georgia. The state created a hybrid plan for new employees hired on or after January 1, 2009 that provides a defined benefit with employees contributing 1.25 percent of their salary to it. The defined contribution component is optional; however, the government used auto enrollment at 1 percent to encourage participation. In addition, the state provides up to a 3 percent match to employees contributions to their defined contribution accounts. The employees’ 1 percent contribution is matched at 100 percent, and additional contributions are matched at 50 percent up to an additional 2 percent match from the state. Therefore, employees maximize the match when their contributions reach 5 percent. The default fund is a target date fund.

State of Oregon. For employees hired after August 29, 2003 the state’s defined benefit multiplier is 1.5 percent for regular employees and is fully funded by the employer. Employees’ 6 percent contributions are deposited into individual defined contribution accounts.¹⁵⁸ These contributions are invested by the Oregon Investment Council. For employees hired prior to the effective date of the reform, their 6 percent contributions are also directed to the defined contribution accounts. However, they continue to have the option of selecting a pension benefit based on a traditional defined benefit formula (1.67 percent multiplier for regular employees) or a money-match plan.

City of Fayetteville, Georgia. Beginning in 2012, new employees participate in a defined benefit plan with a 1.5 percent multiplier and contribute 2 percent of their salary to it. The defined contribution component is optional with the city providing a 50 percent match up to a total contribution of 2 percent. The city extended the match to current employees as well. The city did not adopt auto enrollment because it already has a strong culture of high participation in its 457 plan. Daily management of the plan is through the state’s municipal association.

Gwinnett County, Georgia. Since January 1, 2007 new employees have participated in a mandatory core defined contribution retirement plan. The county contributes 7 percent of salary and employees choose their contribution level at 2.5 percent, 5 percent, or 7 percent. Gwinnett also adds 1 percent to the defined contribution plan for employees who contribute at least 2.5 percent to their 457 plan accounts.

Administrators for the state of Georgia, city of Fayetteville, and Gwinnett County all said implementation of their new retirement programs went smoothly. In all three instances, the governments were building off existing defined contribution plans. Georgia had a 401(k) plan in place that had limited use.¹⁵⁹ Gwinnett County had created a 401(a) plan in 2000 for exempt employees while Fayetteville simply restructured its 457 plan for all employees. None of these governments encountered problems with technological or data changes. For Georgia, the retirement system administrator hired its record keeper to make the modifications for an extra fee. Fayetteville’s city manager worked with the Georgia Municipal Association to develop the plan, and the human resources (HR) director adjusted the payroll.

In Gwinnett County, the reforms were part of a larger effort to take over management of the county’s pension plans from the state county association. Staff needed to hire a record keeper, develop policies and benchmarks, and appoint a board. Gwinnett staff used this opportunity to create a core defined contribution plan based on best practice. For example, participation is mandatory and loans are prohibited in order to increase retirement savings. One drawback staff see with the plan is that it does not allow employees to change their contribution levels, such as with a 401(k). The HR director would like employees to have the opportunity to raise their contribution rates as they earn more and progress in their careers. Overall, implementation went smoothly because staff had the time to do their research, hire the best consultants, and deliberate over what they wanted the plan to look like in order to meet their goals.

In Oregon, implementation was more challenging for several reasons including a short time frame, the need to create new accounts for existing employees, implementing a new computer system, litigation over the new laws, and an extremely large caseload of new retirements prompted by the reform’s impact on existing employees.¹⁶⁰ Eventually some of the reform provisions were deemed unconstitutional. However, Oregon’s experience provides a good lesson about the importance of ensuring sufficient time for implementation and thinking about the unintended consequences of changing retirement benefits for existing employees.

Each government took a different approach to employee contributions. Oregon’s mandatory 6 percent was a transfer of an existing contribution and provides a healthy amount for the individual account program (IAP), particularly since the defined benefit will provide a 45 percent replacement ratio for a career employee. Gwinnett’s contribution is also mandatory, but the amount can be as low as 2.5 percent, resulting in a combined total contribution of 9.5 percent.¹⁶¹ This is less than the 12 to 15 percent amount that is generally perceived as necessary for an employee to reach an income replacement ratio of 80 to 85 percent at retirement with Social Security. Employees choosing the 5 or 7 percent contribution rates should meet that goal. Georgia chose a 1 percent auto-enrollment amount for its defined contribution in order to not discourage employees from participating. Approximately 90 percent of employees have stayed in the plan. However, 80 percent are still at the 1 percent contribution amount even though the government matches higher contributions. In Fayetteville, contribution to the defined contribution plan is also voluntary, and auto enrollment is not used. With the plan being so new and the city so small (only 150 employees), it is difficult to draw conclusions about this decision’s impact on employee participation.

Summary of Key Findings
This report has touched on the major issues and considerations surrounding defined contribution plans in the public sector. Currently, defined contribution plans play a supporting role to define benefits plans and Social Security for the vast majority of public sector employees and that will likely continue for some time. However, pensions reforms across state and local governments are increasing in importance and dependence on defined contribution plans for producing a larger portion of retirement income, or in rate instances, even becoming the primary source. Hybrid plans may also likely grow in popularity over the next several years. With the increasing importance of the defined contribution plan portion of retirement savings, it is worthwhile to consider the benefits and limitations of this savings instrument so that it can be used to best serve public employees.

About the Authors
Paula Sanford, Ph.D., is a public service and outreach faculty at the Carl Vinson Institute of Government, University of Georgia.

Joshua M. Franzel, Ph.D., is vice president of research at the Center for State and Local Government Excellence (www.slge.org)

About the ANC Foundation
The Arthur C. Caple Foundation was formed to advance knowledge in the field of public sector retirement security. The Foundation, established in 2006 as a supporting organization of the National Association of Government Defined Contribution Administrators (NAGDCA), supports both individual educational opportunities and research to expand knowledge related to the importance of retirement readiness. To accomplish its mission, the Foundation operates under the following principles: Retirement Education – The Foundation is to provide higher education students with funding to study financial or retirement planning and to create opportunities for the students to participate in related learning opportunities. Research and Information Exchange – The Foundation supports research, information sharing, and collaborative endeavors that further retirement readiness and expand knowledge of retirement issues and solutions. www.caplefoundation.org

About NAGDCA
NAGDCA’s mission is to unite representatives from state and local governments that service and support defined contribution plans. NAGDCA provides an environment to foster growth in professional development of its members through networking with peers, educational opportunities, and information sharing that includes comprehensive publications, reports, and surveys. NAGDCA will promote and support federal legislative initiatives for the advancement of retirement plans. www.nagdca.org

About the Center for State and Local Government Excellence
The Center for State and Local Government Excellence helps state and local governments become knowledgeable and competitive employers so they can attract and retain a talented and committed workforce. The Center identifies best practices and conducts research on competitive employment practices, workforce development, pensions, retiree health security, and financial planning. The Center also brings state and local leaders together with respected researchers and features the latest demographic data on the aging work force, research studies, and news on health care, recruitment, and succession planning on its web site, www.slge.org.

Footnotes

5 Clark, Robert L., Lee A. Craig, and John Edward. Sabelhaus. State and Local Retirement Plans in the United States. Cheltenham, UK: Edward Elgar, 2011.
6 Vested Employees
7 Clark, Robert L., Lee A. Craig, and John Edward. Sabelhaus. State and Local Retirement Plans in the United States. Cheltenham, UK: Edward Elgar, 2011. Pgs 24 and 72
8 “Retirement Plans, Benefits & Savings.” U.S. Department of Labor. 18 July 2012. http://www.dol.gov/dol/topic/retirement/typesofplans.htm.
9 “Table 2. Retirement benefits: Access, participation, and take-up rates, State and local government workers, National Compensation Survey, March 2011.” U.S. Bureau of Labor Statistics. http://www.bls.gov/ncs/ebs/benefits/2011/ownership/govt/table02a.pdf
10 “Latest EBS News Release.” U.S. Bureau of Labor Statistics. U.S. Bureau of Labor Statistics, 18 July 2012. http://www.bls.gov/ncs/ebs/
11 ibid
12 “Table 2. Retirement benefits: Access, participation, and take-up rates, State and local government workers, National Compensation Survey, March 2011.” U.S. Bureau of Labor Statistics. http://www.bls.gov/ncs/ebs/benefits/2011/ownership/govt/table02a.pdf
13 There has been increased interest in hybrid retirement plans. For more information, please see: http://www
.nasra.org/resources/HybridBrief.pdf
14 Clark, Robert L., Lee A. Craig, and John Edward. Sabelhaus. State and Local Retirement Plans in the United States. Cheltenham, UK: Edward Elgar, 2011. Pg 75 and http://slge.org/wp-content/uploads/2011/12/S-L-
pensions-are-different.pdf
20 “STATE PENSION REFORM, 2009-2011.” State Pension Reform 2009-2011 . 18 July 2012. http://www.ncsl.org/issues-research/labor/state-pension-reform-2009-to-2011.aspx
21 http://slge.org/publications/state-and-local-government-workforce2012-trends.
22 “STATE PENSION REFORM, 2009–2011.” State Pension Reform 2009-2011. 18 July 2012. http://www.ncsl.org/issues-research/labor/state-pension-reform-2009-to-2011.aspx
23 Based on current trends and responses from interviewees.
24 Based on current trends and responses from interviewees. The vast majority of interviewees believed governments will be moving to hybrid plans in the future.
25 Responses from three interviewees.
26 Munnell, Alicia H, Jean-Pierre Aubry, Josh Hurwitz, and Laura Quinby. 2011. Issue Brief: A Role for Defined Contribution Plans in the Private Sector. Washington, DC: Center for State and Local Government Excellence.
27 Response from interviewee and argument made in Munnel, Aubry, Hurwitz, and Quinby. 2011.
28 Munnell, Aubry, Hurwitz, and Quinby. 2011.
29 A few respondents cautioned about possible changes to Social Security and the impact that would have on retirees’ income.
36 This was confirmed through this report’s interview research as well.
37 For example Stefaniak, Angela and Clayton Vetter. 2007. “Understanding the Generation Gap in Today’s Workplace” Policy Perspectives. Center for Public Policy and Public Administration, The University of Utah. 3: 4. Found at http://www.imakenews.com/cppa/e_article000797869.cfm
38 Center for State and Local Government Excellence. 2011. Strengthening State and Local Finances: Lessons for Negotiating Public Pension Reform Plans. Found at http://slge.org/publications/strengthening-state-and-local-government
39 Concern raised by a couple of the respondents.
40 Lucas, Lori. 2010. “The Next DC Frontier: An Outcomes Based Approach to DC Plan Management.” Benefits Quarterly. 26: 4, pp. 15–21.
156 Interviewed Jim Popvin, Executive Director of Employees’ Retirement System of Georgia on June 20, 2012 and Joe Morton, City Manager of Fayetteville on June 26, 2012.
157 Center for State and Local Government Excellence. 2011. Strengthening State and Local Government Finances: Lessons for Negotiating Public Pension Reform Plans.
158 Starting in 1979, some employers in OPERS negotiated with unions to pick up their employees’ retirement contributions in lieu of a pay increase. Today, 53 percent of employers pay the contribution which covers 70 percent of employees in the system. The state created the Individual Account Program (AIP) which is similar to a 457.
159 Plan was established in the 1980s but was dormant until the 1994 when it started being used for mental health providers who were no longer able to participate in the state’s DB plan. In 1998, it was opened up to all employees as a supplemental DC plan. The 401(k) is used for a handful of small public employers.
160 Center for State and Local Government Excellence. 2011. Issue Brief: Strengthening State and Local Finances: Lessons for Negotiating Public Pension Reform Plans. Please read the case study for full details of the report.
161 Assuming employees do not contribute to the supplemental DC fund.