Public Employee Retirement Benefits: Defined Contribution vs. Defined Benefit Plans

Barbara T. Reid
Hardly a week goes by without a state or national news story about public employee pension benefits. Within the past few years, national associations and research institutes such as the National Conference of State Legislators, the Pew Research Center, the Center for State and Local Government Excellence, and the Center for Retirement Research at Boston College, as well as numerous actuarial consulting firms have released dozens of studies, reports, white papers, issue briefs and summaries about the financial status of public employee pension programs and changes being enacted.

Across the country, state and local governments are challenged with balancing the need to provide reasonable retirement benefits for their employees with the need to provide those benefits at reasonable costs to their taxpayers, a daunting task especially during the economic conditions of recent years. Those same challenges are being faced here in New Hampshire. Nearly every municipality, school district, and county, along with the State of New Hampshire, participates in the New Hampshire Retirement System (NHRS), a defined benefit program. The NHRS has experienced significant rate increases on both employers and employees over the past several years, while at the same time eliminating cost-of-living adjustments for current retirees and curbing future pension benefits for non-vested and newly hired employees. Even with these cost-saving measures, the prospect for the immediate future is that employer rates will continue to increase as the unfunded pension liability of approximately $4.3 billion is paid off over the next 26 years of the statutory 30-year amortization period. (For further information on what led to this unfunded liability, see "Public Pensions and the Perfect Storm: National Strategies for Reform," New Hampshire Town and City, June 2010.)

Facing the reality of paying off this $4.3 billion "mortgage," coupled with headlines about some public sector employees taking advantage of the retirement system by spiking their benefits or double-dipping (continuing to work in the public sector while drawing pension benefits) has led to serious discussions about alternative retirement programs-most notably defined contribution plans. On the surface, the "solution" to ending the apparent ever increasing costs associated with a defined benefit plan and the pension loopholes that make headlines appears to be simply closing that plan for newly-hired public employees and instead providing a 401(k)-type of retirement benefit through a defined contribution program. If it were that simple, one would reasonably ask: "Why haven't more than just a handful of public pension systems across the country made the switch from a defined benefit plan to a defined contribution plan?" Like so many other public policy decisions, the answer is just not that simple. The following article outlines some of the financial issues surrounding the transition from a defined benefit plan to a defined contribution plan for public sector workers in New Hampshire.

Defined Benefit Plan vs. Defined Contribution Plan
To begin this discussion, it is important to recognize the fundamental difference between the two plans-the fundamental difference being who bears the financial risks. In a defined benefit (DB) plan such as New Hampshire's current plan, the employee bears little financial risk, being guaranteed a lifetime pension annuity per a statutory formula based upon years of service and average final compensation. The employee contribution rate is set by statute and only increases upon legislative act, a situation which occurred recently for the first time in many decades. The employee cannot outlive his or her pension benefit regardless of the amount of money he or she has contributed into the retirement system.

For the employer, however, the rate of the pension contribution fluctuates, often with dramatic increases, based upon any number of circumstances, therefore requiring the employer to bear the full financial burden of pension risk. These circumstances include lower than expected investment earnings on pension assets, financial consequences due to other economic and demographic assumptions not being met (such as employees retiring at higher pay than expected or living longer than expected), and increased funding requirements due to enhanced benefits approved by the legislature. In other words, with a DB plan, the employee is guaranteed a set pension benefit, while the employer-ultimately the taxpayer-bears all of the financial risk associated with fully funding the benefit.

A defined contribution (DC) plan, on the other hand, completely flips the financial risk, with the employer only responsible for funding a set amount, usually a percentage of compensation during the employee's active years of service. The employer contributions over the years, along with employee contributions and investment earnings, create an individual account that provides the basis for the retirement benefit. Upon retirement, all that is guaranteed to the employee is the amount in that individual account, and any subsequent investment earnings. The employee therefore bears all the financial risk associated with volatile investment earnings both pre and post retirement, and assumes the risk of outliving the accumulated assets in this individual account. As would be expected with a proposed change such as this, employee groups are very concerned about the risk and uncertainty inherent in a DC plan.

Funding the Existing Liability
Implementing a DC plan for newly-hired employees is not necessarily a difficult task to undertake. While there are numerous policy decisions that need to be addressed in advance of implementation, several DC plan administrators have indicated that once those decisions have been made, setting up such a program could be accomplished within a six-month time frame. The more significant issue is the financial impact that closing the DB plan to new participants will have on the cost of maintaining the promised benefits to the approximately 75,000 current retirees and active members of the NHRS. This is due in part to the extent of the existing unfunded liability: $4.3 billion. The bulk of the dollars that employers currently pay into the system goes toward paying off this liability.

The following table shows the projected rates for fiscal years 2014-2015. (See table.) The rate of the unfunded actuarial accrued liability (UAAL), which is the portion of the rate for past pension liabilities, is very close to-or, in the case of the teacher rate, exceeds-the normal contribution rate, which is the portion of the rate funding current pension obligations. (Line 1 compared to line 2). The sum of these two rates represents the total pension cost (line 3). From this amount, the employee's contribution is subtracted (line 4) to arrive at the employer's pension contribution (line 5), with the rate for the medical subsidy (line 6) then added to arrive at the total employer contribution rate (line 7). This rate is then multiplied by the actual payroll to determine the required cost that each employer must pay into the system. Comparing the UAAL (line 2) to the employer pension contribution (line 5) shows that for the four different employee groups, between 69% and 83% of the employer's pension costs goes toward paying off the unfunded liability.

Changing to a DC plan does nothing in terms of reducing this $4.3 billion unfunded pension liability. It will still exist, and it will still need to be funded. Implementation of any DC plan needs to consider how the pay down of the existing unfunded liability in the DB plan will be accomplished. One possible answer is for employers to continue paying off the DB unfunded liability based upon the compensation of those new employees in the DC plan. Under such a proposal, employers would pay the UAAL rate (line 2) on the payroll of the employees in the DC plan, but rather than that money going into the DC member's individual accounts, it would go toward paying off the DB unfunded liability. This proposal would basically continue with the current plan for employers to pay off the unfunded liability over the 26-year amortization period.

Transition Costs Due to Closed Group
The projected employer rates include assumptions about the level of payroll on which the employer contributions will be based. If the DB plan is closed to newly hired employees, over time there will be a significant drop in the payroll on which the employer's contributions are computed. Therefore, less money will flow into the plan, while the amount of benefits being paid out will increase due to active members eventually retiring. According to both the NHRS actuaries and investment advisors, in a closed group scenario such as this-with no new members joining the DB plan-a more conservative investment strategy may need to be considered in order to assure that sufficient funds are available to pay the required benefits in the long-term. Since funding for the NHRS comes from only three sources-employer contributions, employee contributions and investment earnings-and since employee contributions are fixed by statute, any decrease in the investment earnings will need to be made up by increasing employer contributions.

During this past legislative session, Senate Bill 229 initially proposed a defined contribution plan for all new state and local government employees hired after November 1, 2012. In the fiscal analysis, the NHRS investment advisors suggested that at some point the assumed rate of investment return, currently 7.75%, would need to drop to an amount somewhere around 4.5%. (See chart.) This would be in response to the need to modify the investment portfolio, adopting a less risky and more conservative investment philosophy (such as increasing the allocation to fixed income investments) as the investment horizon for the closed group of participants becomes shorter and shorter. This is similar to the investment strategy often used for a child's college savings account. When the child is very young and money is not needed for fifteen to twenty years, a more aggressive investment strategy is justifiable, especially since the benefit of "time" is available to help respond to any unanticipated circumstances such as a downturn in the market. But when the child reaches age sixteen or seventeen, a less risky, more conservative investment strategy may be prudent to ensure that the accumulated savings and investment earnings will be available when those tuition payments come due in the very near future.

To illustrate the impact of eventually moving to a more conservative investment strategy due to closing the DB plan to new hires, the NHRS investment advisors offered the following as one possible scenario. In this example, the current expectation of an annual rate of return of 7.75% declines to 4.5% over 26 years. The average rate of return during this 26-year time period would be approximately 6.65%. Changing the assumed rate of return from 7.75% to 6.65% would increase the liability by $1.2 billion-on top of the $4.3 billion existing unfunded liability-and cause the projected employer's pension contribution rates (line 5) to increase by approximately 30% for employees and teachers and 36% for police and fire, clearly not a desirable outcome. The investment advisors noted that this is only one model, that other scenarios are certainly possible, that the investment policy may not need to change immediately, and that the actual dollar impact could vary from this estimate. However, their point was this: with an open DB plan, younger members continually join the pension system, providing a mix of active members and retirees, with upwards of a 70-plus-year investment horizon for those younger members, allowing the plan to take on investment risk to seek higher returns. Once new hires are precluded from joining the DB plan, the investment horizon for the closed DB plan eventually diminishes, and a more conservative investment approach is warranted, which will likely result in lower investment returns and necessitate increased funding from employers. During the debate on Senate Bill 229, this increased cost became known as the "$1.2 billion nut" that needs to be cracked before proceeding further with a DC plan.

Continued Debate
While Senate Bill 229 did not pass the legislature during the 2012 session, that by no means indicates the end of discussions concerning a move from a DB plan to a DC plan for New Hampshire's public employees. In July, the New Hampshire House Speaker convened a special committee to continue work on this during the summer and fall with the goal of putting forth legislation in 2013 for a mandatory DC plan for new state employees, with optional participation by local governments. Implementing a mandatory DC plan for state employees raises concerns that, over time as more state employees participate in the DC plan rather than in the DB plan, the State may just walk away and leave local government employers holding the DB unfunded liability bag. The impact on the current DB plan from a move to a DC plan needs to be fully vetted and understood, with projections of the effect on the liabilities and employer's costs, and with assurance that the State will continue paying its obligations under the DB plan.

Barbara Reid is the Government Finance Advisor for the Local Government Center and New Hampshire Municipal Association. Contact Barbara at 800.852.3358, ext. 3308, or by email.

Governor and Executive Council Confirm Guy Scaife to NHRS Board of Trustees

At their July 11, 2012 meeting, Governor Lynch and the Executive Council confirmed Guy Scaife, Milford Town Administrator, as the New Hampshire Municipal Association's appointment on the New Hampshire Retirement System Board of Trustees. Guy replaces Keith Hickey, Salem Town Manager, who served from 2007 as the first local government appointee to the Board. NHMA thanks Keith for his five years of service on the Board, and also thanks the Milford Board of Selectmen for supporting Guy's appointment.

GASB Adopts Significant Pension Accounting and Financial Reporting Changes for Local Governments

The Government Accounting Standards Board (GASB,) which establishes the requirements for accounting and financial reporting by states and local governments, announced in June the adoption of Statement 68 dealing with pension accounting and reporting. This standard requires that employers participating in a cost-sharing multiple employer pension plan, such as the New Hampshire Retirement System, report a proportionate share of the NHRS unfunded liability (approximately $5 billion as of June 30, 2011) on their government-wide financial statements. Statement 68 is effective for financial reporting periods beginning on or after June 15, 2014. The NHRS, in conjunction with the Local Government Center, the New Hampshire Government Finance Officers Association, and the Association of School Business Officials, plans to hold employer information sessions to explain the timing and process of providing required data and note disclosure information to NHRS participating employers.

Plan to attend the LGC annual conference session Pensionomics: Change on the Horizon for preliminary information about GASB Statement 68, the implementation process, and future information sessions.