Analysis of the 2005-06 Budget Bill Legislative Analyst's Office February 2005

Addressing Public Pension Benefits and Cost Concerns

Introduction

Over the last decade, state and local retirement systems have experienced dramatic changes:

• A booming stock market in the late 1990s resulted in well-funded systems, which in turn led to low employer contribution rates and significant benefit increases.
• The subsequent market collapse resulted in system funding problems and skyrocketing employer rates.

In response to these dramatic cost changes, the Governor has proposed a constitutional amendment to switch new public sector employees from defined benefit pensions to defined contribution plans.

In this piece, we:

• Describe how defined benefit programs currently operate.
• Identify key issues with this type of pension plan.
• Describe the Governor's proposal regarding defined contribution plans.
• Assess alternative ways for the Legislature to address concerns with public sector retirement plans.

Background

Defined Benefit Plans Are Core of Public Retirement

In public sector employment, defined benefit plans are the norm. Below, we outline the features of this type of retirement plan.

Benefit Formula Guaranteed. Under a defined benefit program, an employee receives a set pension amount based on a formula that includes age and salary at retirement and the number of years of service. These benefits are guaranteed lifetime annuities in that the retiree receives benefits until death.

Public Safety Employees Get Higher Benefits. Public safety employees—primarily police and firefighters—have richer defined benefit formulas than nonsafety employees. That is, they generally receive a higher percent of salary for each year of service, and they can retire at a younger age with similar benefits. This reflects an expectation that public safety employees have shorter careers due to the hazards of the job. In addition, public safety employees do not participate in the federal Social Security program, unlike most nonsafety employees. Thus, public pensions have been structured to provide more income in retirement for safety than nonsafety employees.

Public Sector Retirement Benefits Considered an Unbreakable Contract. Court decisions have prohibited reducing retirement benefits for current employees without an offsetting benefit. Courts have considered pension benefits to be part of the employment contract, and the State Constitution prevents the government from unilaterally breaking contracts.

The expected employment contract is determined by the benefits in place when one begins work. Public agencies, therefore, can adopt different retirement benefits prospectively for new employees. Such changes would not violate the court decisions noted above regarding employment changes for existing employees.

How Are Defined Benefit Plans Funded?

Defined Benefit Plans Have Three Sources of Funding. Defined benefit plans have three sources of funding—employee contributions, employer contributions, and returns on invested assets. (Investment returns, in fact, are the biggest component of defined benefit funding.) These contributions—and the earnings on them—are intended to pay for future retirement benefits as they are earned.

Employee contributions are usually fixed, while employer contributions vary from one year to the next. Investment returns depend heavily on the financial markets. When returns are greater than expected, fewer contributions are needed. When investment returns are less than assumed, larger contributions are needed. With a fixed employee contribution, employers tend to reap any benefit of extra investment income through lower contributions. Conversely, employers pay for lagging investment income through higher contributions.

Employer Contribution Consists of Two Parts. The annual employer contribution for retirement is comprised of two parts—the "normal cost" and the "unfunded liability"/"actuarial surplus."

The normal cost is the average annual cost of the retirement benefits earned by the employee in a given year of service. In other words, it is the amount (usually expressed as a percentage of salary) the plan needs to invest, earning the assumed returns over time, to accumulate enough assets to pay the retirement benefits for that year of work when the employee retires. (The normal cost is often expressed for the employer contribution only. The employee contribution, however, can be considered to pay for a portion of the annual cost of service as well.)

For several reasons, the normal cost collected over time and invested can be insufficient to pay future retirement benefits. This shortfall is known as an unfunded liability. Unfunded liabilities can arise when:

• Investment returns fall short of expectations.
• Benefit enhancements are implemented retroactively to apply to past, as well as current, service time. (For the years of past service covered by the enhancement, no one contributed payments to cover the costs.)
• Demographic changes do not conform to assumptions. For example, earlier-than-expected retirements reduce the assumed amount of time the plan has to collect contributions and generate sufficient assets to pay for these retirement benefits.

These liabilities are paid off by increasing employer contributions.

By contrast, in some cases, greater-than-assumed investment returns generate more assets than needed to pay future benefits. In this instance, this actuarial surplus offsets annual normal cost contributions, thereby reducing total employer contributions. In fact, it is possible for contributions to be reduced to zero.

"Smoothing" Spreads Out Investment Returns, Liabilities. To keep plan funding on track to acquire sufficient assets to pay future retirement benefits, any unfunded liability must be reflected in contributions. If these shortfalls were paid off or credited in full each year, employer contribution rates would swing dramatically and could easily be a very large percentage of payroll. To limit such a yo-yo effect of wildly varying contribution rates from one year to another, retirement systems spread out—or smooth—the recognition of investment gains and losses over multiple years. Similarly, retirement systems credit contributions for actuarial surpluses over time to limit rate fluctuations.

Four Sets of Laws Govern State and Local Government Retirement Plans

Public Employees' Retirement System. The Public Employees' Retirement System (PERS) administers the defined benefit plans for state employees. In addition, many local government entities contract with PERS to administer their retirement plans. This includes almost all cities and a majority of counties. Current law specifies the benefit formulas for state retirement plans. Local agencies that contract with PERS can select from a variety of benefit formulas enumerated in state law.

State Teachers' Retirement System. The state prescribes in statute a standard retirement plan for all K-14 public school teachers. This plan is administered by the State Teachers' Retirement System (STRS). Teacher and school district contributions are set in statute, and the state annually contributes an additional amount of General Fund resources. (Please see page F-67 of our 2005-06 Analysis for a discussion of the STRS retirement program.)

1937 Act Counties. Twenty counties have chosen to establish their own retirement systems under a separate body of law. These public agencies are known as "'37 Act counties" (named for the 1937 legislation that created these statutes). As with PERS contracting agencies, state law specifies the benefit formulas from which these counties can select for their employees. In some cases, these counties also offer their plans and services to cities and special districts within their boundaries.

General Pension Law. A fourth category of law authorizes local governments to establish their own retirement systems as pension trusts. These statutes are much more limited than PERS or '37 Act county law and do not specify what level of retirement benefits these entities can offer. Pension trusts have been established by large cities such as Fresno, Los Angeles, San Diego, and San Francisco, as well as San Luis Obispo County.

State Law Ultimately Sets Parameters for All. Proposition 162 (approved by voters in November 1992) gives authority for administering and determining actuarial funding requirements for retirement plans to the governing retirement boards. This limits state and local government control of funding and oversight of retirement plans. Regardless of the type of plan established under different statutes, however, the Legislature has the authority to establish provisions of law governing retirement benefit programs.

Key Issues With Current Defined Benefit Plans

In our research and discussions with state, county, and city representatives, a number of issues came up regarding the current retirement programs offered to state and local employees. These concerns fall into two broad categories—benefits and funding. (Ultimately, these categories overlap to some degree since benefits affect costs.)

Concerns Regarding Benefits

Below, we discuss several issues with particular aspects of benefit formulas.

Benefits Are "Locked In"

As noted previously, employers cannot readily change retirement benefits for current employees without an offsetting benefit. In other words, public agencies face a lot of inflexibility under a defined benefit structure to "undo" past decisions. Consequently, in cases where the cost of a benefit enhancement was underestimated, a market downturn increases contribution rates far above what was expected, or a future governing body wants to change a retirement decision of a past body, very little can be done affecting existing employees. Benefit formulas and employee contributions tend to be locked in place.

Some Benefit Formulas Are Overly Generous For Maintaining Living Standard

Income Needs Are Usually Less in Retirement. Retirement income generally comes from three sources—Social Security, employer-based pensions, and private savings. A person's income needs are generally less in retirement than when working. This is because clothing and daily travel expenses decline, home mortgages are often paid off at this point in life, and retirees may be in a lower tax bracket than when working. As a result, retirees typically need less income to maintain the same standard of living as when they worked.

California Comparatively Generous in State Benefits. In our 2004-05 Analysis (please see page F-19), we compared state retirement benefits for a typical California employee with a few other states. California pensions surpassed the other states—often significantly—at all retirement ages. Figure 1 shows that this comparison holds for an expanded number of states for an average employee retiring at age 55. (We have included larger states—that also participate in Social Security—from each region of the U.S. In many states, employees are not even eligible to retire at this early age with the given years of service.) Of the 16 states shown, California offers the highest retirement benefits.

Formulas Can Be Particularly Generous. For longer-term employees or those covered by particularly generous formulas at the local level, some can receive more annual income in retirement than when they worked.

Miscellaneous. In 2001, the state approved two Miscellaneous retirement formula options for local governments—2.7 percent at 55 and 3 percent at 60. Since that time, more than 50 local governments contracting with PERS have elected to provide the 2.7 percent at 55 benefit, and more than 20 have elected to provide 3 percent at 60. (This amounts to 15 percent to 20 percent of PERS contracting entities.) Most of these agencies also have at least some of these employees in Social Security. As noted above, the typical employee needs significantly less income in retirement to maintain the same standard of living. With these benefit formulas, it takes just 20 to 30 years of work (that is, less than a full career) to have retirement income (adding in Social Security and/or private savings) equal to working pay. Even for Miscellaneous employees not in Social Security, these formulas provide a large amount of retirement income.

Public Safety. Similarly, in 1999, the Legislature approved 3 percent at 50 formulas for California Highway Patrol and local public safety officers (effective beginning in 2000). Pursuant to their current collective bargaining agreements, state firefighters and correctional officers also will be eligible for 3 percent at 50 formulas beginning January 1, 2006. For 25 years of service, this benefit provides three-quarters of income in retirement. As noted previously, public safety officers in California do not participate in Social Security. Private savings, however, and the likelihood of post-retirement employment (given the age at retirement), would significantly add to the guaranteed public pension.

Final Salary Used to Calculate Retirement Benefit

Salary Period Used to Calculate Pension Affects Benefits. One of the key components of a defined benefit pension is the salary used to calculate the benefit. Almost all states use the average of the three- or five-year period of highest salary (typically the final years an employee works). This averages the impact of any pay raises or promotions during the designated period.

California, on the other hand, uses the highest one-year salary. Using a single year increases retirement payments for most employees by fully capturing their highest level of pay. Local agencies that contract with PERS and `37 Act counties use three years, unless they specifically elect to use a one-year period. Most PERS entities have switched to the one-year calculation. In our review of other retirement systems, we did not find any other state that uses one year.

One-Year Salary Calculation Encourages "Salary Spiking." The one-year period can encourage salary spiking, in which an individual gets a sharp increase in compensation during the last year of work to deliberately "bump up" their retirement benefits. This can occur, for example, when a housing or car allowance (which is not compensable for retirement purposes) is eliminated in favor of a corresponding pay raise. Based on our discussions with state and local agencies, it is not clear whether this is a frequent practice. Basing pensions on the highest single year of salary, however, certainly provides a fiscal incentive for such spiking.

Retroactive Benefit Enhancements

Typically, when public agencies increase retirement benefits, the enhancements apply not just for service following the changes, but to all years of service previously rendered by current employees. For instance, state employees who retired in 2000 and thereafter have received enhanced benefits for their entire careers even though they had worked most of that career under the expectation of the lower benefits.

Granting benefit increases retroactively has serious consequences for plan funding. Neither employees nor employers were paying the increased normal cost of the higher benefits for the previous years of service. Thus, the cost of this benefit for past service is essentially paid for with plan assets on hand. This immediately creates an unfunded liability or reduces surplus funds (if the plan had sufficient assets). Providing retroactive benefits violates the principle of paying for retirement benefits as they are earned—that is, through annual normal cost payments.

In addition, the inevitable cycles of the stock market can quickly reduce or erase any surplus (or enlarge an existing unfunded liability). If these excess assets are used up or diminished to pay for retroactive benefit increases, then they no longer can serve as a financial cushion to weather an investment downturn. Consequently, we consider retroactive benefit increases to be fiscally unsound.

Concerns Regarding Funding

Concerns regarding the funding of retirement systems often come down to the employing agency being "on the hook" for all rate fluctuations. We describe various aspects of this concept below.

Volatile and Uncertain Contribution Rates

The state and local governments have seen their contributions decline—even to zero or near-zero levels—and then climb significantly again in recent years. This volatility and uncertainty can make overall budgeting difficult, particularly in times of fiscal crisis.

Down, Then Up…When Agency Budgets Could Ill Afford It. After a series of double-digit investment returns in the late 1990s greatly improved plan funding, employer contributions dropped substantially. In addition, the state and local governments increased benefits, which used up surplus assets and increased the annual normal cost. When the stock market declined, plans experienced consecutive years of less-than-expected investment returns. This double whammy—higher benefit costs and major asset losses—led to hefty increases in employer contribution rates. For example, Figure 2 shows how state contributions went from almost nothing at the start of the decade to over $2.5 billion just four years later. These cost increases came at a time of operating budget shortfalls for the state and many local jurisdictions—forcing additional programmatic reductions or revenue increases elsewhere in their budgets.

Unknown Annual Costs. The dramatic stock market changes were such that even the moderating effects of the smoothing techniques described earlier could not prevent sizeable changes in contribution rates. Consequently, many governments did not know from one year to the next what annual contributions would be—making budgeting even more difficult.

More Difficult Compensation Decisions. Retirement is one component of a total compensation package for employees. With defined benefit pensions that require contributions that can vary each year (sometimes significantly), it can be difficult for the state and local governments to accurately gauge compensation levels and make total compensation decisions. Retirement compensation is subject to contribution changes that are driven by actuarial calculations—outside of a government's direct control. As a result, compensation choices to enhance pay or retirement benefits based on costs at the time of the decision can turn out much costlier than expected.

Employees Shielded From Costs of Retirement Decisions

Employee Contributions Fixed, If They Pay Them at All. For the state and local governments that contract with PERS, employee retirement contributions are set in statute for each retirement plan. While the Legislature has reserved the right in law to change these employee contribution rates, in practice, the state has included the amount of employee contribution rates in collective bargaining agreements.

For `37 Act counties, employee contributions are set by the county. In many cases, however, these counties have agreed in collective bargaining to pay all or part of the employee retirement contribution, in addition to paying the employer contribution.

Employees Shielded From Cost of Decisions. Because their contributions are fixed or paid by their employing agency, employees are generally shielded from the cost of decisions about benefit enhancements and from investment performance. Consequently, employees do not have an incentive to weigh the costs of enhanced pension plan provisions.

How Can the Legislature Address These Issues?

To address the growing cost of defined benefit pensions, the Governor has proposed defined contribution plans for all new public sector employees. We review this proposal, which is embodied in a proposed ballot initiative, below. The Governor's proposal would address many of the benefit and funding issues highlighted above, but would introduce other concerns as well. In addition, we also discuss ways the Legislature can address the concerns identified above through (1) changes within the current defined benefit structure and (2) other types of retirement plans.

Including Local Governments or Not? We noted above that the state has authority over the structure of local government retirement plans. To the extent the state adopts changes for its own employees, the Legislature could give local governments the option to make similar changes. This would allow local governments to retain the retirement programs they have, at their discretion and responsibility, instead of being required to implement changes. In some cases, however, the Legislature may wish to apply certain changes to local governments as well as the state.

Governor's Defined Contribution Plan

Under the Governor's proposal, all new public sector employees—state and local government employees as well as teachers—would be prohibited from enrolling in defined benefit plans after June 30, 2007. Instead, they could enroll in defined contribution retirement plans. While the defined benefit plans guarantee at career's end a certain formula-based pension, defined contribution plans guarantee upfront a certain employer contribution (as a regular percent of pay) to individual accounts. Employee and employer contributions are invested, and the employee has whatever these assets have generated for retirement income. There is no guaranteed benefit.

Contribution Maximums Specified. As shown in Figure 3, employer contributions could be up to 6 percent for nonsafety employees and up to 9 percent for police officers and firefighters (if employees contribute specified matching amounts). For employees not covered by Social Security, employers could contribute an additional 3 percent above these maximums. Local agencies could increase employer contributions with two-thirds approval of voters. The state could amend any part of the established defined contribution plans with three-fourths approval of the Legislature in two consecutive sessions.

Fiscal Impact of the Plan. Whether this plan results in reduced retirement contributions compared to current pension plans for an individual government entity would depend on whether defined benefit contributions are higher or lower than the specified maximums. On a statewide basis, the proposed maximum rates are generally lower than the employer normal cost contributions governments are currently paying for their defined benefit plans. Consequently, the proposal would result in a net reduction statewide in retirement contributions for new employees. The amount of savings would depend on the extent to which public agencies chose employer contributions that are less than the maximums allowed. Once fully phased in for all public sector employees after several decades, these savings in annual retirement costs could potentially be in the hundreds of millions of dollars to over $1 billion annually.

Proposal Would Resolve Identified Issues With Current System

We assess the Governor's plan against the benefit and funding issues described above. Figure 4 summarizes our findings. Based on these criteria, the plan does well in addressing issues with the current system. It resolves the benefit issues discussed above by not guaranteeing a benefit level. As a result, there are no fiscal problems arising with end-of-career benefits that are locked in place. Providing compensation retroactively and based on a final salary are no longer considerations. In addition, the set contribution maximums eliminate the volatility of annual costs and the uncertainty about compensation decisions. The plan also gives employees a stake in retirement decisions by requiring employee contributions to get the maximum rates from employers.

Other Advantages

Flexibility, Portability. Defined contribution plans are flexible for employees. Those who leave public service can take these funds with them and either keep them for retirement or cash them out to use for other purposes. In other words, defined contribution plan assets are "portable."

Defined benefit assets, however, are not as flexible or portable. Employees who leave service can only take with them the accumulated value of their own contributions plus interest. They lose all employer contributions and excess investment earnings above the interest rate applied to member accounts. Individuals who work in public service for less than five years are not eligible (or "vested") to receive a defined benefit pension upon retirement. For employees who leave public service before five years, the loss of the employer contributions can be significant.

Individual Control Over Assets. With their own retirement accounts, individuals can determine how much risk they are willing to accept in their investments in exchange for potentially higher returns. Those who are risk-averse can choose investment funds with lower and less variable returns. Those who are willing to accept higher levels of risk (such as younger employees who are far from retirement) can choose investment funds with historically higher yields but greater volatility.

But Also New Concerns

No Guaranteed Benefit, Retirement Income Uncertain. As highlighted above, defined contribution plans do not guarantee a certain benefit level for retirees. This means that employees would have significant uncertainty about their expected level of retirement benefits. In addition, defined contribution plans shift investment-related risk from the employer to employees.

Retirement systems, on average, tend to have better returns investing assets for defined benefit plans than individuals in charge of investing their own defined contribution plan assets. This does not necessarily mean that defined contribution accounts will provide inadequate retirement income (especially when combined with additional resources from Social Security benefits and private savings). The risk of inadequate retirement income does exist, however, due to inadequate contributions and/or insufficient investment returns over time. We note that the Governor's proposal does not preclude PERS or other existing systems from offering investment options and managing the accounts for employees. Such an approach would allow employees to avoid many of the risks of individual investment choices.

Investment Fees. Because retirement systems invest plan assets for all members together, their annual administrative and investment consultant costs tend to be small as a portion of assets—a fraction of 1 percent in the case of PERS. Defined contribution plan assets, however, are invested on an individual-account basis, with each employee making individualized investment selections. As a result, the per-account charge as a portion of assets is higher than for retirement systems investing defined benefit plan assets altogether. These annual charges can be 1 percent to 2 percent of assets.

No Specific Provisions for Disability Retirement. Defined benefit plans usually include provisions that pay a modified retirement benefit to individuals who become disabled and cannot work. The cost of these benefits is included in plan funding. Defined contribution plans, however, do not provide for such contingencies. Absent a separate insurance policy or program, a disabled worker would have the balance in the retirement account to draw from as needed. If the disabling injury occurred relatively early in the career, an employee's retirement account assets could be relatively modest. Thus, the account could provide significantly less income than disability retirement under a defined benefit program.

Pressure to Raise Other Forms of Compensation. With a defined contribution plan that has a smaller portion of salary going toward retirement than defined benefit plans, employees face the potential for lower pension benefits in retirement. Since pensions are one piece of overall compensation, switching to defined contribution plans could result in pressure for public agencies to increase other forms of compensation. For example, employee unions could press for (1) additional salary now to make up for potentially reduced compensation in retirement or (2) a separate disability benefit program. Collective bargaining negotiations that add such items to make up for reduced retirement benefits would offset some portion of savings in total compensation from moving to defined contribution plans.

What Have Other Entities Done?

Some States Have Added or Switched to Defined Contributions. Five states have defined contribution plans. Michigan's program is mandatory for its employees. The plan is optional in the other states. Figure 5 shows the provisions of these plans in other states.

Recent Switches From Defined Contributions. In contrast to the Governor's plan, some public entities have recently replaced defined contribution programs with defined benefit-type plans. In 2003, the City of Irvine adopted a defined benefit plan in place of defined contribution plans for nonsafety employees. This occurred because of perceived difficulty recruiting employees to work for the city without a guaranteed PERS pension.

After several decades of experience with a defined contribution plan, Nebraska recently implemented a "cash balance" retirement program for nonsafety employees. Cash balance plans are a hybrid between defined benefit and defined contribution. These plans guarantee an annual rate of return on contributed funds (thus eliminating the employee's risk of variable investment returns with a defined contribution plan), but do not set a benefit level upon retirement. At retirement, an employee has the balance of the plan to (1) draw from directly or (2) purchase an annuity that does guarantee annual payments. Prior to the switch, a contracted consultant's analysis of Nebraska's defined contribution program found that the plan, combined with Social Security and additional personal savings, met nearly all of estimated retirement income needs. Nonetheless, Nebraska officials decided to end the defined contribution plan and replace it with the cash balance plan.

Identified Issues Can Also Be Addressed Within Defined Benefit Structure

While the Governor's proposal would address the current system's problems, the Legislature could instead choose to amend or restructure its defined benefit plans. As discussed below, many of the problems could be lessened or eliminated through various changes. These changes could apply prospectively to new employees or through collective bargaining to existing employees. Securing changes through collective bargaining usually involves some tradeoff—that is, agreeing to some other benefit in return. Consequently, the Legislature would want to consider whether a desired change in pension plans for current employees is worth the cost of the potential offsetting concessions.

Possible Benefit Changes

Benefits Still Locked In. Fixed benefit guarantees are inherent to defined benefit plans. Revising defined benefit plans, therefore, would not address the issue of locked-in benefits.

Close Some Formulas to New Entrants. There are a number of ways to modify benefit levels. For instance, if some benefit options are deemed too generous, the Legislature could close benefit formulas that far surpass those in other states and/or readily result in retirees having more income in retirement than when working. Most notably, this would include the 2.7 percent at 55 and 3 percent at 60 Miscellaneous formulas, as well as 3 percent at 50 for public safety.

Return to Three-Year Final Salary for Pension Calculations. As discussed above, the state and many local governments calculate pensions based on the highest one-year salary. The Legislature could adopt the three-year standard again for new employees. This would limit the incentive for salary spiking and conform with a typical defined benefit structure in other states.

Restrict Retroactive Benefit Enhancements. Because the stock market goes in cycles, excess pension assets at any particular point in time will likely be needed in the future to weather a market downturn. With retroactive benefit increases, these assets are used to pay the unfunded liability created by the enhancement. As a matter of fiscal prudence, the Legislature could prohibit retroactive benefit enhancements, or at least require them to be paid for upfront with governmental operating funds—not pension plan assets.

Possible Funding Changes

Set Aside Funds When Rates Dip. As mentioned previously, there is an ongoing, annual cost for defined benefit pensions—the normal cost. Contribution rates will vary around the normal cost over time—above to pay off unfunded liabilities and below to credit actuarial surpluses. The normal cost percent of salary, however, is the expected annual cost of retirement benefits over the long term. Consequently, one idea to explore is budgeting at least the normal cost in times when contribution rates dip below that amount because of higher-than-assumed returns. The budgeted funds above required contributions could be set aside to help offset future rate increases when investment returns inevitably decline. This would help blunt the impact of rate volatility and uncertainty, keeping budgeted contributions more stable during up and down times for the stock market.

Variable Employee Contributions to Share Cost Fluctuation. The Legislature could require employees to share in the growing or declining cost of the system, depending on investment performance and benefit enhancements. This would be accomplished through employee contributions that vary in the same manner as employer rates. Currently, state employees do not share any risk or benefit from changing contribution rates.

The Governor's proposed package of employee compensation savings includes this concept of shared costs. Current state employees would pay half the total (employee and employer shares) contributions to PERS. For most state employees, this would mean contributing approximately 11 percent of pay in 2005-06 instead of the current 5 percent. The Legislature could adopt this approach for new employees without collective bargaining.

Reassert Right to Change Employee Contribution. In addition to variable employee contributions, the Legislature could also reassert the right it has reserved in statute to change, at its discretion, employee retirement contributions for PERS. At the state level, this would need to be done for current employees through collective bargaining since current contribu tion rates have been established in employee contracts. For new employees, the Legislature could enact legislation specifying such adjustments.

Compensation Decisions Still Obscured. Revising defined benefit plans would not address the concern that they fundamentally make total compensation decisions more difficult because of the variable costs involved. Having a less generous benefits structure, however, would tend to reduce the annual cost of those benefits to the public agency. A smaller share of total compensation, therefore, would be variable.

Figure 6 summarizes how adjustments to the defined benefit structure could address many of the concerns with the existing system.

Other Pension Possibilities

In addition to modifying defined benefit plans within their current structures, there are other types of plans besides defined contribution pensions that can address the identified concerns. Below, we highlight these other possibilities.

Blended, or Hybrid, Plans

Smaller Defined Benefit Plus Defined Contribution. The federal government and several states have retirement programs that include both defined benefit and defined contribution components. The guaranteed benefit with these blended plans is reduced (generally paying approximately one-half the benefit per year of service as their original defined benefit plans). The contribution to the employee's defined contribution account adds additional retirement income from investment returns. With blended plans, employer contributions typically pay for the defined benefit component, and employee contributions go into the defined contribution account. Figure 7 shows the details of the plans sponsored by other states and the federal government. Two plans are optional and two are mandatory.

Reduces Magnitude of Rate Fluctuation. By maintaining a defined benefit component, blended pension plans would not necessarily resolve the cost concerns we identified. The costs of the system would depend on plan design. The smaller guaranteed benefit, however, would reduce the magnitude of employer contribution rate fluctuation. The defined benefit component of a blended pension plan could be structured to account for the benefit changes and cost controls outlined above in our discussion of modifying the existing system.

Cash Balance Plans

As discussed previously, cash balance plans share features of both defined benefit and defined contribution designs. These plans guarantee a certain annual return on mandated contributions, but do not guarantee a specific benefit level in retirement. Funds are invested and administered collectively by the retirement system (like defined benefit plans), rather than on an individual basis. These plans build up reserve funds with excess assets earned from returns that exceed the guarantee to offset later periods of lagging returns. Figure 8 shows the details of cash balance plans for nonsafety state employees in Nebraska and part-time teachers in California.

Cash Balance Plans Can Address Most Concerns. Cash balance plans address the contribution rate concerns with defined benefit programs because employer contributions generally are fixed. They do not have to vary to guarantee a particular benefit level in retirement. They do not completely eliminate the locked-in feature of defined benefit plans, however, since a return rate is guaranteed. But they can be designed to allow interest guarantees to change from year to year at the agency's discretion. In addition, the reserve funds from excess assets are intended to meet the guarantee when investments fall short. Depending on plan design, cash balance plans may or may not address the concerns regarding overly generous pensions under defined benefit programs. Like defined contribution plans, cash balance programs offer employees portable benefits. By investing funds at a system level, they also avoid high individual account fees.

Conclusion

Defined benefit pensions are the norm for public sector retirement. These types of plans, as currently structured in California, raise several benefits and cost issues. Focused on the high cost of the current system, the Governor proposes to shift all new public sector employees—state and local employees as well as teachers—to defined contribution plans. This type of retirement system addresses the concerns with defined benefit pensions and offers additional benefits, but also introduces some other considerations.

The Legislature has a variety of options from which to choose. In addition to defined contribution plans, these options include restructured defined benefit, hybrid, and cash balance plans. Each option generally has the ability to address the identified concerns with the current system.