Public Sector Pension Reform: Why Reform and not Elimination?

Strengths of Defined Benefit (DB) Plans DB plans: Have a predictable benefit Provide death & disability benefits Eliminate mortality risk to the retiree Allow for orderly retirements even in times of financial market volatility

Strengths of Defined Contribution (DC) Plans DC plans: Have predictable cost Are portable Do not generate unfunded liabilities for the employer during market declines

Overall Weaknesses of DC Plans DC plan problems: Low percentage of workforce is covered Participation is not required History suggests insufficient contributions Expenses tend to be higher than DB Returns tend to be lower than DB

Weaknesses of DC Plan Data Most studies of DC plan adequacy rely solely on data about DC plans, but do not capture rollovers to IRA, other sources of savings, etc. What is still true is that the current DC model is inadequate based on availability, participation, expenses, returns, and contributions

Retirement Savings Math Retirement math (DB or DC) at its basic level is very straight forward: Benefits(B) + Expenses(E) = Contributions(C) + Investment Returns(I)

DB vs. DC – the Math B + E = C + I Historically DB plans have higher Investment earnings and lower Expenses If I is higher and E is lower, we can conclude that a DB plan can provide an equivalent benefit to a DC plan at a lower cost or a better benefit at the same cost

If DB is so great, why all the outcry for pension reform or even elimination of pensions?

Weaknesses of DB Plans There are three hot button issues that have caused the outcry to eliminate or reform government DB plans: Costs are increasingly volatile Benefits are excessive The private sector is abandoning DB in favor of DC

Government DB Plan Basic Mechanics

Normal Cost Employers and employees pay a relatively stable Normal Cost Normal Cost is the cost of the plan if all of the actuarial assumptions come exactly true It is expected to reasonably represent the expected long term cost of the plan

Unfunded Actuarial Accrued Liability (UAAL) The employer is responsible for the additional payment (or savings) due to actuarial assumption variance to actual Assumptions include: mortality, retirement age, wage growth, incidence of disability, etc. Also included: Investment Earnings

Smoothing DB plans smooth investment returns to dampen the impact of market volatility Some years will be better, some worse, but should wash out over time A typical period would be 5 years, meaning each year a plan would recognize 20% of each of the prior 5 years investment returns in a given year

Amortization of UAAL Smoothed market returns plus other variances in assumption versus actual are combined into the UAAL for that year That UAAL (either positive or negative) is then amortized over a period typically between 10 and 30 years (SB uses 20) The interest rate used in the amortization is the expected rate of return of the plan

Employer Contribution Rate The rate is composed of the normal cost plus the sum of all of the prior UAAL amortization layers, expressed as a % of payroll Two actuarial models for UAAL as % of payroll: level annual payment or level % of payroll – SB uses level % of payroll

Government Pension Reform

Weaknesses of DB Plans - Revisited Costs are increasingly volatile Benefits are excessive The private sector is abandoning DB in favor of DC

Reduce Volatility – No Holidays When plans were 100%+ funded in the early 2000s, UAAL was a large credit, in some cases greater than Normal Cost which drove rates to 0% Part of DB plan reform has to include, and does under the new legislation, setting the rate floor at the Normal Cost and not zero

Reduce Volatility – No Air Time State law allows employees to buy 5 years of “Air Time” increases years of service by up to 5 years Employees pay the full actuarial value The employer takes on the liability for the underlying actuarial assumptions (UAAL) When assets increase faster than comp, volatility increases

Excessive Benefits – Tighten Compensation Definition As a result of prior legislation and litigation, compensation for purposes of calculation of retirement benefit include things like uniform allowance, bilingual pay, various leave cash outs and many more Limiting the definition of compensation reduces the ultimate benefit paid, reducing plan cost

Excessive Benefits – Reduce Formulas The County currently uses a general formula of 2% at 55 and a safety formula of 3% at 50 The benefit is calculated by multiplying the % times number of years of service - so at 55 a general employee with 30 years would get a pension equal to 60% of compensation

Excessive Benefits – Reduce Formulas New formulas in the legislation are set at 2% at 62 for general and three safety formulas that are applicable based on your current formula: 2% at 57, 2.5% at 57, and 2.7% at 57

Excessive Benefits – Compensation Period Currently the highest 12 month compensation period is used in the formula – the new legislation changes that to 36 months Reduces impact of final year pay adjustments and/or promotions to spike compensation for retirement

Excessive Benefits – Employer Pick Up of Employee Cost Many governments have negotiated to pay a share of employee contribution cost The reform bill requires employees to pay their share of cost and goes further to require they pay 50% of normal cost (normal cost split currently varies)

Excessive Benefits Important to note is that all of the actions to address excessive benefits also reduce the amount of assets needed by the pension fund – this in turn reduces volatility to the employer budget creating a second benefit

Those are the big pieces of pension reform. Is it enough?

Further Reform Needed Excess earnings can be used to grant ad hoc benefits Only two ways to generate excess earnings – assumptions are wrong or you chopped the top off a good year and it won’t be available to fill in a bad year Mathematically, excess earnings do not exist – unfortunately they do in statute

Other Reform Options to Debate Should formulas be reduced even further? Should employees share in at least some of the risk of actuarial assumptions gone awry? Are the assumed rates of return overly aggressive?

Other Reform Options to Debate Government employee bargaining often focuses on what unions want and what the employer can afford The larger public policy issue of what goals are we trying to achieve with tax advantaged retirement savings get lost Why don’t we ask what % of income are we replacing and at what age?

What about reforming DC to make it a viable alternative?

DC Reform Options Mandatory participation Minimum contribution levels No cash out or loan options Better annuitization options along the way to avoid the risk of a low interest rate environment on retirement day

DC Reform Problems If we agree to mandate participation and contribute at a certain level, how do we: Reduce investment expenses? Get people to invest more like a professional – i.e. don’t be overly conservative? What about time horizon issues?

Even IBM Abandoned DB in Favor of DC – or – Why You Shouldn’t Jump Off a Cliff Just Because All of Your Friends Did

Living in an Unreformed DC World The switch from DB to DC in the private sector did not eliminate future UAAL risk – it simply moved it to government in the form of future costs that will have to be paid for retirees who have inadequate retirement savings and can no longer work – those costs are unfunded liabilites that are incorrectly being called savings

Living in an Unreformed DC World We’re already living with Medicare deficits, Social Security deficits, a $1.3 trillion operational budget deficit, and a massive trade deficit The Social Security and operational budget deficits will both be exacerbated by the switch to DC – there is a Social Security benefit offset for pension income

Conclusions Neither DB or DC in their current form are answers to providing secure retirements that reduce reliance on government programs The traditional retirement concept of the 3-legged stool, with pension, social security, and personal savings could work with DB and DC reform

Hybrid Plans and the Case for 1.5% at 65 Answering our two earlier questions – let’s assume we want to replace 90% of income in retirement and that 65 is a reasonable retirement age For sake of making the math easier we’ll also assume an effective career of 40 years

Hybrid Plans and the Case for 1.5% at 65 The 3-legged stool concept says about 2/3 of savings should come from a non- risk based source to provide some base level of income that can be relied on for basic necessities – typically this would come from pension and social security SB is a non-SS employer so 2/3 is pension 2/3 of 90% replacement is 60%

Hybrid Plans and the Case for 1.5% at 65 60% replaced after 40 years of service equates to a 1.5% at 65 pension formula, much lower than the 2% at 62 under the pension reform legislation The remaining 1/3 of the 90% replacement income, or 30%, would come from savings plan and would effectively determine lifestyle

Hybrid Plans and the Case for 1.5% at % at 65 with a DC component: Reduces retiree dependence on government aid programs Leaves retirement lifestyle quality up to the individual’s willingness to save Maintains many benefits of DB while limiting the employers exposure to the bad parts by severely limiting benefits