Recent headlines about Orange County's bankruptcy have focused attention on the misunderstood world of public sector "457" deferred compensation plans. When it was reported Orange County employees could lose a significant percentage of their 457 savings, employees of state and local governments across the country became alarmed.
Amid such confusion and fear, there is often a tendency toward misinformation and misconception. Some forget the many strengths of a plan that has served the public sector well for more than 20 years, with only recent setbacks. Others attempt to exploit the fear by offering investment gimmicks that don't protect the interests of plan participants.
Let's not leap to simplistic solutions that will mandate new administrative burdens on state and local governments and undermine the retirement futures of government employees. Instead, let's examine the basics of 457 plans, explore their deficiencies and develop some legislative solutions. Now is the time to fix 457 plans.
A 457 plan is a non-qualified deferred compensation plan that permits employees to annually reduce their salaries by as much as $7,500, a limit imposed in 1978. By statute, assets in a 457 plan are owned by the employer and remain subject to the claims of the employer's creditors until received by the employee. Through this arrangement, the employee avoids receipt and, therefore, taxation as current income. As with other defined contribution plans, 457 plan participants are allowed to direct the investment of their contributions.
Despite their quirks, these plans have served the state and local government sector well over the years. A classic case has been the city and county management profession. This highly mobile, dedicated cadre of professionals continues to work for salaries well below their private-sector executive counterparts, rarely with golden parachutes, and often unable to obtain vesting under governmental defined benefit pension plans that may require 10 years or more of service. For many such employees, 457 plans are their only viable retirement vehicle.
For some, the knee-jerk solution may seem to be to scrap 457 plans and replace them with 401(k) plans. But 457 plans have thrived in the public sector for a number of reasons, among them that they are simple to administer. Even the smallest governmental units and the most understaffed personnel departments are able to make them available for their employees. That is clearly not the case in the private sector, where 401(k)s are rarely offered at the smallest plan level.
In addition, 457 plans are cost-effective. Imagine the financial burden if governments were forced to comply with all of the administrative regulations and non-discrimination tests that apply to private sector 401(k) plans. The regulatory complexity would overwhelm governments. Congress just voted to curtail unfunded mandates. We don't need to create a new one.
The arguments against 457 plans are similar to those that were made at the time of other financial setbacks. When people suffered losses from derivatives, some argued they should be eliminated. But wiser heads have understood their value. When pension plans suffered setbacks because of underfunding, the solution was to provide protection, not eliminate the pension plans. The best solution for 457 plans is to fix their deficiencies.
The first defect is the limit on contributions. While virtually every other limit used with tax-deferred employee contributions has been indexed to inflation, 457 deferred compensation contribution limits have remained fixed at $7,500. One solution would be to raise the limit to equal the maximum annual contribution allowed to employees under section 401. If Congress is truly devoted to the concept of promoting savings by public sector employees, then it should take the steps necessary to eliminate this inequity.
A second problem in the 1978 legislation was the drafters' use of employer ownership of the funds as a mechanism to achieve tax deferral. While useful at the time, subsequent legislation has made this artificial construct obsolete. Congress since has enacted IRA legislation, which provides for custodial arrangements to protect the contributor and beneficiaries. Modern fiduciary trusts likewise have been created to protect the interests of private-sector employees in defined contribution plans, whose life savings would otherwise be obliterated during a corporate bankruptcy. Why should the contributions of 457 plan employees be treated any differently? Why should their status in a bankruptcy proceeding be inferior - especially when almost all the money at risk is accumulated from their own personal contributions and its earnings?
Congress should enact a subsection in the 457 statute - a 457(g) provision - to protect public-sector employees' retirement savings plans. Public employers should be able to establish a fiduciary trust fund that would protect the interests of contributing employees in the event of an insolvency. No public policy is served by subjecting these assets to claims of general creditors. By the stroke of a pen, Congress can make these trusts eligible for tax deferral.
The 104th Congress promises to offer the best legislative environment in years for achieving workable reforms of retirement and savings legislation. As these bills move through Congress, let's not forget state and local government employees. Public sector participants have waited patiently in recent years while Congress has turned its attention to other pressing matters. But we shouldn't wait any longer.
It's time to fix this law, not wreck it.
Girard Miller is president of ICMA Retirement Corp. and the ICMA Retirement Trust, Washington.