Pensions: Gambling Our Futures (1997)
Late last year, in the final days of the State of Michigan’s legislative session, a bill was passed that will likely lower the retirement benefits of many of the state’s future retirees. Under this bill, state employees hired after March 31, 1997 will no longer be covered under the state’s current defined benefit pension plan. Instead, they will be covered by a defined contribution plan. Legislation changing coverage for Michigan teachers to defined contribution is also under consideration.
How Do Defined Benefit and Defined Contribution Plans Differ?
- A defined benefit plan guarantees a specified benefit. Typically, the level of benefit is stated as a formula, usually a percentage of pay multiplied by years of service. The employer’s contribution to the plan is the amount necessary to pay the cost of the benefit, less amounts paid through employee contributions. Any risk is borne by the employer. Pension funds represent enormous sums of money ($1.7 trillion for all public pension funds nationwide). That money is typically invested in corporate stocks and government bonds. If the investments do well, the employer will have lower contributions in the future. If they do poorly, the employer will need to make higher contributions to make up the loss. In addition to providing retirement security, defined benefit plans often provide post-retirement pension increases, pre-retirement death and disability coverage, and unreduced early retirement benefits, after some minimum years of service.
- In a defined contribution plan, on the other hand, only the employer’s contribution is guaranteed. Often this contribution is tied to a matching employee contribution, so it is based on how much the employee chooses, or is able, to contribute. There is no guaranteed level of income at retirement. The final retirement benefit depends on the level of contributions and, probably most importantly, the investment income earned on the money contributed. Employees bear all of the investment risk. Poor investments result in a lower, and possibly inadequate, retirement income. With a defined contribution plan, there is no mechanism to provide post-retirement pension increases. Defined contribution plans do not make any special provision for disability or death of a participant.
Are Defined Benefit Plans Common in the Public Sector?
Michigan is the first state to impose a defined contribution plan on its general employees. The Michigan counties of Wayne, Saginaw and Oakland converted to defined contribution coverage prior to the state’s change. West Virginia adopted a defined contribution plan for teachers a few years ago. Teachers in Colorado and Washington are partially covered by a defined contribution plan, as a retirement plan mix. Two other states, Kansas and California, defeated attempts to change some employees to defined contribution plans. Some public sector jurisdictions provide supplemental defined contribution plans, usually funded solely by employees.
Why Have Some Jurisdictions Considered Defined Contribution Plans?
Proponents of defined contribution plans claim that these plans offer employees control over their own investment decisions as well as portability from job to job. In reality, the motivation behind most defined contribution proposals is controlling employer costs. Concern over underfunding and the possibility of future tax increases is often cited. However, on average, public plans are currently over 90 percent funded. Where underfunding is a problem, it has often been the result of employers raiding the pension fund to balance their budget, revising their actuarial assumptions to lower their contribution, or otherwise deferring, delaying or reducing necessary funding.
Some proponents argue that public sector defined benefit plans are too generous when compared to private sector plans. What they fail to point out, however, is that public employees almost always contribute to the cost of their plans, while private sector employees typically do not. Also, many public employees are not covered by Social Security, while all private sector employees are.
Is There Ever A Case for Defined Contribution Plans?
Employees who change jobs frequently may benefit from a defined contribution plan because these plans are usually fully portable. Vested employees can "roll-over" their own contributions and employer contributions — plus or minus any investment earnings or losses — to a new defined contribution plan. Under a defined benefit plan, employees who leave employment before vesting are refunded their own contributions plus a stated interest rate. An employee who is vested in a defined benefit plan will generally receive whatever benefit has been earned at their retirement date, rather than being refunded contributions.
Also, under a defined contribution plan, there is no cost to the employer to allow for early retirement. However, employees would had to have made substantial contributions and received favorable investment results to have earned enough to live on for the rest of their lives.
Plan sponsors and legislators may look to defined contribution plans as a quick fix to funding employees’ retirement. We should be cautious not to let a decent retirement plan slip away for the benefit of those simply attempting to reduce spending on public employees.
For more information on defined benefit and defined contribution pension plans, contact the Department of Research and Collective Bargaining Services at 202/429-1215.