Foreword: This is the first of six weekly articles on public safety pension plans. They will not be “pep rallies.” They will be thought provoking and controversial discussions of sensitive issues designed to facilitate serious thinking. In addition, I will have an examination of the thesis by Jack Dean from Fullerton, California. Jack represents the other side of the pension issues – very well I must say. Some weeks he will agree with me, but with a different rationale. Other weeks he will rip me to shreds. If Jack and I do not get you stirred up, I will consider it a failure. Ron York
Why Defined Contribution Pensions Are Best For Employees
By: Ron York, President
POLICEPAY.NET
All retirement plans, both defined benefit and defined contribution, have three risks:
1) Market Risk (the interest that will be earned)
2) Mortality Risk (how long the employee will live)
3) Actuarial Risk (inflation, raises, retirement age, etc.)
The employer bears the risk with a defined benefit plan. With the defined contribution plan, the employee has the risk. If the administrators of the plan had perfect vision into the future, they could make exact predictions (actuarial assumptions). Alas, they cannot. Using the standard assumptions used by most actuaries, a police officer’s pension that pays 75% of the last year’s pay requires annual contributions of about 21% of total pay. A 90% pension would need a 25% contribution. The contribution rate is the total amount for both the employer and the employee. If the actuarial assumptions were perfect, the type of plan would not matter.
One thing we can be sure about is that the actuarial assumptions will not be 100% correct. As a result, both defined benefit and defined contribution plans have a major advantage and a major disadvantage from the employee’s perspective.
Defined Benefit Plans
Advantage – the benefit is fixed and will last for your entire life
Disadvantage – the employer’s contribution rate is volatile
Defined Contribution Plans
Advantage – the employer’s contribution rate is stable
Disadvantage – you might outlive the savings account
There is one more risk – the political risk. This is potentially the largest and most lethal risk. Under the defined benefit plan, an actuary is hired, either each year, or every other year to determine the amount of money that needs to be in the fund to cover all benefits earned to-date. Next, the values of all the pension fund assets are determined and compared to the amount that needs to be in the fund. The employer is then required to fund the difference. If there are more assets than the total earned benefits, the employer contributes nothing.
Here is the political risk. As long as the employer’s contribution is low, or even zero, there is no problem, but when the contribution rate gets high there is an uprising by politicians and tax watchdogs. The primary cause of swings in the employer’s contribution rate is the market risk. Unless the pension funds are invested in low earning interest paying instruments, it is impossible to totally avoid some volatility. As investment strategy becomes more aggressive, the swings become more exaggerated.
California is the best case study of this volatility. The California Public Employees Retirement System (CALPERS) is well known for being a high-rolling gambler with its funds. When they win, they break the bank, but look out when the luck runs out. The losses are staggering. In the end, they do okay, but the ride would kill an old man with a bad ticker. The city’s finance director loses his lunch when the rollercoaster goes over the high hump. The ride up was fun, but the drop causes panic and sends the director into a cutting frenzy. The hysteria soon overcomes the city council. Suddenly, your safe and reliable pension is fighting for its life. That is where we are today.
During the late 90’s and the start of this decade, most California cities were making contributions at a very low rate. Some, like Long Beach, were contributing nothing, not even the employee’s portion that they had agreed to pay. Few California cities were paying the current costs each year. This was made possible by CALPERS astute investment strategies. During 2000, the strategy began looking more and more non-astute. Overnight, the over-funded pension system was suddenly under-funded. By 2003, most cities saw their contribution rates skyrocket. Instead of paying a very low rate, many cities were faced with contribution rates in the 40% range. There was one other factor that increased the funding need – an increase of the annual accrual from 2.5% to 3.0% (3% @ 50). Many cities adopted the 3% @ 50 plan and grandfathered in prior service credits. The combined losses with CALPERS and the prior years service credits caused a few cities to have contribution rates near 50%.
CALPERS’ portfolio has improved since 2000, but cities addicted to low contribution rates began a cooperative rebellion. Public employee groups have not developed an effective plan to deal with the political pushback. There are two tactics being utilized since 2003. The teachers and nurses are screaming and hollering while throwing a tantrum. They were relatively effective doing this in 2005. Today, they are not getting any traction. Police officers and firefighters are utilizing the “hunker down and hope the storm blows over” strategy. That might work, but it is doubtful. One thing that cannot be done is to make a 90% pension acceptable to a typical citizen. You can put all the lipstick on it you want, but it will still look like a pig. I completely understand why public safety pensions are mostly in the 75% to 100% range. Few citizens do and it would be impossible to bring around a critical mass of them.
So, what can be done? Repackage and reposition the pension. How can this be done? Convert to defined contribution plans. I can hear you screaming, even though I am 1,500 miles away. Keep your seat and hear me out. Why do you find a defined contribution plan to be repugnant? I know why. It is the disadvantage I listed above – you are afraid you will outlive your pension account, either because the contributions will prove to have been inadequate or that you will live longer than anticipated. I believe I can address both of those issues. The annual contribution could be recomputed each year, based on new data. When you retire, your funds could be placed in a life annuity. Forget about the argument that defined contribution plans do not do as well as defined benefit plans with investments. It is a red herring.
With a defined contribution plan, the employer’s contribution would be constant and less likely to come under attack. The employer pickup of the employee’s contribution needs to end. Build it back into base pay. I fully understand the rationale for the pickup, but it looks bad. In the political arena, looks are everything. Under the defined contribution plan, there would be no discussion of the ultimate benefit, only the amount being contributed each year. If your 90% pension was converted to a defined contribution plan, with the employer contributing 16% and the employee contributing 9%, it would draw little attention. In my business, all publicity is good for business, even bad publicity. For the police union, all publicity is bad. You want to stay just under the radar. You do not want a public discussion about your pension – not ever.
The real risk to your pension is not the stock market. It is not the possibility that you will live to be 100 years old. The risk that needs to be moderated and hedged is the political risk. If you have too high of a profile, such as a 90% pension and periodic 40% contributions by your employers, politicians will drag you off to the “hanging tree.” They will let you live, but will take away your gold. Play it smart and you can keep your life and your gold.
Examination by Jack Dean, Fullerton, CA
I agree with everything you say in this article, and would only add more emphasis to your comments about the political risks unions are taking when they continue to ask for increases to defined-benefit pensions that are already considered to be extravagant by most in the private sector. Taxpayers are finally awakening to the fact that -- while pensions and benefits are being slashed in the corporate world -- public employees are getting bigger pensions, more generous benefits and retiring earlier.You have very astutely identified that a maelstrom is approaching over these defined-benefit plans, and that all publicity about them will be bad publicity -- not just for cops, but for all public employees.
Jack Dean is actively involved in the smaller government, lower taxes movement in California.
Editor & Publisher
PensionTsunami.com
www.PensionTsunami.com
President
Fullerton Association of Concerned Taxpayers (FACT)
Fullerton, California
Advisory Board Member
California Foundation for Fiscal Responsibility (CFFR)
www.CaliforniaPensionReform.com
