The saying is intended to admonish and warn us that failing to learn from historical mistakes leads to their repetition. Recent efforts in multiple states to undo public pension reforms of the past are a real-time illustration of the fragility of good pension policy. 

With term limits and ever-evolving political interests, the loss of institutional memory can be a challenge in government. Circumstances in which lawmakers today do not remember the purpose of reforms from the past make it difficult to maintain and manage defined benefit (DB) pension plans in particular.

Without the ability to retain and understand lessons from past mistakes in designing, funding, and managing public pensions, public policymakers are doomed to repeat the same pension management errors and create new cycles of pension problems for the state, local governments, and taxpayers.

The financial stakes of proper public pension management remain high.

The extent of the fiscal problems related to public pension plans is reflected in the sheer size of unfunded pension liabilities. The 2024 Annual Pension Solvency Report by Reason Foundation’s Pension Integrity Project reported that between 2007 and 2010, unfunded liabilities grew by over $1.11 trillion—an abrupt 632% increase—reflecting the financial challenges faced during that period. Despite some improvements in funding ratios over the last decade, these liabilities have continued to rise, underscoring ongoing financial pressures.

As of the end of the 2023 fiscal year, total unfunded public pension liabilities (UAL) reached $1.59 trillion, with state pension plans carrying the majority of the debt. The median funded ratio of public pension plans stands at 76%, but another economic downturn could significantly increase unfunded liabilities, potentially raising the total to $2.71 trillion by 2026.

Governments, by their nature, are predisposed to mismanaging public pension plans and face few legal guardrails.

While public sector defined benefit pension plans are designed to provide retirees with a guaranteed income for life, their structure and oversight are commonly vulnerable to political pressures that undermine their sustainability and fairness. Unions and other stakeholders wield significant influence over lawmakers through campaign contributions and lobbying.

This clout often translates into enhanced pension benefits negotiated with too little consideration of the risks and long-term costs that taxpayers will bear.

A recent pension boost for Chicago’s police and firefighter pensions is an example of this pitfall, with new legislation handing out expensive benefit upgrades despite the city’s pension debt (reported to be $27 billion in 2023) exceeding that of 43 states.

Unlike private sector plans, which are subject to federal Employee Retirement Income Security Act (ERISA) regulations—imposing minimum standards for funding, benefit eligibility, vesting, and discriminatory benefits for highly paid employees—public sector plans face no such constraints. This lack of oversight creates fertile ground for political influence, where lawmakers, responsive to short-term political pressures, can manipulate pension benefits and funding to favor specific groups and constituent demands.

Institutional memory is easily lost in the political sphere.

Recent actions to reverse previously-made pension reforms in several states, including Washington, New York, and potentially California, suggest that lawmakers are inclined to succumb to political pressures while neglecting the reasons behind those essential reforms. 

California: According to a recent Reason Foundation analysis, California’s 2025 Assembly Bills 1382 and 569 aim to repeal key provisions of the 2014 Public Employees’ Pension Reform Act (PEPRA), which were crucial in reducing the growth of the state’s pension unfunded liabilities and the level of pension benefit abuses. The bills would reverse a ban on supplemental DB plans for local government employees hired after Jan. 1, 2013, and expand the definition of pensionable compensation for all PEPRA members. They would also remove critical cost-sharing requirements and again subject what are currently agreed-upon contributions to collective bargaining.

Additionally, it would create a new, higher-cost benefit for public safety employees and reduce retirement age requirements back to where they were before the 2014 PEPRA reform. AB 569 passed through the Assembly Public Employment and Retirement Committee in May 2025 with no opposition from either party, illustrating how political pressures can threaten past reforms.

Washington: According to Reason Foundation’s analysis of 2025 Engrossed Substitute Senate Bill 5357 (ESSB 5357), the bill raises the long-term investment return assumption from 7% to 7.25% for every plan in the state (except the Law Enforcement Officers’ and Firefighters’ Plan 2) and pushes the amortization of two legacy plans’ unfunded liabilities over an additional four years in order to gain short-term lower contributions to deal with budgetary pressures. The bill undermines past funding progress at the expense of future taxpayers and is counter to the trend of most other public retirement systems, which have lowered investment return assumptions and shortened unfunded liability amortization periods. It sets a dangerous precedent that prudent pension funding is optional and takes a backseat to more politically advantageous spending.

Alaska: Citing the need for better recruitment tools, Alaska has been considering reversing its landmark pension reform of 2005, when it froze its DB pension plan and created a new defined contribution (DC) structure for new hires. According to Reason’s analysis of 2025 House Bill 78, the newest iteration of that proposal would cost Alaska an additional $2.1 billion over the next 30 years. Under a more realistic scenario, if investment returns over the next 30 years resemble those Alaska has experienced over the past 23 years, the cost increases to $11.4 billion​. In addition, the existing DC plans actually provide better benefits for most Alaska public employee participants, a fact that undercuts the argument that the DB plan is needed for recruitment.

Minnesota:  While Minnesota continues to underfund its public employee pension plans with contribution rates below recommended actuarial rates, the state recently passed Senate File 2884, increasing the retirement benefits for teachers, firefighters, police officers, state patrol officers, and public employees. The legislation does provide some additional contributions to pay for added benefits ($20 million per year for 2026-29), but risks adding to the state’s estimated $18 billion in pension debt. Increasing benefits while plans are still short on paying for current pension promises is indicative of misguided public policy around the state’s pension benefits.

Oklahoma:  2024 House Bill 2854 attempted to undo the highly successful 2014 DB to DC reform adopted by Oklahoma. The reform resulted in the legacy pension plan achieving nearly 100% funding and creating a DC program that follows best practices.  HB 2854 would have eliminated the current Pathfinder DC retirement plan and retroactively reopened the legacy pension plan, re-exposing the state to unnecessary unfunded liabilities, financial risks, and hidden costs that would ultimately be borne by taxpayers. The state saw similar efforts in 2025, which did not pass, but would have also undermined the progress Oklahoma has made in fully funding the retirement promises made to public workers.

New York: Last year, New York lawmakers undermined a 2012 pension reform by boosting public worker pension benefits and limiting the crucial contributions coming from employees. Adding to ongoing political pressures to undo prudent, cost-saving reforms in the Empire State, New York City mayoral candidates (including Former Gov. Andrew Cuomo who was part of the effort to pass the original 2012 reform) have been outspoken about supporting a return to the previous pension benefits that catapulted the state into massive unexpected costs.  Public employee unions are advocating for decreasing the minimum retirement age from 63 back to 55 for teachers, and 62 for other employees, which would bring back significant costs for taxpayers.

The fragility of public pension reforms.

The durability of past public pension reforms is precarious. As the influence of reformers like former California Gov. Jerry Brown wanes, institutional memory fades, and newer generations of lawmakers, less attuned to the fiscal crises that prompted reforms, may chip away at its protections.

Bills like those cited previously demonstrate how quickly reforms can be undone under pressure from influential groups. The absence of a formal retirement funding policy leaves these reforms vulnerable to political whims, allowing lawmakers to prioritize short-term political gains over long-term fiscal responsibility. For instance, California PEPRA’s prohibition on supplemental DB plans was a direct response to past abuses, yet AB 569 threatens to reinstate these plans without addressing the risks of favoritism or unfunded liabilities.

The need for formal retirement benefit and public pension funding policies.

As a matter of public policy, government retirement plans will always be at the whim of elected lawmakers, for better or for worse. One method that today’s lawmakers could consider to, at the very least, nudge future lawmakers to maintain and not undermine good pension policies would be to enshrine sound formal retirement and funding policy statements in law—potentially at the constitutional level—which is largely not yet common practice. These binding statements should articulate the core purpose of public pensions: to provide a level of benefits sufficient to provide adequate and secure financial security for all public employees, concurrent funding of benefit promises, with actuarial assumptions and methods that do not place unreasonable financial risks on future generations of taxpayers and employees (e.g., reasonable investment return and liability discount rates and short amortization periods for any unfunded liabilities that do arise).

Such formal policies would act as a guardrail, reminding future lawmakers of the risks of unchecked pension promises. They would also provide a framework for evaluating proposed changes, ensuring that reforms prioritize fiscal sustainability and equity. For instance, a policy statement could require that any new pension benefit be fully funded at inception and subject to public disclosure, preventing opaque deals that favor the politically connected. These measures would not entirely prevent any future attempts to undermine cost-saving reforms, as any law enacted can be just as easily overwritten with new laws, but it would at a minimum require some level of accountability, as lawmakers would likely need to state their justification for going against what was enacted by their predecessors.

The case for defined contribution retirement plans for public workers.

The inherent flaws of public sector defined plans suggest a need for deemphasizing DB plans in favor of best practice DC plans or hybrid DB/DC combination approaches. Defined contribution plans allocate contributions to individual accounts with employees rather than employers and politicians in control. This cuts off both the means and motive for political manipulation.

Defined contribution plans also offer greater transparency and fairness. Contributions are visible and predictable, making it harder to conceal special benefits for influential groups. Public employers can still attract and retain talent through competitive salaries or supplemental  DC plans, which are less likely to create long-term fiscal burdens. These plans can be tailored to meet recruitment needs without twisting and manipulating DB plans to do things they were not intended to do.

Conclusion

With fewer legal guardrails on funding practices, public sector pension plans are inherently vulnerable to political manipulation and mismanagement. The absence of strong guardrails and ERISA-like funding and nondiscrimination rules allows influential groups to secure benefits that are applied unevenly, potentially undermining hard-won reforms. The loss of institutional memory further exacerbates these risks, as newer lawmakers may not fully grasp or choose to ignore the consequences of weakening prudent pension reforms.

To address these issues, policymakers can shift toward best practice defined contribution-type retirement plans, which offer greater transparency and reduce fiscal risks for taxpayers.

Additionally, formal retirement funding policies should be codified to communicate to future lawmakers the intended purpose of these pension plans: delivering equitable and sustainable retirement security for all public employees in ways that taxpayers can afford.

The post Important public pension reforms are under threat in several states appeared first on Reason Foundation.

Background 

The cost of a defined benefit pension plan is usually divided into two main categories: normal costs and unfunded liabilities.

Normal costs refer to the ongoing expenses of funding pension benefits earned by employees in a given year, determined by actuarial valuations.

Unfunded liabilities arise when a pension plan’s liabilities exceed its assets, often due to investment returns below expectations, insufficient contributions, or changes in actuarial assumptions. 

The pros and cons of defined benefit cost-sharing

Having employees help pay for some portion of defined benefit (DB) pension costs has advantages and disadvantages, which can vary depending on the context and specific arrangements.

Advantages

• Financial sustainability: Cost-sharing can help ensure the financial sustainability of pension plans by distributing the funding burden between employers and employees.
• Risk mitigation: Cost-sharing can mitigate the financial risk for employers (taxpayers), reducing the likelihood of severe budgetary impacts.
• Equity: Cost-sharing can promote a sense of fairness, as both employers and employees contribute to the funding of retirement benefits.
• Incentives for fiscal responsibility: When employees share the cost of their pensions, they may be more invested in the pension plan’s financial health and supportive of prudent management practices.

Disadvantages

• Affordability for employees: Increased employee contributions can strain household budgets, particularly for lower-income workers.
• Fairness and equity concerns: Defined benefit plans are supposed to fund each year’s accruing benefits as they are earned through normal cost contributions. While cost-sharing for normal costs is a fair proposition, cost-sharing for unfunded liabilities is for benefits earned in the past. So, asking employees (particularly new hires) to pay for a portion of unfunded liability costs might be perceived as unfair because it means they might be paying for someone else’s accrued liabilities.
• Complexity in negotiations: Cost-sharing agreements can complicate labor negotiations, potentially leading to labor disputes or employee dissatisfaction.
• Negative retention impacts: Some cost-sharing arrangements may be perceived as a reduction in pay and may lower employee retention rates. Again, this would particularly occur if employees share in the cost of any unfunded pension liabilities.

Defined benefit cost-sharing practices in the private sector

The private sector has seen a significant shift from DB plans to defined contribution (DC) plans. However, some private sector employers still offer DB plans, and their cost-sharing arrangements differ from those in the public sector.

In the private sector, normal costs and any unfunded liability costs are typically 100% funded by the employer. In the case of collectively bargained employees, the pension costs are set within the collective bargaining agreement. Even for these arrangements, the employer technically is paying 100% of the cost of the pension plan via a negotiated trade-off between taxable pay and benefits.

Private sector employers also avoid having employees share in the funding of pension plans because employee contributions would generally be on an after-tax basis (the 401(k) cash or deferred plan rules cannot be used to make employee contributions on a pre-tax basis). After-tax employee contributions for pensions complicate plan administration and compliance with federal laws governing the funding of private-sector pension plans, such as ERISA. To avoid legal and financial complications, private-sector employers have preferred not to adopt employee cost-sharing practices for pension benefits.

DB cost-sharing practices in the public sector

Public sector defined benefit cost-sharing practices are quite different from those in the private sector. The vast majority of plans require both employer (taxpayer) and employee contributions, with only a few being “non-contributory,” requiring no employee contributions. 

Using 2023 data from the Public Plans Database (PPD), we examined the cost-sharing practices of roughly 230 state and local pension plans in the U.S. The PPD had normal cost data for 194 of these pension plans and total cost data (with unfunded liability costs) for 192. 

We first look at how much of the public pension plans’ normal costs are being paid by employees. Figure 1 shows a distribution of employee shares for the 194 pension plans as a percentage of the total normal cost. Among these plans, the average share of normal cost paid by employees is 51%. The median level is 49%. But the range of cost-sharing of the normal cost is extremely broad, ranging from 0% to 100% (or above 100% in some cases).

Figure 1 

Source: Reason analysis of contribution data from PPD.

It’s also valuable to see how much of the public pension plans’ total pension cost (normal cost plus any unfunded liability cost) is being paid by employees. Figure 2 shows a distribution of the 192 plans as a percentage of total pension cost. Among these plans, the average share of the total pension cost paid by employees is 25%, with the median at 23%. The sharing of total costs ranges from 0% to 72%.

Figure 2

Source: Reason analysis of contribution data from PPD.

Differentiating between normal costs and unfunded liabilities

It is essential to distinguish between normal costs and unfunded liabilities when determining any cost-sharing structure for DB pension costs. Normal cost-sharing is more straightforward to manage and share, as it is based on current employment and actuarial projections. Fixed contribution rates for both employers and employees can provide stability and predictability in funding.

Unfunded liability cost-sharing poses a more significant challenge, as it represents historical deficits that require additional funding. Sharing these costs with employees can be more contentious. This often involves increasing contributions or reducing future benefits to address the shortfall.

Policymakers must carefully consider the fairness concerns of newer employees who may not have any relationship with those past liabilities, and how such measures may impact employee morale, retention, and retirement security.

Figure 1 shows that some public plans have employees pay more than 100% of the plan’s normal cost. This means that employees are helping pay part of the unfunded liability that, in many cases, was accrued before they were hired. 

IRC Section 414(h) “pick-up” arrangements can muddy the water

Public policymakers need to factor in how Internal Revenue Code (IRC) section 414(h) “pick-up” arrangements may impact the desired pension cost-sharing structures. Under this code section, employee contributions are paid by the employer, treating them as pre-tax employer contributions for tax purposes. While this arrangement can provide tax benefits for employees, it complicates the crafting of appropriate pension cost-sharing models, depending on whether the “pick-up” is using a salary reduction method or an offset against future pay increase approach. If all or part of the employee contribution is paid by the employer as an offset against future pay increases, it can obscure the actual cost of pension funding to the employer, making it difficult to assess the balance between employer and employee contributions. This complexity is absent in the private sector, where such pick-up arrangements are not available. 

For example, assume a pension plan has a normal cost contribution rate of 10% of pay with a cost-sharing policy that splits the cost evenly between the employer and employee. The employer contribution rate would be 5%, and the employee contribution rate would be 5%. A salary reduction “pick-up” would not change this split. It would make the employee’s 5% share pre-tax instead of after-tax. In contrast, if an offset against salary increase “pick-up” is used, this effectively results in the employer paying the full 10% amount, notwithstanding the plan nominally adopting an evenly split cost-sharing policy.   

Public policymakers need to consider how the different pick-up arrangements can affect employer contribution rates.

Recommendations for public sector policymakers

Public sector policymakers should design pension cost-sharing policies that support a pension plan’s funding policies and objectives.  

• Periodic reexamination of cost-sharing policies: Cost–sharing structures that may have worked in the past may not remain optimal as the plan’s funding requirements change over time. Pension reform efforts should include cost-sharing policy discussions. 
• Transparency and communication: Both participating employers and employees must clearly understand the pension plan’s financial status, funding requirements, and cost-sharing arrangements. Transparent communication can build trust and support for necessary changes. 
• Balance contributions and benefits: Strive to balance the need for sustainable funding with the affordability of contributions and the adequacy of benefits. This may involve setting contribution rates that are fair and manageable for both parties while also ensuring that benefits provide sufficient retirement security.
• Address unfunded liabilities separately from normal costs: Develop strategies to address unfunded liabilities without placing an undue burden on employees, particularly new generations of employees. This may necessitate looking at new benefit structures, benefit adjustments, or seeking additional funding sources. 
• Consider hybrid plan designs: Explore hybrid pension program designs that combine elements of defined benefit and defined contribution plans. Such designs can provide a balance between predictable retirement income and shared funding responsibility.
• Consider the impact of any IRC Section 414(h) pick-up arrangement: It is important to know whether the employer is already paying part of the employee contribution rate via an offset against future pay increases. 

Conclusion

The sharing of public sector defined benefit pension costs between employers and employees is a complex but essential aspect of ensuring the financial and benefit sustainability of pension plans. Public sector practices often involve fixed employee rates for normal costs and varying approaches to addressing unfunded liabilities.

By considering the pros and cons of cost-sharing and differentiating between normal costs and unfunded liabilities, policymakers can design public pension plans that balance financial sustainability with retirement security. Transparent communication, proactive strategies, and employee engagement are key to successfully balancing interests and successful pension plan management in the public sector.

The post Sharing defined benefit pension costs: A survey of public sector practices appeared first on Reason Foundation.

Two bills recently passed by the Pennsylvania House (House Bill 1416 and House Bill 1379) would increase public pension benefits for about 64,000 school and government retirees and about 26,000 retired police and firefighters. The pension benefit increase ranges for government and school employees from 15% to 24.5%, depending on the date the participant retired. For eligible retired police and firefighters, a special ad-hoc increase ranging from $75 to $300 per month would be provided. The State Senate has not yet taken up these proposals.

House Bill 1416 would add over a billion dollars to the already daunting unfunded liabilities of the Public School Employees’ Retirement System, PSERS, and the State Employees’ Retirement System, SERS, to be paid for over a 10-year period. 

The already high employer contribution rates for PSERS and SERS would increase by about .81% and .74% of projected payroll, respectively. House Bill 1379 adds over $300 million in liabilities to the Pennsylvania Municipal Retirement System, PMRS, plans as well but is paid for by a one-time direct General Fund appropriation.

Retired public employees in Pennsylvania generally participate in pension systems that do not provide automatic protection against inflation in retirement, and many have certainly experienced a significant drop in purchasing power due to inflation. However, the recently proposed catch-up and ad-hoc cost-of-living adjustment (COLA) bills passed by the Pennsylvania House are only temporary Band-Aids over a problem that will occur again and again for all future generations of public employees in the defined benefit pension plans of the state.

While defined benefit (DB) pension plans for public employees are designed to provide guaranteed lifetime income in retirement, not all include protection against inflation. Even with a modest 2% Consumer Price Index inflation per year, an initial pension benefit might lose 30% of its purchasing power after 20 years of retirement. 

Many lawmakers, like those in Pennsylvania, pass legislation to give one-time ad-hoc adjustments to retirees because they understand the degrading impact of inflation on public retirees.  The reality of recent high inflation makes the problem even bigger. However, providing a built-in cost-of-living adjustment can be costly. Even a simple 3% non-compounded annual increase might cost 20% more in annual pension costs to a pension plan that doesn’t have any inflation protection now.  Not providing a built-in COLA does lower the cost of the plan, but it does mean legislators are more likely to be asked for ad-hoc increases like those proposed in these two bills.

The Pennsylvania legislature last provided a COLA benefit in 2002 when it increased benefits for retirees before 1990 by an average of about 14% and for retirees between 1990 and 2002 by an average of about 7%. Prior to that legislation, Pennsylvania adopted pensioner increases of various amounts on an ad-hoc basis about every five years since 1968.

The 2002 COLA increased unfunded liabilities by about $640 million, which was paid for over a 10-year amortization period in level dollar payments. At the time of the 2002 COLA increase both PSERS and SERS were approximately 105% funded. However, the financial picture of PSERS and SERS has changed dramatically since 2002. As of June 2023, the funded ratio of the two systems is 63.2% and 69.3% for PSERS and SERS, respectively. The unfunded public pension liabilities are $44.3 billion for PSERS and $17.5 billion for SERS as of the same date. The funded status, as reported in the 2023 actuarial valuation for PMRS, is more positive at about 99% of liabilities overall. However, the report also acknowledges that 391 of the 738 plans in PMRS are less than 90% funded and considered under financial stress.

According to the actuarial note for HB 1416, the increase in pension benefits would add about $821 million in liabilities to PSERS and $371 million to SERS—a total increase in unfunded liabilities of about $1.19 billion. These additional liabilities would be funded in equal dollar installments over a period of 10 years.

The actuarial note for HB 1379 calculates the bill would add up to $374 million in liabilities to the Pennsylvania Municipal Retirement System, PMRS. In contrast with HB 1416, this additional liability for PMRS plans would be fully paid for by an appropriation from the General Fund.

As detailed in the Reason Foundation’s analysis in Nov. 2023, HB 1416 would resurrect a COLA design not used by Pennsylvania since 2002. Both COLA bills bring back an approach to dealing with inflationary impacts on pensions that is not guided by any clearly adopted retirement benefit policy. HB 1416 is not concurrently funded or guided by any formally stated inflation benchmark. Both bills raise expectations for similar treatment for future retirees. This sets the stage for the return to the pre-2002 pattern of ad-hoc COLA bills every few years. While HB 1379 is concurrently funded through a general fund appropriation, it otherwise falls short of best practices for similar reasons.

If the General Assembly makes a policy judgment to move forward with these bills, the better approach would be to fund the cost immediately in a manner similar to that taken in HB 1379 rather than pay for it over time with money from future taxpayers. To break the cycle of continuing down this same road for future retirees, consideration should be given to establishing a policy that either supports or rejects a regular COLA benefit that is automatic and recurring, pre-funded, and also subject to change if necessary.

The retirement benefit policy should clearly define what inflation protections are or are not being provided to public employees in these pension systems to set expectations for employees and to provide concurrent funding for any promises being made. Not doing so perpetuates the unending cycle of demands for pension increases from retirees and the prospect of pushing additional pension unfunded liabilities to future taxpayers.

The minimum change to adopt is to provide concurrent funding for the proposed COLA benefits. HB 1379, as amended, takes this approach, but HB 1416 for PSERS and SERS does not.  Concurrent funding of ad-hoc COLAs is a better and more transparent way to address and pay for the impact of inflation on these particular retirees versus amortizing the cost over time, like a mortgage.

Concurrent funding allows public policymakers to make prudent fiscal decisions that more properly balance the distribution of the public treasury among all Pennsylvanians without adding to the financial strains of PSERS, SERS, and PMRS.

The post Pennsylvania’s proposed public pension increases would be costly to taxpayers appeared first on Reason Foundation.

A combination of better funding policy and reductions in future benefits (e.g., lower accrual rates, reduced cost-of-living adjustments) have assisted in paying down some of these massive costs. Still, hardly a month goes by without releasing some article or study claiming to show the opposite—that these public pension reforms have made things worse. The arguments imply that any attempt to close a DB pension plan creates higher pension liabilities, increases costs, worsens employee recruitment and retention, and that any replacement defined contribution (DC) plan reduces employees’ retirement security. 

Examination of these arguments, however, reveals that most of the claimed negative impacts of public pension reform are not supported by the facts. Here are some of the more common claims of problems caused by public pension reform and why public sector policymakers should not be swayed by them. 

Claim: Closing a DB pension plan will increase plan liabilities  

False: Closing a DB pension plan by itself does not impact existing plan liabilities. The accrued benefit promises made to the participants are the same before and after closing a pension plan to new entrants. Every dollar of benefits to be paid to these existing participants will be the same regardless of whether the plan remains open or is closed to new participants.  

Claim: Closing a DB pension plan will immediately increase plan unfunded liabilities and increase required employer contributions 

False: The claim asserts closing a pension plan causes higher levels of negative cash flow, which requires lower return investments for the plan to maintain the sound funding of the benefit promises that have been made. The argument (sometimes called “transition cost”) generally goes as follows: 

1. Closing the plan causes an increase in future “negative cash flow”–benefit payments that will exceed employer and employee contributions and investment returns coming in. This occurs because contributions for new hires are no longer being made. 

2. Increased negative cash flow means plan investments must be more liquid to pay benefits as the membership gradually diminishes in a closed plan. 

3. More conservative liquid investments mean lower investment returns. 

4. The expectation of lower investment returns means the assumed future investment return assumption must be reduced. (e.g., from 7% to 4-5%). 

5. Lower investment return assumptions for the future mean a lower discount rate is used by the plan actuary, causing an increase in unfunded liabilities. 

6. Higher unfunded liabilities mean employer contributions must immediately increase to make up for the lost investment returns. 

The argument, while logically coherent, is very misleading because it suggests that a DB plan will always need new entrants to remain sound and affordable. If that were true, then it would mean a DB pension plan ought to never be closed because contributions will always be needed from future generations of taxpayers and employees to pay the benefits of current employees. This is not consistent with sound actuarial funding methods for pensions. DB pension plans are supposed to prefund benefit promises during the working years of each employee. If money is always needed from new hires, it becomes more like a giant Ponzi scheme that requires unending funding from, and risk-shifting to, future generations of employees and taxpayers. This would make public pension funding more like the nearly bankrupt federal Social Security system. 

The “transition cost” argument is further weakened by the fact that there has never been a case where a plan sponsor with a closed public sector DB pension plan immediately changed their actuarial funding methods and assumptions because of cash flow concerns. It simply hasn’t happened because plan sponsors have decades to manage the closed plan liabilities and assets. Current participants in a frozen DB plan can expect to work 20-40 years before retiring and will have an additional 20-35 years in retirement.  Examples of states that have closed their DB plan and moved to DC plans but have not immediately changed their investment structure and actuarial return assumption for this reason include Alaska, Michigan, Oklahoma, Rhode Island, Utah, and most recently North Dakota. 

Further, any increase in negative cash flow for the closed plan is a problem that gets smaller with time. The problem gets smaller as the size of the remaining liability decreases and as the number of retirees and benefit payments in the closed plan becomes smaller. Any funding volatility because of “negative cash flow” can be handled more easily in the future because it represents a much smaller piece of the financial picture of the plan sponsor. There is a lot of time to allow closed plan liabilities and investments to evolve without the need to push the panic button. 

Those who criticize the closing of DB pension plans don’t often address the possibility that unfunded liabilities will increase if the plan is not closed. In an open pension plan, prolonged market outcomes below expectations and failure to make sufficient contributions will apply new costs to the benefit promises for new hires. No one seems to mention that risk when criticizing proposals to close an existing DB pension plan. Pension liability derisking efforts are severely handicapped if the plan sponsor cannot at least start curtailing unexpected costs for new hires. 

Claim: Closing a DB plan will increase the actuarial required contribution percent rates for unfunded liabilities because the cost is being amortized over a frozen and diminishing salary base 

True, but misleading: This is a non-problem because any unfunded liability can still be amortized by simply continuing to have employers fund the closed DB plan on the total compensation of both the DB plan participants and the new employees in the replacement plan. This helps ensure unfunded liabilities continue to be paid off as if the DB plan had not been closed. It also reduces negative cash flow impacts. Nothing has changed except new hires are not being asked to subsidize the unfunded liabilities of the DB plan participants with their own money. As long as unfunded liabilities are, on an actual dollar basis, being paid off at the current rate or faster, the required percent of payroll is inconsequential.   

Claim: States that closed their DB plans have experienced higher employer contribution requirements because of greater exposure to volatile markets  

Unproven: Critics sometimes assert that specific states have experienced unexpected cost increases for their closed DB plans because they have higher negative cash flow and greater exposure to market volatility. Closing the plan means the loss of contributions for new hires that could have been invested to weather volatile investment markets. Instead, the closed plan must cash out of investments to pay benefits and miss out on gains during periods of market recovery. This is claimed as an additional consequence of the negative cash flow argument previously discussed. 

The proponents of this claim fail to specify what part of any employer cost increase is attributable to just the negative cash flow versus how much is attributable to other factors, including investment loss vs. assumptions, less than full actuarial funding by the employer, demographic experience gains and losses, or change in actuarial funding assumptions (e.g., discount rate). Only through a full attribution by source analysis can one know what marginal amount of cost increase is attributable to excess negative cash flow. 

Claim: Moving from DB to DC negatively impacts employee attraction to public employment 

Unproven and misleading: It has become axiomatic among DB pension advocates to claim that DB plans improve the attraction of employees compared to DC plans. Very little actual evidence has been presented in support of this claim. Usually, the argument is made that surveys show most employees like the idea of guaranteed lifetime retirement income and, because DB plans provide that, most employees will prefer employers that have one.   

In contrast, the argument goes, DC plans do not typically offer guaranteed income features and have uncertain outcomes because investment risk is shifted to the participants. The assertion is that employees are less likely to want to join an employer that offers only a DC retirement plan. 

This objection can be refuted by making a few points: 

• Preferences for guaranteed income for life in retirement do not automatically require a DB pension. The preference can easily be satisfied by designing a DC plan to include guaranteed lifetime income features. There is no inherent reason why non-DB plans cannot accomplish this. See the Reason Personal Retirement Optimization (PRO) plan design for a good example of how DC plans can be structured to provide lifetime income, just like DB plans.  
• DB pension plans actually do less to deliver retirement income security than many prospective employees might think. Most public employees are not full-career employees and never earn full DB benefits. One study by the Urban Institute and Bellwether Education Partners notes that because of the backloading of benefits and a lack of portability of benefits, DB plans have a particularly negative impact on employees with short and even moderate periods of service. The study examined the benefit accrual experience of teachers under DB plans and concluded that three in 10 new teachers leave within five years, thereby forfeiting their benefits. The study notes that because many teachers cross state lines to teach elsewhere they “split” their careers between multiple state pension systems, greatly reducing their retirement benefits compared to those who stay for a full career in one state. The study also finds that only 25% of teachers break even and earn a pension benefit that is equal to the value of the contributions made by themselves and their employers. If educated and informed properly, most employees who are focused on the value of their retirement plan should actually prefer a well-designed DC plan to a traditional DB pension. 

Claim: Moving from DB to DC negatively impacts employee retention rates 

Unwarranted conclusion based on misleading correlation of data: Some DB advocates claim that employee retention is hurt by the introduction of DC plans for new hires after closing a previous DB pension. They point to comparisons of retention rates of new hires into DC plans versus what the assumed retention rate would have been under the DB plan.  

The comparisons show some level of worsening retention rates and conclude that the change must be caused by the adoption of the DC plan. A complete analysis, however, would ask more questions about other variables that might be contributing to the change in retention outcomes, including: Are the DB and DC groups comparable? Do they have similar demographic characteristics? Are the age and service, job occupations, and even geographic location characteristics the same? What other changes in salary and benefits might be affecting turnover? Generally, these other factors and variables are ignored by those making a shallow comparison between DB and DC employee groups. They often overlook changes in other societal factors and events, such as the COVID-19 pandemic and changes in generational work patterns and preferences.   

The conclusion that a DC plan worsens retention can, at best, be considered a weak correlation based on incomplete data and, at worst, is a purposeful attempt to mislead public policymakers.  

A 2022 study by John Brooks of Appalachian State University examined the retirement and retention impact of public sector DC plans replacing DB plans, finding that a change in plan type has no significant effect on retirement decisions. The results suggest that public policymakers should focus more on employee contribution levels and other factors, not plan type, when intending to address recruitment and retention. A separate Pension Integrity Project analysis also found that changes in retention rates in some states are more attributable to compensation and changes in the broader labor market and cannot be attributed to changes in DB plans.  

Claim: DC plans reduce employee retirement security compared to DB plans 

False for most individuals: As noted previously, DB pension plans do a poor job of contributing to the retirement security of most employees. Traditional DB plans are designed to provide maximum benefits only for those fortunate few who work full careers in covered employment. The lack of benefit portability and backloading of benefit accruals does substantial damage to public employees who do not stay for a career. Short-service employees are subject to benefit forfeitures because of often lengthy vesting schedules that are common in public pension plans. Making things worse, employees who vest but leave covered employment with a deferred pension to be paid at retirement age will see the value of that frozen benefit massively degrade because of inflation.   

Figure 1 shows that traditional DB pensions are a poor fit for all but a narrow band of workers nearing retirement age. In most cases, the DC benefit accruals exceed DB pension benefit accruals until an employee reaches over two decades of service.  

DC plans are also criticized because participants leaving employment can withdraw/cash out their accounts and not save the money for retirement. While this can and does happen, it is also true that DB plan participants who leave employment can withdraw their employee contributions, and many do. This usually results in the forfeiture of the entire accrued pension–even that funded by employer contributions. The retirement asset leakage problem is shared by both DC and DB plans.   

DC plans can be designed to mitigate this concern by encouraging employees to keep their DC plan accounts intact after separation from service or by rolling those over to a tax-deferred account. Communicating the DC benefit as continuing to be invested with earnings growth over time that supports income in retirement can be a strong argument against DC account cash-outs. In contrast, DB benefits for employees who leave service before retirement are frozen and subject to loss of value because of inflation. Younger employees with frozen DB benefits are more likely to cash out because they see less value in keeping that benefit when they still have 20-30 years of work before retiring. 

Conclusion 

Studies condemning the adoption of alternatives to the traditional pension plan for public workers are not supported by the facts. DB pensions are not the only way to provide attractive and affordable retirement benefits to teachers, police, firefighters, and other public workers. Policymakers should not be misled by claims that there are unavoidable structural obstacles to reforming pensions or that changes will inevitably lead to problems with recruiting and retaining quality employees. 

The post Claims that public pension reforms lead to negative impacts are unfounded  appeared first on Reason Foundation.

If the public policy goal for retirement plans is to allow as many individuals as possible to become financially self-sufficient, then public sector defined benefit (DB) plans are falling short and should be redesigned to use individual account features that exist in defined contribution (DC) and cash balance plans.

Traditional defined benefit pension plans have fundamental design weaknesses 

Most traditional public sector plans calculate benefits based on a combination of the number of years of service, compensation, and a benefit accrual factor–e.g., 30 years of service x $50,000 compensation x 1.75% = $26,250 per year.

There is the added bonus that the benefit they accrue each year is not taxable during employment. Federal and state income taxes on this compensation are deferred until they actually retire and start receiving these annuity payments.   

But this only works well for those who actually make a long career with a single public employer. What about workers who are short- and medium-tenure employees? These members simply do not significantly benefit from these defined benefit pension plans because: 1) they do not work long enough to vest in any pension benefit; and 2) even if they do vest, if they leave before retirement age, their benefit is frozen and loses value because of inflation and does not increase with any future pay increases (sometimes referred to as “the back-loading problem”). 

Longer vesting requirements make the problem even worse for public pension plan participants 

In the private sector, employer retirement plans are subject to federal laws under the Employees Retirement Income Security Act (ERISA), which dictates that a defined benefit plan cannot have a vesting requirement that is longer than five years of service (called cliff vesting) or a graduated vesting schedule longer than three to seven years of employment.

For an ERISA cash balance pension plan (another type of defined benefit retirement option), employees must vest in employer contributions no later than after three years. These ERISA minimum vesting rules were adopted, in part, as a response to company pension failures and to protect the benefits that were promised to plan participants. That public policy purpose remains valid today.  

However, public employee pension plans are not subject to these ERISA minimum vesting and other requirements. This means public pension plans can and often do have much longer vesting requirements. A 2022 report by the Equable Institute evaluated the vesting periods for state retirement programs and found that of the examined 43 states with DB pensions, only 15 had an average vesting requirement of five years or less. The remaining 28 states had average vesting periods longer than five years. Seventeen states had vesting periods between five and 10 years, and 11 had average vesting periods of over 10 years. The report noted that of the 14 states with hybrid (combination DB and DC) plans, seven had vesting periods of five years or less and one had vesting longer than five years. In contrast, none of the 13 states that offer DC plans for employees had vesting requirements longer than five years.

A 2012 report from the Center for Retirement Research at Boston College (CRR) determined that long vesting periods mean 47.6% of workers depart without any promise of future benefits. The report finds that an additional 18.6% of workers vest but leave covered employment before full retirement age with a deferred vested benefit. These deferred pension benefits are subject to lost value due to inflationary impacts until the employees retire. This means only about 35% of government-hired employees actually earn a pension that is not forfeited or significantly reduced in value by inflation.

Figure 1 below shows how inflation can substantially reduce the value of deferred vested pension benefits.

Figure 1: Impact of inflation on the purchasing power of pension benefits

Source: Reason Foundation paper “Best Practices for COLA Designs in Public Pension Systems”

Based on this analysis, almost two-thirds (65.1%) of states have vesting requirements that would violate the minimum vesting rules of ERISA for private sector plans. The CRR report notes that a 10-year vesting requirement reduces the probability of public employees earning full pension benefits by 16% compared to an ERISA-compliant five-year provision.

A 2021 Social Security Bulletin also confirmed the long vesting periods for many public pension plans, reporting a mean vesting period (all occupations) of eight years for the public plans examined, with a median of seven years. The mean vesting requirements for public safety employees was even longer at 9.2 years, with a median of 10 years. Many public safety pension plans (local plans in particular) even have vesting requirements as long as 20 years.

Unfortunately, some public pension financial reform efforts have made the vesting problem worse by making employees work even longer to take part in their retirement plan benefits. A 2018 National Association of State Retirement Administrators Issue Brief reported that nine states had increased vesting requirements from five to 10 years since 2009. Two states, Missouri and North Carolina, reversed the changes after further evaluation.

Individual account defined contribution and cash balance plans can provide better retirement security for more public employees

According to recent Bureau of Labor Statistics reports, state and local government employers spend, on average, 13.3% of their total compensation package on retirement benefits. Longer vesting means nearly half of workers who choose to work for public-sector employees will only be paid about 87% of their total compensation package. They will forfeit the rest. This is a fundamental problem for traditional DB pension plans that must be addressed by policymakers if the goal is to help as many as possible be self-sufficient in retirement, rather than relying on government welfare programs.  

The previously mentioned Center for Retirement Research at Boston College report's conclusion states the problem very clearly:

“Sole reliance on final earnings defined benefit plans raises human resource and equity issues. Final earnings plans produce strongly back-loaded benefits and, when combined with delayed vesting, deprive short-term employees of retirement protection, especially for those systems that do not participate in Social Security.”

Individual account plan designs, including defined contribution and cash balance plans, avoid the fundamental problems of traditional DB plans by allowing full portability of benefits, protection against inflation, and more uniform benefit accruals. Where traditional DB pensions are still valuable, such should be part of hybrid DB/DC designs to mitigate the design shortcomings of a straight DB approach. 

Short or immediate vesting can substantially reduce the forfeiture problem and provide a much-needed contribution to the retirement security of this large cohort of public employees who currently receive no significant benefits from traditional defined benefit pension plans.

State and local governments should not continue to support traditional defined benefit-only retirement programs with long vesting periods to the detriment of the retirement security of the many workers who will not make public employment a full career.

The post Nearly half of public employees in defined benefit pension plans will never receive a payout appeared first on Reason Foundation.

Despite these significant challenges, some states and cities provide good examples of what successful public pension reforms can and should look like. For example, the pension reforms made by Oklahoma between 2011 and 2014 resulted in the public pension system being fully funded in 2023.

Oklahoma Defined Benefit Pension Reform

In 2014, Oklahoma’s state legislature capped a multi-year effort to improve the funding and sustainability of the Oklahoma Public Employees Retirement System, or OKPERS, which provides benefits for state and local government employees. The pension system was only 66% funded in 2010. A 2014 Reason Foundation interview with Oklahoma State Rep. Randy McDaniel summarized the two significant changes made to OKPERS between 2011 and 2014:

• 2011 – Elimination of future cost-of-living adjustment (COLA) benefit increases without full advance funding, which reduced pension liabilities and improved funding levels from about 66% to over 80% on an actuarial asset basis.
• 2014 – Freezing the OKPERS defined benefit plan to new entrants after Nov. 2015 and creating a new defined contribution plan – the Oklahoma Pathfinder Retirement Plan — for new hires after that date.

In the Reason interview, Rep. McDaniel outlined some of the key principles that led to these successful pension reform efforts, including “acknowledging the problem” and “teamwork,” but he put a particular emphasis on tenacity:

“The final issue is tenacity. Reforms were required if we were going to have a sustainable Oklahoma. We could no longer make excuses and turn our backs on a problem that was impacting all of our other funding priorities. There is no substitute for hard work and dedication to mission accomplishment.”

These public pension reforms and the state’s proactive pension contribution and assumption policies helped OKPERS improve its funding and reduce pension debt at an impressive rate.

In 2010, the system was only about 66% funded. But, a combination of actuarial assumption adjustments, legislative funding, and benefit changes dramatically improved the financial solvency of OKPERS in the last decade, and the most recent actuarial reporting shows the system reached full funding in 2022 and is now estimated to have more than 100% of the funds needed to pay for promised pension benefits.

Figure 1. Oklahoma PERS Unfunded Liabilities (2001 -2023)

Source: Pension Integrity Project analysis of OKPERS actuarial valuation reports and comprehensive annual financial reports.

How did Oklahoma move from 66% funding in 2010 to full funding in 2023 when many other public pension plans struggled to improve their solvency over that period?

The keys to Oklahoma’s success include:

• Eliminating the automatic cost-of-living adjustments in 2011 reduced OKPERS’ pension debt by $1.7 billion in a single year.
• Maintaining a 16.5% statutory employer contribution rate on total OKPERS and DC Pathfinder covered payroll, which exceeds the actuarially determined employer contribution rate of 13.41% (a surplus contribution of 3.09% of pay in the 2020 actuarial valuation). This provides a funding cushion against future actuarial negative experiences. This cushion set the stage for the system to make real progress on eliminating pension debt by $443 million between 2006 and 2023.
• Continuing the 20-year closed amortization period methodology adopted in 2007 (which pays off unfunded liabilities more quickly).

The combination of these benefit changes and funding policies resulted in a nearly 100% funding level by 2019 (98.6%), which allowed OKPERS to take on additional de-risking measures. OKPERS reduced the investment return assumption (ARR) from 7.25% to 7.00% in 2017, and from 7.0% to 6.5% in 2020. The reduction to 6.5% increased reported unfunded liabilities by about $545 million and reduced the funded status from 98.6% to 93.6% in 2020. However, OKPERS significantly reduced the risks of unexpected growth in unfunded liabilities in the future by lowering its assumed rate of return.

The chart below provides a breakdown of the changes in unfunded pension liabilities by major category for the 2006-2023 period. The red bars indicate an increase in pension debt while the green bars indicate a reduction in liability.

Figure 2. Cause of OKPERS Pension Debt (2006-2023)

Source: Pension Integrity Project analysis of OKPERS actuarial valuation reports and comprehensive annual financial reports.

The Oklahoma “Pathfinder” Defined Contribution Plan

The design of the new Pathfinder defined contribution plan for new hires launched in 2015 received substantial consideration and debate by Oklahoma policymakers. Rep. McDaniels noted in the 2014 Reason interview how important it is that public pension plan design balances the needs of employees with sustainable and affordable contribution levels for taxpayers. The predictability of costs associated with the Pathfinder was also an important factor supporting the state’s ability to maintain his cushion set the stage for the system to make real progress on eliminating pension debt by $443 million between 2006 and 2023 his cushion set the stage for the system to make real progress on eliminating pension debt by $443 million between 2006 and 2023.adequate funding of the legacy defined benefit plan.

While defined contribution (DC) plans have been used as public retirement plans for many decades, not all defined contribution plans meet the definition of an effective retirement plan. Reason Foundation’s Pension Integrity Project has identified a few straightforward plan design principles that, when carefully incorporated into DC plans, serve to create a sound retirement plan that checks all the boxes.

The Oklahoma Pathfinder Plan meets many of these defined contribution retirement plan principles including an adequate total contribution design. It provides a 6% employer contribution, a mandatory 4.5% employee contribution, and an additional employer match of 1% if the employee makes an elective 457(b) deferral of at least 2.5%. The 10.5%-to-14% contribution range meets what the Pension Integrity Project and most other retirement experts consider best practice, which is a 10%-15% total contribution rate.

There are, however, some remaining areas of improvement for Oklahoma’s defined contribution plan that could be considered by the state. Vesting in employer contributions is currently 20% per year with 100% vesting after five years of service. Shorter vesting periods are preferred as a best practice to help preserve retirement savings for shorter-service employees.

Another concern is the plan does not offer any lifetime income solution for participants notwithstanding the authorizing legislation for the Pathfinder plan does allow the the Oklahoma Public Employees Retirement System Board to offer lifetime income solutions to Pathfinder participants. Oklahoma Statutes §74-935.9 provides in relevant part:

“In selecting investment options for participants in the plan, the Board shall give due consideration to offering investment options provided by business entities that provide guaranteed lifetime income in retirement such as annuities, guaranteed investment contracts, or similar products.”

While the statutory directive to the OKPERS Board is not prescriptive, it does indicate legislative intent that retirement income is an important consideration. The OKPERS Board has elected to only offer a participant-directed investment menu of mutual funds with a target-date series. The default investment is a custom-balanced fund. According to the annual financial report, about 91% of assets are in the balanced fund, largely because of this default feature.

The summary of the investment policy statement in the annual financial report for the Oklahoma Pathfinder is wealth accumulation-oriented with no focus on lifetime income as a plan objective. It provides the following purpose statements, which are focused on wealth accumulation:

1. “To provide participants with a prudent menu of investment options to diversify their investment portfolios in order to efficiently achieve reasonable financial goals for retirement.
2. To provide education to participants to help them build portfolios which maximize the probability of achieving their investment goals.”

The Pension Integrity Project recommends the state and the OKPERS Board consider making retirement income a formal objective for the Pathfinder plan with the addition of appropriate lifetime income solutions. Strengthening the current statutory language to provide more direct guidance to the OKPERS Board should also be considered.

Conclusion

The public pension reform efforts in Oklahoma are a success story that can guide other state and local governments as they address their own unfunded public pension plans. Oklahoma’s successful pension reforms can be partially attributed to being tenacious in pursuing sound funding policy for the legacy defined benefit retirement system, along with reforms to manage runaway costs for new members going forward. Such policy improvements preserved the promised retirement benefits for those employees while ensuring a sound retirement plan for future employees.

Also of note, Oklahoma did not view the 2011 and 2014 public pension reforms as one-time efforts, but rather the beginning of a long-term and ongoing process of monitoring changing fiscal circumstances. Oklahoma has remained willing to take additional measures to ensure the resiliency of its public retirement system for the benefit of participating employers, employees, and taxpayers.         

Editor’s note: This post is an update of Crane’s 2021 analysis of Oklahoma’s public pension reforms.

The post How Oklahoma’s public pension reforms led the state employees’ plan to full funding appeared first on Reason Foundation.

This IRS position has never been formalized. The agency has never issued proposed regulations that allow public comment; instead, it has been unilaterally adopted without any chance for public input or debate. It’s time for Congress to step in and force a change to remove at least one of the shackles holding back public pension reform.  

This problem has been recently highlighted in North Carolina, which passed legislation in 2023 to change the retirement plans for the University of North Carolina Health Care System, East Carolina University (ECU) Medical Faculty Practice Plan, and ECU Dental School Clinical Operations. 

North Carolina House Bill 259 provides, among other changes, that employees of these entities hired on or after January 1, 2024, would no longer participate in the state Teachers and State Employees Retirement System, or TSERS, and state retiree health plans. Instead, they would be given the choice of an existing defined contribution Optional Retirement Plan (ORP) or a similar new defined contribution plan. Importantly, existing employees would be given a one-time irrevocable option to stay with TSERS or move to one of the two defined contribution plans.

North Carolina State Treasurer Dale Howell, TSERS, and others have raised several important questions about ensuring the withdrawing institutions continue to pay for existing unfunded pension and retiree health liabilities. These systems should continue to be held accountable for paying for those promises and not shift fiscal responsibility to North Carolina taxpayers.

The controversy over the North Carolina bill does not end with employer withdrawal liability funding issues. Howell and TSERS also pointed out that allowing existing employees the choice to leave TSERS and move to a new defined contribution plan would likely violate long-standing and arcane federal IRS rules that strictly limit how such decisions can be made. Violating these federal compliance rules can seriously affect the Internal Revenue Code-qualified status of the plans involved.  

The IRS restrictions on an employee’s choice of plans have become so firmly entrenched that public employers have almost stopped trying to get a different answer from the U.S. Treasury Department. The result has been the closing of a needed avenue for public employers to make changes required to modernize their plans for existing employees. If the Treasury Department can’t change its views on this issue, Congressional action should be pursued.

Why is the IRS so concerned about employers giving existing employees a choice of new plans? 

The arcane world of 414(h) pickups and 401(k) cash or deferred arrangements.

The IRS’s restrictive views on these kinds of choices are tied up in a gordian knot of rule-making of the provisions governing so-called Internal Revenue Code (IRC) 414(h)(2) pickup arrangements and IRC 401(k) rules governing cash or deferred arrangements.”

Public sector retirement plans are considered tax-qualified under IRC Section 401(a) and often provide for both mandatory (non-elective) employer and employee contributions. Ordinarily, the employee contributions to a 401(a) plan are made on an after-tax basis. IRC Section 414(h)(2) allows public employers (not private sector employers) to pay for or pick up employee contributions. If done properly, the result is that the employee contribution is treated as a pre-tax contribution instead of an after-tax contribution. Nothing in the language of IRC 414(h)(2) says anything about what happens if the employer wants to change the plans in which the employee participates.

The IRS has never issued regulations around the 414(h) pickup provisions of the IRC, with the opportunity for the public to comment and argue for changes. Instead, it elected to unilaterally use revenue rulings and private letter rulings over the years to impose additional conditions on how employer pickup arrangements can occur. In Revenue Ruling 2006-43, the IRS added the additional requirement that an employer pickup arrangement may not allow an employee directly or indirectly to opt out of the pickup or change the pickup amount at any point after becoming first eligible in the plan. Opting out this way would violate IRC Section 401(k) “cash-or-deferred” election rules. These 401(k) rules do not allow qualified 401(a) plans like North Carolina’s Teachers and State Employees Retirement System to let employees make different salary reduction pre-tax contributions that a new plan might require.

Since issuing Revenue Ruling 2006-43, the IRS has repeatedly issued private letter rulings (PLR) to public employers, trying, in various ways, to allow current employees to choose a different plan to participate in with a different contribution rate. In each private letter ruling, the IRS has prohibited the employer from providing current employees the option to move to a plan that better suits their needs unless the picked-up employee contribution amount was the same after the change.

The IRS’ position is unreasonably restrictive and prevents needed public retirement plan modernization.

The IRS has, in effect, taken the position that the 401(k) provisions, which were originally designed to help employees make and change pre-tax contributions on an elective basis at any time, should, instead, be interpreted to prohibit employers from ever offering employees the chance to pick a new plan if it involves any change in the contribution rates under a governmental 414(h) pickup arrangement.

Public employers don’t make big plan design changes very often, and this fact alone should have given the IRS some reason to come to a different position. But it hasn’t. Currently, even if a public employer only makes a plan design change once every 10 or even 20 years, current employees must be locked into their contribution amounts. The result is that public employers are largely precluded from offering new plans with different contribution amounts to current employees. 

The situation in North Carolina is just the latest example. This IRS fixation on making sure that not a dime of an employee’s retirement plan compensation can be exempted from taxation outside of the 401(k) rules is not a required interpretation under current tax law. It is a hyper-technical application of 401(k) plan regulations that could readily be avoided by simply writing specific new regulations for IRC Section 414(h), allowing more permissive approaches. But the IRS has so far refused to do so.

Despite requests to the IRS to take a different position, progress has yet to be made. A National Association of Public Pension Attorneys (NAPPA) report noted that federal legislation may be needed to force some relaxation to allow employers and employees the chance to make needed changes for current employees. The report further notes that there “may be more going on behind the scenes at the IRS with regard to further restrictions on employee elections among plans or tiers of benefits.”

If Treasury won’t make changes, Congress needs to order the IRS to make reforms.

This author’s experience and suggestion is that public employee unions, which oppose most pension reforms, may be influencing the U.S. Treasury’s position in this matter. Congress needs to step in and order the IRS to issue new IRC 414(h) regulations or amend IRC Section 414(h) itself to allow more latitude for public employers to make changes for current employees because the U.S. Treasury Department appears unwilling to do so. There is no good public policy reason why only new hires can benefit from retirement plan modernization. 

The post Congress should remove IRS rules restricting public pension reforms for current employees appeared first on Reason Foundation.

In Governing, Miller argues:

America needs a better system of “longevity insurance” whereby private-sector 401(k) and IRA savers can convert some of their nest eggs into annuities, providing guaranteed lifetime income with an earnings rate at least a little better than what insurance companies typically offer. There could be an important role for public pension systems in making that happen…

If your expectation is that the private sector will figure this all out and that competition will drive the economics for retirees so favorably that they can all get a maximum return on their annuity investments, then you will see no need whatsoever for a public-sector alternative. But if you harbor the average American’s distrust of insurance companies, then you might want to get behind the idea of a competitive yardstick to be provided by public pensions. The idea here is not to replace the insurance and annuity industries, just to keep them honest and price competitive.

This idea attempts to remove perceived impediments to using lifetime income products for private individuals in this country. However well-intentioned, the proposal would create new, complex, government-run enterprises in each state that would do little to improve retirement security for individuals.

Miller rightly points out that our country’s solutions supporting financial security in retirement are not working for too many people–particularly in the private sector. He notes the reality of poor retirement plan participation and savings rates, the relative absence of lifetime income products for 401(k) plans and IRAs, and the absence of retirement medical savings strategies for most private sector employees. If this situation is not fixed, there is a substantial risk that many workers will become elder-care welfare recipients, adding to the fiscal burdens of governments. 

By contrast, the piece notes that most state and local government employees receive defined benefit pension plans, which provide lifetime annuity income. Miller further acknowledges that retirement plans for educators, primarily in higher education and health care workers covered by 403(b) plans historically have long included lifetime income features through annuities issued by private sector insurance companies. The emergence of new retirement longevity insurance products, such as qualified life annuity contracts (QLACs) that provide income protection only if a person lives longer than age 85, is noted favorably.

Miller also argues that private-sector insurance companies cannot be relied on to solve this retirement income security problem for private-sector employees. The piece posits that many private sector workers elect not to use their retirement savings to buy lifetime income products because of a lack of trust in insurance companies and the cost of those products. Based on this theory, the proposed solution is to create an honest and price-competitive standard bearer deemed more trustworthy with lower costs. And in Miller’s piece, the candidate should be a public pension plan run by state governments.

But are the distrust and high annuity purchase pricing truly the core reasons for the low use of private sector insurance company annuity solutions?

Maybe this is true for individuals deciding whether to buy an individual retail annuity product. However, distrust does not explain why private-sector employers and their consultants often do not use group annuity solutions in their employer-based plans. 

Miller acknowledges the success of group annuity solutions in retirement plans when he notes that the traditional 403(b) plan market does not have these trust problems and offers price-competitive group lifetime income solutions. 

The main barriers to retirement income security in this country are actually more about poor retirement plan design than expensive annuity products and distrust of insurance companies. A great deal more could be accomplished if policymakers encouraged employers to offer good lifetime income-focused plan designs in the first place, similar to the higher education market, rather than adding another layer of government-run complexity. 

Even past the high hurdle of creating another government-run enterprise, a myriad of structural, regulatory, and public policy issues need to be examined before accepting the proposition that public pension plans should enter the private-sector lifetime-income product arena. Miller’s Governing piece touches on some. The government-run annuity enterprise would need to have a separate common trust account to manage the assets supporting the annuity products. This is critical because pension systems are fiduciary bodies and must legally keep their main business of providing pension benefits separate from this new private annuity enterprise. The new enterprise would, in effect, need to be run apart from and unsubsidized by the pension system.

Miller says he doesn’t “expect this idea to see the light of day anytime soon.” But it’s worth discussing the proposal, which is based on the premise that costs would be lower, assuming the new publicly owned and managed insurance company has no profit motive and somehow can be operated more efficiently. But will this be likely? In most cases, probably not.

Miller’s proposal would have each state creating its own new annuity trust company, which means it will not have the economies of scale to realize cost savings. Running this new government annuity trust company would not be the same as running the state pension plan. It would involve a great deal of added complexity and cost just to comply with state insurance regulatory requirements. Public pension administrative systems are not designed to handle these regulatory complexities.

The proposed new publicly-owned annuity trust could also run into financial difficulties if not managed properly–just like any other private sector insurance company. Miller argues that “who backstops any actuarial shortfalls” needs to be decided, but that backing might be less costly than letting elder-care welfare costs soar.  

The implication is that state governments and the public treasury should back this annuity enterprise managed by public pension systems. The troublesome reality is that there is no particular reason to think that the administrative bodies of public pension systems and the lawmakers overseeing these plans would be up to the task, given their track record of underfunded benefits and public pension debt. Under the oversight of state governments, unfunded pension liabilities of 118 state pension systems have exploded to an estimated $1.3 trillion by 2023. This does not inspire confidence in the government’s ability to manage additional retirement-related funds properly. 

The proposed new public annuity trust fund would be best set up to stand on its own two feet without recourse to the public taxpayer and should be subject to all the same regulatory, solvency, risk capital requirements, and state-required guaranty association membership rules as any private sector insurance company.

The idea of leveraging state public pension systems to provide lifetime annuity products to private sector individuals is interesting to explore because of the need to help protect people from outliving their retirement assets. Miller’s proposal, however, addresses only the longevity risk part of the retirement savings and security problems that too many are facing.

There are existing cost-efficient market-based annuity solutions that work but have not been widely adopted by employers. Reason Foundation’s Pension Integrity Project has proposed a retirement structure for public employees, the Personal Retirement Optimization Plan, or PRO Plan, that uses tested annuity strategies to address longevity risks, and similar options are available to the private sector.

Appropriately designed retirement plans that focus on the full range of retirement security issues: automatic participation, adequate savings levels, portability of benefits, managed investments, and prominently featured lifetime income solutions would do far more to solve retirement security issues than adding another layer of government with questionable results.

The post Public pension plans should not get into the private retirement annuity business appeared first on Reason Foundation.

As proposed, the measures effectively offer bonus payments rather than true inflation protections for retired public workers. The following analysis reviews how the three measures stand up next to the Reason Foundation Pension Integrity Project’s Best Practices for Cost-of-Living Adjustment (COLA) Designs in Public Pension Systems while also providing insight into how Pennsylvania policymakers can truly address long-term inflation for retired, active, and future public employees. 

Why is the Pennsylvania COLA such a challenge?

To first understand how lawmakers found themselves in their current situation, let’s look at the most prominent claim in support of the three COLA bills being actively considered: House Bill 1415 (HB 1415), House Bill 1416 (HB 1416), and Senate Bill 864 (SB 864). Most of Pennsylvania’s public retirees have not received a cost-of-living adjustment in nearly two decades.

Members of the Pennsylvania State Employees Retirement System, or SERS, last received a benefit adjustment of anywhere between 2.27% and 25% in 2002, while members of the Public School Employees’ Retirement System, PSERS, saw similar adjustments in 2004. During the summer hearings of HB 1415 and HB 1416, legislators from across the political spectrum voiced real concerns about the average public retiree’s ability to navigate these times of historic inflation. 

SERS and PSERS offer guaranteed fixed pension benefits for life but not a cost-of-living adjustment, which is not abnormal among public pension systems.

PSERS administrators said, “COLAs are not a guaranteed part of your PSERS pension benefit. [Members] are guaranteed a pension benefit based on a formula outlined in the Retirement Code that does not include an automatic COLA.”

This benefit was not a part of the agreement made with the state’s public workers, and no funding has been saved to pay for it. Therefore, the Pennsylvania legislature would have to use taxpayer money to pay for it ad hoc. 

Adding more unplanned retirement benefit adjustments like this adds more liabilities and risks unexpected cost increases to already underfunded pension systems. Since the legislature issued the last COLA, SERS has gone from fully funded to 62% funded, and PSERS has moved from 96% funded down to 68% funded. In 2017, the legislature implemented significant pension reforms that included a commission to examine fees paid to asset managers and lower assumed rates of return, which is crucial for long-term financial stability.

Employees and taxpayers also benefited from lawmakers opening two new pension tiers to prevent future generations from bearing the burden of rising public pension debt. With the ongoing challenges in paying for the base pension benefits of these systems, the legislature has rejected previous calls for cost-of-living adjustments.

What do Pennsylvania’s recent COLA bills propose?

Pennsylvania Senate Bill 864, House Bill 1415, and HB 1416 would all provide an ad hoc cost-of-living adjustment. The amount of the supplemental annuity varies by the retirees’ retirement date. HB 1415 would provide increases starting at 10% for those retiring in the 2000-2001 fiscal year (FY) and increasing by .5% for each previous year of retirement, with a maximum increase of 20% for those retiring before FY 1982. HB 1416 and SB 864 are designed similarly, with increases starting at 15% and increasing to 24.5%. 

All three measures add to the estimated unfunded actuarial accrued liability (UAAL) and generate a cost that must be paid through increased employer contributions on a level dollar basis over a 10-year period beginning July 1, 2024. Senate Bill 864 differs from the House bills in that it applies only to PSERS retirees. 

The Pennsylvania Independent Fiscal Office published an actuarial impact note for each of the two House bills with the following findings:

House Bill 1415:

• For SERS, unfunded actuarial liabilities would increase by $265.3 million and decrease the current funded ratio by .33%, from 69.35% to 69.02%. The employer contribution rate would increase by .53%, from 34.12% to 34.65% of covered payroll.
• For PSERS, unfunded actuarial liabilities would increase by $583.6 million and decrease the funded ratio by .31%, from 63.18% to 62.87%. The employer contribution rate would increase by .58%, from 34.73% to 35.30% of covered payroll.

HB 1416:

• For SERS, unfunded actuarial liabilities would increase by $371.0 million and decrease the current funded ratio by .46%, from 69.35% to 68.89%. The employer contribution rate would increase by .74%, from 34.12% to 34.86% of covered payroll.
• For PSERS, unfunded actuarial liabilities would increase by $821.1 million and decrease the funded ratio by .44%, from 63.18% to 62.74%. The employer contribution rate would increase by .81%, from 34.73% to 35.54% of covered payroll.

The actuarial fiscal note included statements that the legislature should exercise caution before increasing benefits under the two bills, given the current funded ratios of the two systems, particularly with regard to recent challenges with investment returns. The bills could put the public pension systems in a negative cash flow position, and certain classes of PSERS employees have “shared-risk” contributions that could be impacted.

An actuarial impact note on SB 864 has not been released as of the date of this analysis. Additionally, the legislative memoranda describing HB 1416 includes a statement from the sponsor that another bill will be introduced to provide an automatic recurring COLA based on the Consumer Price Index for All Urban Consumers (CPI-U) for PSERS and SERS starting in 2024 and every three years after that. The Pension Integrity Project has not yet reviewed this companion COLA legislation.

How do Pennsylvania’s proposed bills stack up to best practices in COLA design?

When ad hoc COLA benefits are issued irregularly or sporadically, stories of retirees suffering in times of inflation create an urgency to act. However, determining the best course of action can be challenging, often leading to expediency as the deciding factor. By reviewing Pennsylvania’s current cost-of-living adjustment effort through the Gold Standard in Pension System Design framework, policymakers and stakeholders can gain a clearer view of the value presented by the current COLA measures.

Best Practice: Participants Receive Continuous COLA Benefit Education

Retirees should have a firm understanding of their pension plan’s COLA benefits to better manage their retirement assets and income most effectively. The ad hoc nature of the proposed PSERS and SERS cost-of-living adjustment benefits is inconsistent with predictable inflation protection expectations and leaves retirees with no long-term assurances to examine or learn about. The bills do not meet best practices in this area.

Best Practice: Adjustments Are Pre-Funded as Part of a Retirement Plan’s Normal Cost

Pre-funding COLA benefits ensures the consistent delivery of inflation protection to retirees and avoids transferring unfunded liabilities to future generations of taxpayers. The proposed bills do not meet gold standards in this category. While the General Assembly has ultimate discretion to award COLA increases under the current ad hoc approach, the resulting cost creates new unfunded actuarial liabilities that must be amortized over future years. All three of the proposed measures require the resulting unfunded actuarial accrued liability (UAAL) to be paid for by increased employer contributions, amortizing the UAAL on a level dollar basis over a 10-year period beginning July 1, 2024.

A better approach is to pre-fund COLA benefits in the normal cost component of the systems’ actuarial funding methods, and this should occur for at least one full year before a COLA is allowed to be granted to ensure that COLA benefits are fully prefunded.

Best Practice: COLA Benefit Objectives Are Clearly Defined

Public pension plan sponsors that integrate a formal COLA benefit policy into the overall objectives of a retirement plan provide retirees with clarity, set transparent expectations, and guide future policymakers facing changing circumstances.

Pennsylvania statutes governing PSERS and SERS do not include a formal statement of purpose or objectives for providing COLA benefits. The Pennsylvania General Assembly, however, has provided ad hoc supplemental annuities in the past. No COLA benefit has been provided since a supplemental increase was awarded to certain retirees retiring in FY 2001 and before. The absence of a formal statement regarding COLA benefits for PSERS and SERS contributes to the past and current practice of making such awards only on an ad hoc and unpredictable basis.

Best Practice: COLA Benefit Eligibility, Amount, and Procedures Are Transparent

Clearly specifying eligibility, applicable benefits, and payment dates protects the value of benefits while avoiding costly and arbitrary cost increases. The current and prior attempts to issue an ad hoc COLA benefit clearly identify eligibility and amount of the COLA awards. 

Best Practice: Objective Inflation Benchmarks Determine COLA Benefit Amount

Cost-of-living adjustments should reflect an objective inflation benchmark to provide a more predictable amount of inflation protection and equitable distribution of benefits for similarly situated retirees. The ad hoc approach to providing COLA benefits for PSERS and SERS does not reflect adherence to an objective inflation benchmark as the basis for determining the amounts provided.

Each historical supplemental annuity and the current amounts under consideration are disconnected from inflation benchmarks. There is no policy statement clarifying the basis upon which amounts are being set. Policymakers in the General Assembly are left to make these important benefit-increase decisions without consistent underlying measurements, data, or goals.

Best Practice: COLA Benefits Adjust Under a Ceiling   

For best practices, limiting COLA benefits distinguishes between normal inflation and periods of high inflation that are more difficult to predict, providing for more sustainable COLA funding approaches.

Using an ad hoc approach to providing COLA benefits provides some control over funding impacts on PSERS and SERS. However, no limit is established as a matter of benefit policy under any of the proposed measures, save for the maximum increase amount set on the ad hoc increase itself. This creates the possibility of increases being made in an amount or when such increases are not affordable.

Bottom Line

None of the three Pennsylvania bills—SB 864, HB 1415, and HB 1416—establishes a cost-of-living adjustment that aligns with best practices.

The historical ad hoc nature of COLA benefits for PSERS and SERS does allow the General Assembly discretion to make or not make such awards as it deems appropriate. However, the result would be another level of unfunded liabilities that must be paid for. 

If the General Assembly makes a policy judgment to move forward with these bills, a better approach would be to fund the cost immediately rather than pay for it over time with money from future taxpayers. Further, to break the cycle of continuing down this same road for future retirees, consideration should be given to establishing a policy that either supports or rejects a regular COLA benefit that is automatic and recurring, pre-funded, and also subject to change if necessary. 

While the intentions behind the SB 864, HB 1415, and HB 1416 supplemental annuity increases are understandable, and it is desirable to protect retirement income security for retired public employees, the current poor funding condition of PSERS (68% funded) and SERS (62% funded) should give lawmakers pause in taking these actions without first evaluating how the costs of these supplemental benefits fits within the core retirement benefit and other funding priorities for Pennsylvania.

Does Pennsylvania’s House Bill 1416 Meet Cost-of-Living Adjustment Design Gold Standards?

The post Pennsylvania’s proposed pension bills don’t meet best practices for cost-of-living adjustments appeared first on Reason Foundation.

In North Dakota, for example, only 33% of employees beginning service at age 22 still participate in the pension plan at age 27. Employees leaving before the five-year vesting requirement keep only their contributions, lose the employer contributions, and receive no pension benefits. In other words, two-thirds of newly hired North Dakota public employees will receive little or no retirement benefits from their North Dakota public employment once they reach the end of their working careers. 

Employee Retention: North Dakota Public Employees Retirement System

Data provided by North Dakota Public Employees Retirement System actuarial reports and compiled by the Pension Integrity Project at Reason Foundation.

The data for public workers looks similar in other states. According to Reason Foundation’s analysis of public reports, the Montana Public Employees Retirement System expects only 30% of employees hired at age 22 to still participate in the system at age 27. 

Another example is the school division of the Colorado Public Employees Retirement Association (PERA), where a Pension Integrity Project analysis in 2018 showed that only 37% of Colorado teachers hired at age 25 remain in the system after five years of service.

The reality that state and local government employees have become a more mobile group—frequently switching between several employers during a working career—has been known for years.  This pattern is consistent with the broader U.S. employment marketplace, and job mobility is only increasing within the modern workforce. Current employment trends, like working from home, add to this mobility.  

So, very few of today’s younger public employees will see a meaningful benefit from participating in a state or local government pension plan. Similar participation patterns in public pension plans throughout careers (i.e., moving from covered employment to non-covered employment or another shorter stay in a different public defined benefit plan) will leave an employee in desperate straits come retirement. Retiring with inadequate savings or benefits from public pension participation will place an even greater burden on personal savings and Social Security. Since many state and local employees do not participate in Social Security, the burden may fall on other publicly funded social service programs. 

Given this reality, why do public employee retirement systems, the unions representing state and local government employees, and the organizations that carry their messages continue to advocate for these traditional defined benefit pensions and shun other retirement plan design options? Isn’t it their responsibility to seek solutions that provide adequate retirement benefits (based on the employee’s employment tenure at that employer) to the most employees possible, and shouldn’t it be their objective to secure good post-employment income for all new hires, not just the ones who stay in jobs for decades? 

One oft-cited reason these groups give is not a defense of the DB plans but rather a condemnation of defined contribution (DC) plans. They posit pension reform efforts as a binary choice between traditional pensions and 401(k)-like defined contribution arrangements. To their point, there are many reasons to oppose using a typical 401(k) design as a core retirement plan. These could include employee-centered risk, lack of focus on income, and inappropriate and expensive investment choices. The 401(k) was designed to supplement a primary retirement plan in the corporate sector, not to be the entire retirement plan. 

A recent National Education Association article promotes some of these points perfectly, but it does not mention that few employees in a defined benefit pension system will stay long enough to see a meaningful retirement benefit. The article also fails to make the distinction that most defined contribution plans for public workers, while often described to be 401(k)-like, are not exactly like 401(k)s and usually do not suffer from the same shortcomings with savings and investment guidance. One novel approach introduced by the Pension Integrity Project is the Personal Retirement Optimization (PRO) Plan, which focuses on meeting individual participant needs while focusing on guaranteed lifetime income.

What public employee advocates often overlook is that there is no reason to frame public retirement plans into a binary framework. Plan designs other than traditional DB pensions or the typical 401(k) DC are available, and some can fit a government’s unique retirement plan needs. Plan sponsors should frame their decisions on what plan design provides the best risk-managed benefit to the broadest number of employees, irrespective of their tenure with that employer. The plan design should also aid the employer in meeting workplace goals. Perhaps the most important is recruiting and retaining quality employees from the marketplace. The plan that positively benefits the most employees is most assuredly the plan that will best meet employer needs as well. 

Promoting traditional pensions as the only appropriate retirement system for state and local government employees by unions, plan sponsors, and associated groups may stem from a need for more awareness about how other retirement plan options could benefit so many workers. When considering these crucial pension policy implications, lawmakers and policymakers should focus on long-term financial security for the broadest cohort of public employees. Fortunately, several excellent solutions are available today that would not leave today’s new hires with inadequate retirement savings when they reach that stage.

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This analysis uses the standards set in Reason Foundation’s Defined Contribution Plans: Best Practices in Design and Utilization to review the Ohio Public Employee Retirement System’s Member Directed Plan’s major design features and efficacy for employees’ retirement. Overall, Reason Foundation’s evaluation determines that the Ohio Public Employee Retirement System Member Directed Plan meets several best practices but needs improvement in other key areas, as described below.

Summary of the Ohio PERS Member Directed Plan

The Ohio PERS Member Directed Plan (MDP) is one of two retirement plan options currently offered to non-law/non-public safety eligible employees.

New employees can choose between the standard defined benefit pension Traditional Plan or the defined contribution Member Directed Plan. The choice must be made within 180 days of covered employment. If no election is made, the default plan is the defined benefit (DB) plan. Members may change their plan election once during their career, but the change is irrevocable. The Ohio PERS website indicates only about 3% of members have elected to participate in the MDP.

The Member Directed Plan is a participant-directed IRC Section 401(a) money purchase defined contribution plan. Employers contribute 14%, and members contribute 10.0% of their annual salary for a total 24.09% gross contribution rate. Of the 14% employer contribution, 7.5% is credited to the member’s MDP retirement account, 4% is credited to the Retiree Medical Account, .26% is allocated for administrative costs, and 2.24% is allocated back to the DB plan as a “mitigating rate” payment to reduce the unfunded liabilities of the Traditional Plan. 

The vesting schedule for new MDP members is 20% per year, with full vesting after five years. Employees who leave before achieving full vesting can take their contributions with them (with interest applied) but lose the unvested portion of the contributions made by their employer.

Importantly, Ohio PERS members do not participate in the federal Social Security program. This means the defined contribution plan (combined with personal savings) must provide enough to meet post-employment goals.

Best Practice Analysis of the Ohio Public Employee Retirement System’s Defined Contribution Plan

Definition of Plan Benefit Objectives

The objectives of the Ohio PERS DC plan are addressed partially in Ohio Revised Code Section 145.81- 145.99, which authorizes the Ohio PERS retirement board to create and administer the MDP program. Ohio Revised Code Section 145.81 allows but does not mandate the board to include a range of potential investment and benefit products, including life insurance, annuities, variable annuities, regulated investment trusts, pooled investment funds, and other investment forms. The authorizing statutes do not appear to provide any additional statement of plan objectives or purpose to guide the Ohio PERS retirement board in designing the MDP.

The Ohio Public Employee Retirement System retirement board has indicated on the PERS website that its mission is: “To provide secure retirement benefits for our members.”

The MDP plan document contains no formal benefits policy or objectives statement. 

However, the MDP’s current design reflects the board’s implied intent to provide members with various investment options and strategies and a significant emphasis on lifetime income options, as further described in this analysis.

Ohio PERS MDP Partially Meets Best Plan Objectives Best Practices

The Ohio PERS MDP partially meets the best practice standard that clear statements be made articulating the benefit objectives and purposes for the plan regarding retirement security and employee recruitment and retention. While retirement benefit security is indirectly addressed in the authorizing statutes, board policies, and the program design, there is no formal and clear statement that the MDP is intended to deliver lifetime retirement income to members and beneficiaries.  

Communication and Education

Ohio PERS provides thorough education and communication to eligible employees to help them choose their initial plan. They do this through benefit comparison charts between the plan options and benefit projection scenario calculators. Communication and education services include web-based resources, brochures, videos, summary plan descriptions (SPDs), group seminars and meetings, individualized counseling, and guidance offerings.  

The initial Traditional Pension vs. Member Directed Plan choice materials on the PERS website are primarily self-serve. New employees must review the PERS benefit projection modeling tools using their situations and potential future work paths. It is unlikely that some workers will be willing and able to effectively consider which plan is most likely to be best for them. 

The plan choice modeling tools are only accessible on the member-only PERS website. PERS webinar material, however, does indicate the modeling tools allow a member to construct a side-by-side comparison of projected lifetime income from each under different salary, retirement age, and investment gain scenarios. A separate comparison tool is provided for members who do not expect to stay an entire career and expect only a payment of the Traditional Plan refund amount or the MDP account value.  

The benefit plan comparison charts clearly outline what is provided and what is not under each plan choice and address the different retiree healthcare and disability benefits that exist under each choice.

DCP participants can access online and call center services to assist with managing their retirement, investments, and distribution planning.

Meets Best Practices for Education and Communication

The Ohio PERS MDP provides comprehensive participant education and communication materials and services covering all aspects of initial plan choice, accumulation period tracking and planning, investment management, and distributions during retirement.  

Note: The extremely low 3% selection rate of the Member Directed Plan raises concerns that members may not fully avail themselves of the plan selection resources. Generally, a higher percentage of younger and shorter-service employees would be expected to earn a higher total benefit under the defined contribution plan than the Traditional Plan. Thus, consideration should be given to automatically offering base-level working-career scenario projections instead of only on a self-serve basis.

Automatic Enrollment

New employees are automatically enrolled in the Ohio PERS program with a 180-day window to choose the Traditional Plan or Member Directed Plan. The Traditional Plan is the default for those who do not otherwise make the MDP selection. Those who choose the MDP have mandatory employee and employer contributions directed into an age-appropriate target date fund with the option for the employee to elect a variety of other investment approaches. 

Does Not Meet Best Practices on Enrollment

Requiring all new members to enroll in either of the two retirement offerings is consistent with best practices, but having the pension option as the default—the automatic choice for those who do not make an active choice within the required timeframe—nudges most new hires into a plan that does not best fit their needs. As it would better suit the mobile nature of the modern workforce, the DC plan should be the default for new hires.

Contribution Adequacy

Ohio PERS Member Directed Plan participants have a gross employer contribution of 14% of pay and a member contribution of 10% of pay. However, only 7.5% of the employer contribution is credited to the MDB investment account. 4% is allocated to the Retirement Medical Account, and the rest is allocated to administrative expenses or the “mitigating” amount to help pay off unfunded liabilities in the Traditional Plan. Because Ohio PERS members do not participate in Social Security, the total contribution rate of 17.5% (7.5% employer and 10% employee) is likely inadequate to fund a retirement benefit that would enable a retiree to maintain their standard of living following a career of employment. The 4% Retirement Medical Account (RMA) contribution helps offset this contribution deficit, but it is subject to a stringent vesting schedule of 10% vested per year beginning at six years of service until fully vested after 15 years of service. This vesting schedule effectively means most employees will not receive significant RMA benefits.

Does Not Meet Best Practices for Contributions

The total employer and employee contribution rate of 17.5% specific to retirement benefits (not health or legacy pension related) is below the best practice standard for non-Social Security employees of 18%-to-25% of covered compensation.

Retirement-Specific Portfolio Design

The Member Directed Plan offers participants a choice of a set of standard target date funds (TDF), a group of “standalone funds,” which includes five passively managed funds and one actively managed fund covering the following major investment classes: stable value, fixed income, large-cap equity, mid-cap equity, small-cap equity, and a non-U.S. equity index fund.   

The TDF options are offered in standard five-year age increments. The default investment is an age-appropriate target date fund if the participant does not choose a different investment.

This evaluation could not identify any investment advice or other asset allocation assistance tool for the standalone options. Such may be provided in the member-only part of the OHIO PERS website but was not identified in the publicly available elements of the website.

A Self-Directed Brokerage Account (SDBA) is also available, offering a selection of 5,000 mutual funds. Members must have a $5,000 minimum account balance to invest in the SDBA and may not invest more than 90% of their account balance into this account to ensure the member shares in supporting the administrative expenses of the Member Directed Plan. SDBA offerings are not typically offered in core defined contribution plans due to the higher investment costs with retail-level investment funds and because very few participants are equipped to properly invest their retirement assets to this degree. SDBA offerings are more commonly available in voluntary deferred compensation plans where only employee money is involved.  

The Member Directed Plan offers no accumulation period (deferred) or immediate annuity options.

Partially Meets Best Practices on Portfolio Design

The Member Directed Plan target date funds and standalone investment menus provide an appropriate range of investment choices covering the risk and return spectrum. The TDF offering includes pre-built target date accounts for those who prefer to avoid managing their asset allocation. If not otherwise available, consideration should be given to providing investment advice or guidance for the standalone fund menu. The SDBA is not considered a best practice for a core defined contribution plan.

Portable Benefits

Accumulations attributable to employee contributions are immediately vested. Accumulations attributable to employer contributions are not fully vested for five years. Vesting is on a pro-rated scale, beginning with 20% vested per year until full vesting after five years. The portability feature is strongly emphasized in the employee communication material and contrasted with the more stringent Traditional Pension vesting and refund rules.

Partially Meets Best Practices for Portability

Full and immediate vesting of employer contributions would be preferred to meet the needs of today’s more mobile workforce. The 20% per-year vesting schedule partially meets this best practice standard.

Distribution Options

The MDP makes various distribution options available, including monthly lifetime annuity payments, full refunds, partial lump sums, and combinations of annuity and lump sums. Retirement annuity benefits are generally payable after attaining age 55 with vested benefits. Full refunds are payable at any age after termination of covered employment. The MDP annuities include a cost-of-living adjustment feature based on a Consumer Price Index inflation benchmark.

Meets Best Practices in Distribution

The distribution offerings meet best practices by including standard lump sum and periodic payment options and, importantly, lifetime annuity options. 

Disability Coverage

Member Directed Plan members are not eligible for any disability benefit from Ohio PERS. The Traditional Plan does provide a disability allowance. Under the closed hybrid Combined Plan, a portion of the employer contribution is used to purchase a disability benefit. There is no similar provision under the MDP.

Does Not Meet Best Practices on Disability Coverage

The absence of a disability benefit is an important missing feature protecting participants in the MDP. One option is to allocate a portion of the employer or employee contribution for this purpose in the same manner as exists under the now-closed Combined Plan.

Conclusion

The Ohio Public Employee Retirement System Member Directed Plan, the defined contribution plan available to all newly hired non-public safety workers, meets most of Reason Foundation’s best practice standards for defined contribution plan design, particularly the focus on providing lifetime income solutions. Still, improvements should be considered in some areas, including:

• Higher total retirement account contributions to at least 18% of compensation;
• A default that nudges new hires to the retirement plan that will best serve the majority of entrants; 
• A shorter vesting schedule;
• Automatic benefit comparison and projection scenarios for new employees for making their initial plan choice;
• The standalone fund investment menu should be examined to ensure members are provided asset allocation investment advice and guidance;
• The SDBA offering should be reconsidered as an investment offering for a core DC plan, and
• A portion of the employer or employee contribution should provide a disability benefit for those who choose the MDP. 

For more information and an in-depth scorecard summary, please see Reason Foundation’s evaluation of the Ohio Public Employee Retirement System’s defined contribution plan.

The post Comparing the Ohio PERS defined contribution plan to gold standards appeared first on Reason Foundation.

In this analysis, we’ve used the leading best practices from our 2022 Reason Foundation study, Defined Contribution Plans: Best Practices in Design and Utilization, which outlined a set of design gold standards as a measure of the plan’s effectiveness.

Overall, the Ohio State Teachers Retirement System’s defined contribution retirement plan meets best practices in most areas but needs some improvement in other areas.

Summary of the Ohio STRS DCP

The Ohio State Teachers Retirement System’s (STRS) defined contribution retirement plan (DCP) is one of three retirement plan options provided to teachers hired on or after July 1, 2001. New teachers are provided a choice between the standard defined benefit pension (DB), the defined contribution (DC) retirement plan, or a hybrid defined benefit/defined contribution (combined plan) alternative. The choice must be made within 180 days of covered employment. If no election is made, the default plan is the defined benefit plan. If the defined contribution retirement plan or hybrid DB/DC combined plan is elected, there is a window in the fifth year of coverage to change back to one of the alternative plans. 

The DCP is a participant-directed Internal Revenue Code Section 401(a) money purchase pension defined contribution plan with employer contributions of 11.09% of annual salary and teacher contributions of 14.0% of annual salary for a total 25.09% contribution rate. The vesting schedule is 20% per year, with full vesting after five years. 

Of note, Ohio STRS members do not participate nor contribute to the federal Social Security program.

Best Practices Analysis of Ohio STRS

Definition of Plan Benefit Objectives

The purpose and objectives of the Ohio STRS DCP are addressed partially in Ohio Revised Code Section 3307.81, which directs the Ohio STRS retirement board to create the DCP and allows the board to include in the plan design regulated investment trusts, pooled investment funds, annuities, variable annuities, life insurance, and other forms of investment. The authorizing statutes do not appear to provide any additional statement of plan objectives or purpose to guide the STRS retirement board in the design of the DCP.

The STRS retirement board has issued a set of board policies that state the purpose of the board is to ensure that statutorily defined current and long-term retirement and other benefits services are provided to covered teachers and beneficiaries.

The DCP plan document mirrors the statutory language about the allowed investments the retirement board may make available but does not contain a formal benefit policy objective statement.

Ohio STRS DCP Partially Meets Plan Objectives Best Practices

The Ohio STRS DCP partially meets the best practice standard that clear statements be made articulating the benefit objectives and purposes for the plan regarding retirement security and employee recruitment and retention. While retirement benefit security is indirectly addressed in the authorizing statutes, board policies, and the program design as described in the plan document, there is no formal and clear statement that the DCP is intended to deliver lifetime retirement income to members and beneficiaries. 

Communication and Education

The Ohio State Teachers Retirement System provides various communication and education services available to eligible teachers, covering the essential areas of initial plan choice, benefit comparison charts between the plan options, and benefit projection calculators. Communication and education services include web-based resources, brochures, videos, summary plan descriptions (SPDs), group seminars and meetings, individualized counseling, and other guidance offerings.  

The initial DB/DC/combined plan choice materials on the STRS website are primarily self-serve, and new teachers must go through each plan’s benefit projection modeling tool separately using their scenarios. The plan choice modeling tools allow comparison of projected lifetime income from each, which is the preferred practice. The benefit projection modeling tools are not highlighted in the overview materials or located in a single place that allows easy access. Benefit projection modeling on a side-by-side basis is not provided for easy comparison by new employees. 

The benefit plan comparison charts clearly outline what is provided and what is not under each plan choice. However, the charts do not include the employer and employee contribution rates. These are described separately under each plan option.

DCP participants have access to online and call center services to assist with managing their retirement planning, investments, and distribution planning, including the “My Interactive Retirement Planner” tool provided by the plan recordkeeper.

Meets Best Practices for Education and Communication

The Ohio STRS DCP provides a wide range of participant education and communication materials and services covering all aspects of initial plan choice, accumulation period tracking and planning, investment management, and distributions during retirement. The benefit comparison charts should be modified to include the benefit accrual and contribution structures and amounts. A more robust side-by-side initial plan choice benefit projection tool for different life career paths should be considered.

Automatic Enrollment

New employees are automatically enrolled in the Ohio State Teachers Retirement System with a 180-day window to choose the DB, DCP, or combined plan. Those who do not make a selection default into the defined-benefit pension plan. Those who choose the DCP have mandatory employee and employer contributions directed into an age-appropriate target date fund until the employee makes a positive election.

Does Not Meet Best Practices on Enrollment

Having new members who do not make a plan selection automatically enrolled in the defined benefit plan is not in line with best practices. The defined contribution plan would better suit most new hires and should be the default.

Contribution Adequacy

Given that Ohio STRS teachers do not participate in Social Security, total contribution rates of 25.09% (11.09% employer and 14% employee) are adequate to fund a retirement benefit that should enable a retiree to maintain their standard of living following a career of employment. 

Meets Best Practices for Contributions

The total employer and employee contribution rate of 25.09% meets the best practice standard for non-Social Security employees of between 18%-25% of covered compensation.

Retirement-Specific Portfolio Design

The DCP offers participants a broad array of 17 investment choices covering the spectrum of risk and return asset classes, as well as real estate and target date fund (referred to as “Target Choice”) options. The Target Choice options include five alternative personal risk profile choices ranging from conservative to aggressive. The default investment is an age-appropriate Target Choice fund. A member cannot purchase or invest in annuity options while working, but they can purchase a lifetime annuity option offered by the plan after retirement.

Partially Meets Best Practices on Portfolio Design

The DCP investment menu provides an appropriate range of choices covering a wide risk and return spectrum. It includes pre-built target date accounts for those who prefer to avoid managing their asset allocation. Some improvements could be made by offering accumulation period annuity options. 

Portable Benefits

Accumulations attributable to employee contributions are immediately vested. Accumulations attributable to employer contributions are gradually vested over five years. Vesting of employer contributions is pro-rated, from 20% vested per year until full vesting after five years. The portability feature is strongly emphasized in the employee communication materials.

Partially Meets Best Practices for Portability

Full and immediate vesting of employer contributions would be preferred to meet the needs of today’s more mobile workforce. The 20% per year vesting schedule partially meets this best practice standard.

Distribution Options

The DCP makes various distribution options available, ranging from leaving the assets in the plan to various fixed-period and lifetime annuities. 

Meets Best Practices on Distribution

The distribution offerings meet best practices by including both standard lump sum and periodic payment options and, importantly, lifetime annuity options.

Disability Coverage

The DCP members are not eligible for any disability benefit under STRS. The DB and combined plan options do provide a disability allowance. Under the combined plan, 2% of the participant’s 14% contribution is used to purchase a disability allowance. There is no similar provision under the DCP.

Does Not Meet Best Practices on Disability Coverage

The absence of a disability benefit is an important missing feature protecting participants in the DCP. One option is to allocate 2% of the employee contribution for this purpose in the same manner as exists under the combined plan.

Conclusion

Among public worker retirement systems, the Ohio State Teachers Retirement System is a national leader in flexibility and choice. The ability of each new teacher to choose the retirement structure that works best for them gives STRS a notable advantage in serving a wider variety of preferences and post-employment plans. The Ohio defined contribution plan meets most of Reason Foundation’s best practice standards for defined contribution plan design, particularly the focus on providing lifetime income solutions. 

The Ohio State Teachers Retirement System should consider improvements in some areas, including:

• Providing a shorter vesting schedule;
• More robust benefit comparison and projection scenarios for new employees for making their initial plan choice; and,
• Providing a disability benefit for those who choose the DCP. 

Most notably, Ohio policymakers should consider making the defined contribution plan the default plan for new hires who do not make a selection since this is the most advantageous option for most teachers, who aren’t likely to remain in the system for decades. 

For more information and an in-depth scorecard summary, please see Reason Foundation’s evaluation of the Ohio State Teachers Retirement System’s defined contribution plan.

The post Comparing the Ohio State Teachers Retirement System’s offerings to gold standards in retirement plan design appeared first on Reason Foundation.

This authority is in the very nature and purpose of being the plan sponsor in the first place. A good technical resource describing this authority can be found in the Public Pension Governance Series published by the National Association of State Retirement Administrators (NASRA).

However, the scope of the plan sponsor authority over public pension plans can get confusing when state and local governments take on the complex and often thankless task of reforming the defined benefit pension plans they sponsor. Attempts to change public pension benefits, funding, investment, and governance structures and policies are frequently met with pushback from plan participants, retirees, and, in some cases, even the trustees and system staff administering the pension plan. 

The pushback can take the form of political opposition during the legislative process and, sometimes, in the form of litigation. The outcomes of these processes vary from state to state, leaving plan sponsors often uncertain as to what can be done to move forward with needed public pension reform.

It is necessary to know where the boundaries of permitted change really lie. The reality is that state and local government policymakers have more latitude than many realize, and it is vitally important to resist any encroachment by third parties and stakeholders on the authority of the public pension plan sponsors to design and manage the plan, particularly when changes are necessary in response to changing circumstances to business objectives of the plan sponsor.

The boundaries of pension reform can be best understood by becoming familiar with the basic rules of pension trust creation and administration, particularly the rights and responsibilities of the three major parties involved:

1. The state or local government acts as plan sponsor and “settlor” of the trust holding plan assets;
2. The fiduciary entity is charged with the responsibility of administering the retirement plan and beneficiaries, and
3. The plan participants and beneficiaries. An explanation of these parties and other relevant factors follows.

The Settlor Function 

The legal authority governing how state and local governments can create retirement plans for public employees is primarily found in state constitutions, statutes, and common law. The amount of authority and control can vary somewhat from state to state. But generally, the basic rules for creating pension plans and trusts are not that different.

A state and local government is considered the creator or “settlor” of the public pension plan and trust. Through enabling legislation, the “settlor” sets the initial terms and conditions of the plan and trust and identifies the fiduciary, administration, and investment structures under which the pension plan must be operated.  

While not directly applicable to governmental plans, federal case law under the Employee Retirement Income Security Act of 1974 (ERISA) accepts that “settlor” functions include decisions relating to the establishment and design of plans and the amendment of those plans. Settlor functions are not fiduciary activities.  

The Fiduciary Function 

The settlor sets the fiduciary governance structure in the enabling legislation creating the pension plan and trust. Generally, the settlor designates one or more fiduciaries who are obligated to administer the pension plan and trust consistent with the terms and conditions set by the settlor. The fiduciary entity is usually a board of individual trustees. In most states, the applicable law will require these trustees to conduct their assigned duties for the exclusive benefit of plan participants and beneficiaries but must conform their actions to the terms and conditions of the enabling legislation of the pension trust. The fiduciaries for a plan are not permitted to override the plan sponsor’s directives in the enabling legislation.

The Rights of Plan Participants and Beneficiaries 

The rights of pension plan participants and beneficiaries are determined under state laws applicable to public pension plans. Examples of such provisions include the basic terms of any retirement plan, including eligibility and participation, benefit accrual and vesting provisions, retirement benefit eligibility, and forms of payments. 

Federal Law Implications Are Limited  

The federal Internal Revenue Code (IRC) does require public retirement plans to comply with a few requirements to obtain status as a tax “qualified plan,” including that public pension plan assets be held in trust for the exclusive benefit of plan participants and beneficiaries and maximum benefit limits. Federal law does not otherwise define or regulate the scope of the settlor or fiduciary functions of public retirement plan trusts. None of the minimum participation, vesting, nondiscrimination, or funding rules apply to government plans.

Pension Benefit Reductions

Reductions of pension benefits for current employees and retirees create the most problems for plan sponsors and give rise to the most litigation, given that accrued public pension benefits are almost ubiquitously protected from diminishment by federal and state constitutional provisions related to contracts.

This helps explain why most public pension reform involves prospective benefit design changes for future hires, as described below.

Courts in different jurisdictions have come down on one side of the issue or another to different degrees based on interpretations of federal and state laws on the participant contract or property rights to the earned and accrued pension benefits.

In some states, the contract or property rights of current employees, even for future service, go well beyond what exists for private sector employees under ERISA. A good summary of how the courts have viewed various proposed changes to plan design and funding can be found here, here, and here. The lesson in these cases is to get good legal advice before reducing plan benefits, even for future service, for existing employees and retirees.

Benefit Changes for New Hires 

None of this litigation, however, has ever challenged the right of state and local governments as the plan sponsor and “settlor” to set the terms and conditions for the benefits initially or to make changes for new hires. The plan sponsor is always free to design the retirement plan as it wants to, as long as accrued benefits and (depending on the jurisdiction) the rights to future benefit accruals are not impaired. 

Changes to the Pension Plan’s Fiduciary Structures 

The right of the public pension plan sponsor to alter the fiduciary and governance structure for a plan is also not in question. Again, this is a principal feature of being the settlor of the plan and trust. State or local governments can change the makeup of the fiduciary entity charged with administering the pension plan—typically a board of trustees—at any time.

For instance, Arizona Senate Bill 1428 in 2016 created a new tier of pension benefits for public safety personnel statewide and also included an overhaul of the composition of the governing board designed to enhance its financial expertise and better balance the interests of employers, employees, and taxpayers (see section 11 here).  

Changes to Public Pension Funding Policy 

State and local governments set the pension plan funding mechanism in the enabling legislation. Historically, most governments set the contribution levels directly in the law. More recently, this contribution method has been considered too rigid to ensure the proper funding of the pension plan, and plan sponsors have begun to delegate to the pension board of trustees the responsibility for setting required contribution levels based on some form of actuarially determined amount.

If delegated, the plan sponsor has the unrestricted right to set the parameters over how the board of trustees will determine the required contribution levels, including setting the actuarial funding methods, investment return discount rates, and demographic assumptions. 

The plan sponsor can also change its funding policy for any reason it deems appropriate. For example, if a state and local government determines that the actuarial funding methods and assumptions set by an administrative body (e.g., board of trustees) create unnecessarily high or low contribution levels, it has the right to intervene and direct the use of different assumptions and methods to meet the business needs of the plan sponsor and prudent funding needs for the plan.  

Setting Investment Policy for Public Pension Plan Assets 

Generally, as a settlor, the plan sponsor delegates the pension plan asset investment to a fiduciary/board of trustees. The plan sponsor, however, has the right to set the terms and conditions of that delegation for how the pension plan assets will be invested.

The Uniform Prudent Investor Act, which has been adopted in whole or in part by 43 states and the District of Columbia, follows this line of thinking stated in Section 1. (b): “The prudent investor rule, a default rule, may be expanded, restricted, eliminated, or otherwise altered by the provisions of a trust…”

Absent some other limiting state law (e.g., constitutional), the state or local government has every right to set the funding and risk-taking guardrails that must be followed to meet their business needs. 

Conclusion

State and local governments have wide latitude to change or modify most aspects of their retirement plans’ design, funding, and administration. This authority is inherent in the very nature of the legislative power and in standard trust and fiduciary laws that define the settlor and fiduciary functions.

Public pension plan sponsors seeking to enact needed reforms to the design, funding, investment, and management of their pension plans should always seek the advice of experts before taking any action and, as noted previously, must be mindful of how benefit reductions for current employees are considered. This is just a matter of prudence in matters of importance. But as plan sponsors, state and local governments should not abdicate their policy control over the plans they create. They should zealously guard against encroachments by other stakeholders and plan fiduciaries.

The post Examining the control state and local governments have over public pension plans appeared first on Reason Foundation.

Three ESG advocates recently teamed up to use the Harvard Law School Forum on Corporate Governance to promote their paper “The Liability Trap: Why the ALEC Anti-ESG Bills Create a Legal Quagmire for Fiduciaries Connected with Public Pensions.” However, the report’s authors base their conclusions on an overly broad understanding of the anti-ESG proposals being considered and consequently mischaracterize some of the impacts these policies would have.

The study’s authors, David H. Webber (Boston University), David Berger (Wilson Sonsini Goodrich & Rosati), and Beth Young (Corporate Governance & Sustainable Strategies), critique two American Legislative Exchange Council (ALEC) policy proposals. 

The first is the “State Government Employee Retirement Protection Act,” which, as approved as ALEC model legislation in 2022, would direct government pension plan fiduciaries to consider only pecuniary factors in their investment decisions. These factors must have a material effect on the risk and return of an investment based on appropriate investment time horizons consistent with the pension plan’s investment objectives and funding policy. 

This piece of model legislation excludes non-pecuniary, environmental, social, political, or ideological goals or objectives. It directs fiduciaries that they cannot consider risks or return factors that primarily relate to events that involve a high degree of uncertainty in the distant future and events that are systemic, general, or not investment specific. It also prohibits the voting of shares held by these pension plans to promote non-pecuniary or non-financial goals. 

The second proposal is the “Energy Discrimination Elimination Act,” which was rejected by ALEC as model legislation in Jan. 2023. This proposal would have generally prohibited state and local government agencies and funds from investing in identified financial service companies that boycott either fossil fuel-based energy companies or companies that do not commit or pledge to meet environmental standards beyond applicable federal and state law. Despite its rejection as an ALEC model in January, other organizations are promoting similar policies. 

If Webber, Berger, and Young focused on this “Energy Discrimination Elimination Act” proposed model only, their critique would have more merit. But they often combine and conflate the two bills in arguing the two ALEC draft bills should both be rejected: 

“The boycott bill and the fiduciary duty bill dramatically increase liability risk for plan fiduciaries and service providers without providing any corresponding or even off-setting benefits to fiduciaries or their members. They will reduce the number of service providers willing to work with such pensions, increase liability, insurance, and investment costs for taxpayers, and fund participants and beneficiaries. They should be rejected.”

The principal arguments in support of their position include the following:

• The distinction in the ESG bill between “pecuniary” and “non-pecuniary” is blurry and self-contradictory. 
• Using the concept of “materiality” for determining pecuniary factors conflicts with other securities and U.S. Supreme Court decisions. 
• The boycott bill suffers from similar and self-contradictory requirements.
• The bills effectively transfer proxy voting rights to politicians, ensuring the politicization of such voting rather than restricting it.

According to “The Liability Trap” authors, ESG considerations are good for investing, and the two model policies offered in the draft bills limit investment opportunities and put fiduciaries in jeopardy of breaching their legal obligations. However, instead of providing a separate systematic and objective review of the two very different policy proposals, the authors constantly conflate the two draft bills while ultimately arguing for greater access and use of public pension dollars by private fund managers. Due to their failure to recognize the fundamental differences between the two model bills, many of the points made are relevant to one but not the other, yet they reject both as if they are the same.

The heart of the argument against anti-ESG legislation is that the policies in question “proceed from the erroneous assumption that investors’ consideration of systemic risks … is improper.” By claiming that ESG skeptics ignore basic systemic risks facing investors, some ESG supporters attempt to offer a counter-narrative made to imitate an objective, technical critique without sounding political. 

What policymakers should recognize is that clarifying a public fiduciary’s responsibilities is an attempt to improve fiduciary investment risk management. It reflects the risks associated with the lack of transparency around much of today’s subjective environmental, social, and governance (ESG) goal-setting and reporting, the inaccuracy of many long-term models, the premiums placed on ESG investments by money managers, and a host of other issues that surround many ESG investment products, services, and strategies that are considered by public pension fiduciaries with little to no public oversight. 

Systemic risk is an established concept in investing that the ALEC bills’ proponents would generally recognize as a prudent consideration, but not all ESG factors are universally defined, much less understood universally as systemic risk factors. “The Liability Trap” authors prove this by acknowledging that “the line between governance and ‘environmental, social, or political,’ as well as the definition of governance itself, can shift over time.” Although the authors attempted to highlight a contradiction in the ESG model policy text, they inadvertently stated the obvious. Of course, things change as new information comes in to validate or invalidate criteria for investment risk management.  

The ESG fiduciary policy in the “State Government Employee Retirement Protection Act” does not change that dynamic one bit, but it does make public fiduciaries “show their work” when it comes to investment decisions.

“The Liability Trap” authors argue that the definition of a “pecuniary factor” is too vague to administer because the list of non-pecuniary factors is too long, and the definitions of pecuniary and non-pecuniary do not mirror each other. But there are plenty of legal terms that are asymmetrical. The fact is that the term “pecuniary” is well understood in the public pension and investment world, and the test for fiduciaries is to make sure it is present when acting. If it is not there, they should pause and conduct the necessary due diligence to find it if it exists.

The argument that the securities law definition of materiality is in conflict with that of the “State Government Employee Retirement Protection Act” is simply misleading. Different bodies of law can have different meanings for terms of art. The fiduciary body of law can use materiality in a different way than securities law. They need not and probably should not be identical. It is not problematic that a fiduciary actor requires a different level of materiality than what a company must use when disclosing financial information to shareholders.

Requiring a fiduciary responsible for public dollars to adhere to objective criteria set within a specified time frame and to remain oriented towards achieving the pecuniary goals of the pension trust is the most basic policy plan sponsors can set. That does not mean factors like rising sea levels or prolonged droughts are barred from consideration by public fiduciaries when weighing investment opportunities. If climate change and fossil fuel investments can be demonstrated to have pecuniary effects in the investment time frames specified, then the fiduciary should feel comfortable acting in accordance with those factors. If not, then greater due diligence is needed before acting. 

The argument against the need to show objective due diligence is predicated on the logic that, first, an investment can and should be used to make the world a better place. Second, if the world is a better place, it must have a vaguely measured positive impact on pension risk and return. For these important public funds, more evidence is needed than mere speculation. The use of mere speculation is already prohibited under general fiduciary standards. The model ESG policy is trying to shine a light on something that already should be part of every public pension fiduciary’s playbook.

Being a fiduciary of public funds is not a position to be taken lightly. Being elected or appointed as a trustee puts you at the helm of hundreds of millions, if not tens of billions, worth of taxpayer and pensioner dollars. Any decision to allocate those funds in any way should be held to higher standards than the decisions of those who manage their own funds or the funds of a client with an appetite for risk. 

The ALEC model, “State Government Employee Retirement Protection Act,” ESG fiduciary policy understands the unique and inherent gravity of public pension funds and aligns public policy to ensure decisions are objective and pecuniary as required by the fiduciary “sole interest” standards. However, the authors claim that clarifying public fiduciary policy like this will make it more difficult to make important investment decisions. In “The Liability Trap,” th authors jump from one scenario to another, emphasizing contradictions where there are none and offering hypotheticals to test the logic of the pecuniary standard, but ultimately offer little in the way of evidence for their hindrance claim.

For example, the authors cite Russia’s invasion of Ukraine as a governance risk that would be prohibited from consideration under the proposed fiduciary policy. However, as part of their argument, the authors make the error of describing the internal governance of investment firms instead of the governance structure of a public pension trust. 

So, what would Russian divestment mean for a pension investment fiduciary? The model ESG fiduciary policy only requires that public pension trustees understand what the companies they are investing in are doing. If trustees find out that the company or fund is being managed in a way that doesn’t align with the pecuniary risk and return objectives of the pension trust, then they must divest and look for alternative investments. The investment company or fund, on the other hand, can keep doing what they are doing, but if it cannot justify the quality of its investment offering as supporting the pecuniary interest of the retirement plan, then they run the risk of losing the business. That is as it should be.

According to the “State Government Employee Retirement Protection Act,” mode fiduciary policy, it doesn’t matter what the fiduciary’s subjective intentions are as long as the decision is justified under the pecuniary standard. Public fiduciaries don’t have to ignore a company’s statements, nor are they prohibited from considering any specific type of reporting from a company. The model fiduciary policy frees trustees to continue to do so, and prudence demands that they listen to those sources. But a public fiduciary should not stop there. They must make an objective assessment about whether those non-pecuniary, ESG-based business decisions are valid enough to warrant an investment based on the pecuniary standard. 

With the report’s authors conflating the prohibitions included in the model boycott bill with the limits placed on public trustees and investment managers in the model ESG fiduciary bill, “State Government Employee Retirement Protection Act,” they incorrectly conclude that the fiduciary bill would limit investment opportunities. 

However, the lack of clarity around objective ESG factors leads the report’s authors to argue that constraints on using ESG factors will hinder a fiduciary’s ability to manage long-term risk and return strategies while simultaneously arguing that it also slows them down and prevents them from being nimble for short-term investment management decisions. One could easily interpret the authors’ argument to be that pension fiduciaries must have unfettered discretion to manage the investments of a trust. Without universal standards based on pecuniary factors, how can public pension plan sponsors have confidence that the plan’s very real pecuniary objectives aren’t just strived for but actually met?

A public pension plan sponsor that creates the pension trust has every right to set the rules governing how fiduciaries go about their business. That’s the nature of being a plan sponsor—they get to set the rules under which plan fiduciaries must do their job. It is untenable to argue that once you start a pension plan, you lose complete control and can never ask whether it is being managed properly. 

Having said that, this is one of many red herrings offered by “The Liability Trap’s” authors. The fiduciary policy in question does not require freezing investment approaches in place. It simply requires justification for the discretionary management decisions being made and proof that they stay within the set of fiduciary boundaries.  

In the end, the report’s authors mistakenly see the two ALEC drafts, the boycott bill, and the fiduciary bill, as one entity with identical implementation and impact. Their belief is that value isn’t always pecuniary, but this perspective leaves far too much opportunity to insert controversial political or social considerations into investment decisions. They use qualitative examples to argue against adding a pecuniary limit and, in doing so, imply that those examples couldn’t exist in the free market under the fiduciary bill. By extending the timeframes for potential returns or finding ways to expand the scope and magnitude of an issue, anything can be considered an ESG investment. The authors insinuate that public pension trustees, for example, should be free to do whatever they feel is right when it comes to managing public funds, despite the potential negative outcomes of those actions being fully borne by retirees, active members, and taxpayers. In doing so, they exhibit a fundamental misunderstanding of the relationship between governments and their public pension trust.

As the investment world continues to see new products, services, and philosophies directed at influencing policy, public pension system trustees and their government sponsors would do well to seek out ways to increase the prospect of investment returns to fund promised pension benefits, not try to solve society’s problems. The State Government Employee Retirement Protection Act would be a great first step in that direction for any state and shouldn’t be lumped together with other proposals.

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According to a Senate committee’s summary of the legislative history of the Setting Every Community Up for Retirement Enhancement (SECURE) Act 2.0, the rationale for this change is:

“One of the main reasons many Americans reach retirement age with little or no savings is that too few workers are offered an opportunity to save for retirement through their employers. However, even for those employees who are offered a retirement plan at work, many do not participate.”

There is data to back up this concern. The Bureau of Labor Statistics (BLS) reported in 2022 that 69% of private industry workers had access to retirement benefits through their employer, and of those with access, only 52% chose to participate.

Retirement benefits access, participation, and take-up rates. March 2022

Source: U.S. Bureau of Labor Statistics

This adjustment in federal retirement benefits policy, however, is not likely to materially change the participation rates for a large number of individuals in this country because it only applies to new plans established after 2022 and because employers are still not required to offer a retirement savings plan in the first place and SECURE 2.0 will not likely change that.

The SECURE ACT 2.0 requires auto-enrollment and auto-contribution increase features for new plans. This policy attempts to address the problem that the purely voluntary retirement savings approach to one of the legs of the proverbial three-legged stool of retirement security—Social Security, employer retirement plans, and personal savings—isn’t working for many Americans.

The solutions adopted in SECURE 2.0, and over the years by Congress, rely heavily on the ‘libertarian paternalism’ philosophy that individuals should not be forced into retirement savings plans but should instead be ‘nudged’ into participation by using auto-enrollment and auto-increase features with the ability to opt-out. This nudge approach steers individuals into retirement participation but preserves their freedom of choice to not participate.

But will this approach work?

One way to try and answer the question is to look at the previous BLS chart more closely. Interestingly, the BLS data show a marked difference between the retirement plan participation rates for private sector and public sector employees, with over 80% of state and local government employees taking advantage of their retirement plan vs. just over 50% for private sector employees. Why the difference?

A significant reason for the difference is that for long-standing public policy reasons, participation in core retirement plans of state and local governments has been mandatory—not voluntary. State and local governments have made retirement plan participation a firm part of their total compensation and benefits policies. Public employees, generally, must participate and may not opt-out. 

Special federal tax code provisions have even been adopted to support this approach. An important one is the Internal Revenue Code Section 414(h)(2) pick-up arrangement, which allows mandatory salary reduction pre-tax employee contributions. This simple difference in tax code rules around how employee contributions can be made pre-tax is one important reason the public sector retirement plan participation rates are significantly better than the private sector. Under current tax law, private-sector employers cannot use the same mandatory pre-tax employee contribution.

This fundamental difference in retirement plan coverage and participation policies between the private and public sectors must be examined more closely. As noted, a voluntary-based approach to the private sector employer-based retirement plan system does not and will not approach the results of what happens for employees of state and local governments—even with increased nudges as imposed by SECURE 2.0.

Should the federal government stretch the boundaries of its voluntary employer-based retirement system to allow employer and employee mandates like state and local governments? Or, is this a step too far and an unwarranted intrusion on the choices of individuals? The consequences are substantial on individuals and society in general. One thing is certain—SECURE 2.0 isn’t going to be the final answer.

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In the piece, Siedle mentions that “flawed 401(k) defined contribution plans” could not produce adequate retirement results. This is based on a poor understanding of what a defined contribution (DC) plan can accomplish, and it is not the case in Alaska. In the corporate world, 401(k) plans were originally intended to be tax-deferred savings plans designed only to supplement existing defined benefit pensions. But when the private sector largely moved away from defined benefit pension plans because of funding risks and a changing workforce, they often replaced them with broader 401(k)-style defined contribution plans that were intended to replace the level of benefits being offered previously.  

Unfortunately, the retirement income focus of the defined benefit pension designs was typically not carried forward in these new 401(k) plans, with wealth accumulation being the default focus. Siedle rightly identifies this as a fault. The typical 401(k) plan does not have the income-focused design necessary to be a true retirement plan. Make no mistake—this is not a fundamental shortcoming of all DC funds. Rather it is an absence of articulated plan objectives that led to plan designs with suboptimal outcomes. The mistake he makes is in stopping there as if no other inquiry should be made. Many DC retirement plans have, and do, focus on income and are excellent designs.

If a proper inquiry is to be made, it should be understood that the ultimate benefit to a participant from a retirement plan is not determined just by whether the plan is DC-based or defined-benefit-based. That over-simplification ignores a large list of other factors, including benefit accrual structures, vesting rules, the level of funding from the employer and employee, the employee’s tenure, age at entry into the plan, investment performance, and work and compensation patterns as major examples. 

The commentary uses an analysis from the Alaska Division of Retirement and Benefits (DRB) to conclude that the state’s DC plan is providing “significantly smaller benefits than the pension-style system discontinued in 2006.” Again, Siedle takes this as evidence to make a categorical judgment about the evils of DC plans. But he fails to ask a simple question: To whom is this DRB analysis relevant?  

The Alaska Division of Retirement and Benefits comparison was addressing only a narrow cohort of longer-term employees, and it did not purport to say that all employees in all circumstances would be better off under the old pension plan than the new DC plan. If one looks at a broader set of employees with different lengths of service, the result is quite different. 

Pension Integrity Project analysis (Figure 1) compares the defined benefit (DB) pension proposed in a bill being considered in the Alaska legislature and the state’s current defined contribution plan. The analysis projects annuity values for regular public employees (teachers and public safety modeling show slightly different results) with an entry age of 30. The results clearly show that for any employee the DC plan will provide higher lifetime income benefits for the first 20 years of service. It is only the small number of very long-service employees who may be earning a higher benefit amount. For the vast majority of Alaska’s employees, the DC plan can be a more effective way to provide retirement benefits than the DB plan.

Figure 1: Comparing the Value of Alaska’s Defined Contribution Plan to the Proposed Defined Benefit Plan at Different Years of Service

Source: Pension Integrity Project actuarial modeling of Alaska’s existing defined contribution plan benefits compared to the pension benefits being considered in the proposed Senate Bill 88. This analysis displays results for non-teacher, non-public safety employees. The analysis assumes entry age 30, 6% DC investment return, 5% annuity payout rate, and 2.75% annual salary growth, and that DC benefits are not annuitized until normal retirement age.

The reality is that defined contribution plans can and are often used as the foundation for well-designed and effective retirement plans. Just look to Alaska’s higher education system for a local example. In fact, the primarily DC-based national higher education retirement system (for both public and private institutions) is arguably the most successful retirement system the country has ever produced because of adequate contribution rates, portability of benefits, and the flexibility to take retirement benefits as lifetime income, a position validated by a recent survey of higher education institutions.

This key point missing from the article is that it is very rare for employees in any industry to spend a full career with any single employer today. This anachronistic notion is a primary reason defined benefit plans have dwindled, although it remains the basis for defining success in remaining public sector DB plans today. The problem (aside from potential ongoing crippling unfunded liabilities) with most DB plans is that the employee must spend a full career with the same employer to receive a lifestyle-sustaining income in retirement. Public defined benefit plans, like the old Alaska plans, are designed to heap up benefits in later years and are not portable. It is only in the later years nearing retirement that an employee’s benefits would accrue significantly. Those benefits and accrued assets do not travel with the employees as they change employers throughout their careers, they sit in the pension fund until the employee reaches the retirement age set by the plan.

Alaska’s defined contribution plan, however, is designed to be portable and move with employees as their careers span several employers and there is no backloading of benefits. The issue of benefit portability is critical when determining effective retirement plan designs today. In Jan. 2022, median state employee tenure nationally was measured at only 6.3 years. It is clear that most employees in the modern workforce will have a fair number of employers during a 30–40-year career. Another example of this comes from the Pension Integrity Project analysis of the Colorado PERA School Division, which shows that only 37% of hires remain in the system after five years of service. Benefits that are illustrated based on formulas may look adequate on paper, but if only about a third of workers will actually get that level of benefit the illustrations are essentially meaningless.

Siedle also makes the misleading argument that in defined contribution plans Wall Street bankers make money at the expense of retirement plan participants. We retort: Are Wall Street investment firms not involved in managing the hundreds of billions of dollars in state and local governments’ defined benefit pension plans? Of course, they are. Large pools of pension money enjoy the benefit of favorable rate classes of investments. This is true for DB plans and should be for DC plans as well. 

While the portable nature of DC plan benefits fits the modern workforce better than traditional DB plans, typical 401(k)-style DC plans do have their own shortcomings. As previously acknowledged, a DC plan design that is focused on wealth accumulation rather than income replacement may be overlooking its primary purpose. The Pension Integrity Project recently introduced a new plan design called the Personal Retirement Optimization Plan (or PRO Plan) that uses existing market-available products and is built on a DC foundation but is focused on income replacement. The PRO Plan further focuses on DB-type lifetime income benefits at the individual participant level—producing previously unavailable customized benefits. 

Whether or not a retirement plan is DB or DC logically has no direct impact on plan effectiveness. While the defined contribution plan in place in Alaska could be enhanced, it is a plan that recognizes the reality of the modern workforce and works to meet employee needs. A theoretical and flawed comparison of defined benefit and defined contribution plans does not shed light on the reality facing public employees and employers in Alaska today. Responsible retirement plan experts should honestly focus on how retirement plan objectives and design, not defined benefits vs. defined contributions, can combine to meet the needs of both employers and employees in the modern environment.

The post Alaska’s defined contribution retirement plan is better for most workers than defined benefit plan appeared first on Reason Foundation.

The major defined contribution retirement plan-related changes in SECURE 2.0 include:

Strengthening auto-enrollment and auto-savings in retirement plans

Effective for plan years beginning after 2024, all 401(k) and 403(b) plans must automatically enroll participants with a 3%-10% contribution rate and provide an auto-save increase of 1% per year until it reaches a maximum of 10-15%. The participant must be given the opportunity to opt out of the default rates under current rules governing so-called “eligible automatic contribution arrangements” (EACA). 

This change is significant as it makes retirement plan participation the default position, which was not an option under current law. This will get more individuals into retirement savings plans—something very much needed in the United States. The Bureau of Labor Statistics reported in 2021 that 68% of private industry workers had access to retirement benefits through their employer, but only 51% chose to participate. In contrast, 92% percent of workers in state and local governments had access to retirement benefits, and 82% participated.  

The impact of this change will not be realized immediately because it only applies to new plans established after Dec. 29, 2022. In addition, government plans, church plans, new businesses, and small businesses with 10 or fewer employees are exempt.  

Refundable saver’s match tax credit

The current tax law provides a “non-refundable” tax credit for eligible individuals who contribute to IRAs or employer retirement accounts. Starting in 2027, The SECURE Act 2.0 changes the tax credit to be “refundable” in the form of a federal 50% matching contribution, up to $2,000 per year. The matching amount phases out depending on the employee’s income (e.g., $41,000-$71,000 for married filing jointly; $20,500-$35,000 for single taxpayers.

Using a federal matching contribution to provide the refundable credit will likely improve lower- and middle-income retirement savings.

Increased catch-up contribution limits for older workers

Individuals aged 50 and older under current law can make “catch-up” contributions up to $7,500 to 401(k), 403(b), and governmental 457(b) plans. The SECURE Act 2.0, effective in 2025, increases the catch-up limit for individuals ages 60-63 to $10,000 (indexed beginning in 2024). For higher-income individuals earning over $145,000 in a tax year, the contribution must be made to a Roth Account on an after-tax basis.

Lowered barriers to the use of lifetime income annuities

Beginning in 2023, the SECURE Act 2.0 further reduces tax code barriers for using annuities in defined contribution plans as recommended in Reason’s DC Personal Retirement Optimization Plan (or PRO) plan design in two ways.

Required Minimum Distribution Rules (RMD) Relaxed for Partial Annuitization: Current law requires an individual to determine RMD separately for annuitized and non-annuitized amounts. The result is a higher RMD amount than if the individual had not annuitized anything. The SECURE Act 2.0 removes this disincentive to annuitize by allowing the individual to aggregate both annuitized and non-annuitized distributions for RMD purposes.

Higher Qualified Longevity Annuity Contract (QLAC) Purchase Limits:  A QLAC product allows an individual to buy an annuity with a start date that begins only if they live longer than a stated age (no later than 85) as a way to help protect against the risk of outliving their retirement assets. Under current law, an individual can purchase a QLAC product but cannot spend more than 25% of the account value up to $135,000 (as currently indexed). The SECURE Act 2.0 eliminates the 25% limitation and increases the dollar limit to $200,000 (indexed). 

Other changes help portability, RMD distribution planning, and flexibility

The SECURE Act 2.0 permits retirement plan service providers to offer account portability services that automatically transfer retirement savings to an individual’s new employer’s plan. This helps preserve retirement savings instead of just cashing out of the prior employer’s plan. 

The act also increases the Required Beginning Date for minimum distributions from 72 to 73, depending on the individual’s “applicable age”:

• For those who turned age 72 before 2023, the applicable age is 72 (or age 70 ½ if they were born before July 1, 1949).
• For those who turn 72 after 2022 and reach the age of 73 before 2033, the applicable age is 73. 
• For employees turning 74 after 2032, the applicable age now is 75.

The onerous excise tax for RMD violations is also reduced in 2023 from 50% to 25%. The penalty tax is further reduced to 10% if the failure to take the RMD is corrected within a two-year window period.

Conclusion

The SECURE Act 2.0 takes important and meaningful steps toward increasing retirement plan savings participation. It reduces tax policy disincentives and tax code rules that perversely inhibit lifetime annuity solutions, which would improve retirement income security. It also provides additional flexibility for tax optimization for retirement distributions. 

The post Ways the SECURE Act 2.0 can help people save for retirement appeared first on Reason Foundation.

Beyond the growing pressures of crippling unfunded liabilities, DB plans suffer from a fatal flaw – they are unable to meet the portability needs of today’s highly mobile workforce. Only about one-third of plan participants will ever receive a meaningful benefit from a public DB plan.  

Another significant shortcoming of DB retirement plans is a failure to address specific individual needs. In a traditional DB plan, every person with the same salary and length of service is eligible for the exact same annual benefit. But treating everyone the same ignores the reality that individuals are almost never average. Individuals have different needs based on many factors, such as health or other sources of income.   

A typical DC arrangement suffers many of the same shortcomings. Managing investment risk is often solely on the shoulders of participants. Default investments often use target date funds, so every person with the same birthdate has the same investment mix regardless of circumstances.   

Neither DB nor DC plans are able to meet the needs of broad swaths of individuals. Historically, cost restrictions have made it difficult to design a plan that recognizes individual needs while covering a wide range of participants. Fortunately, that is no longer the case. 

To address these traditional design shortcomings, and in partnership with the Pension Integrity Project at Reason Foundation, we applied decades of retirement plan-related experience to develop a new design approach: The Personalized Retirement Optimization Plan (PRO Plan). This new plan design uses a mix of tested and proven options, making it easy for policymakers to implement. Offering a wide range of individual flexibility in contributions and annuities, the Pro Plan can better fit the unique retirement needs of each individual, making the plan advantageous not only for employees but for employers looking to better serve and retain their workers. 

The PRO Plan starts with the endgame in mind: a lifetime of inflation-protected replacement income. With immediate or very short vesting periods, the plan allows all participants (not just a few) to earn meaningful benefits. It also allows individuals to tailor and structure funding of the target benefit and benefit distribution strategy by first using independent financial advisors and/or advice tools to determine the appropriate investment strategy.  

All other assets available to the individual are considered, including other retirement plans, spousal assets, inheritance, and others. While participant input is critical for success, it is not overly burdensome and only needs periodic updating. This input enables the creation of an appropriately risk-managed and liability-driven portfolio that is adjusted as appropriate throughout the working career. Utilizing a combination of plan-provided annuities and other distribution methods, a default income plan is created that is specifically tailored to the individual.   

Our analysis comparing this new design to existing options finds that the PRO Plan addresses many of the common shortcomings and enables each participant to address their specific retirement needs. Using existing market-based products and modern financial technology, the PRO Plan enables government employers to provide lifetime-guaranteed benefits to their employees, and in a way that is cost-effective. Our research indicates that our new plan design could meet the needs of retirees at 28 to 38 percent lower cost than it would be for an individual covering lifetime benefits on their own. 

Applying some of the best features found in DB and DC plans, along with modern financial technology, the PRO Plan can meet both employer and individual employee needs for a more effective retirement plan. Rather than attempting to fix current plans, the PRO Plan is a design that should be considered throughout the public sector as a plan that policymakers can fully implement today. 

The post A better public sector retirement plan for the modern workforce  appeared first on Reason Foundation.