Michigan will begin a significant shift in the philosophy underlying the state's pension plan next month. State employees hired after March 31 no longer will be eligible for the traditional defined benefit pension plan. Instead, a new law requires new employees to join a defined contribution plan.
Defined contribution is the right choice for employees and taxpayers, for the state government and the financial markets.
For employees, it provides greater mobility of pensions. It will decentralize investing. This includes enabling employees to exercise their social conscience by putting their money in mutual funds that reflect their views instead of having the state make those contentious decisions.
For taxpayers, defined contribution forces greater budget discipline and reduces budget uncertainty. Defined contribution requires decisions to increase state employee retirement benefits be paid when the decision is made, not 30 years in the future. It forces the state to bear the full cost of increased benefits immediately and no longer asks the taxpayer to shoulder the cost of poor investment performance.
For the capital markets, the decentralization of decision-making represents good investment policy, both for the state and for the national economy. Government should not be able to select a company's chief executive officer. Yet, today's traditional public pension system - with its highly centralized defined benefit plans - is heading toward that possibility.
Among the advantages, adopting a defined contribution system constitutes superior personnel policy. Defined contribution eliminates inequities inherent in a traditional defined benefit system and offers great advantages to employees. Public Act 487 of 1996, which was signed by Gov. John Engler Dec. 23 and which also changes the state's traditional retiree health care plan, includes a mechanism for current state employees, vested and non-vested, to switch to the defined contribution system.
Public pension funds are becoming more important as investors in the marketplace.
As the table shows, the 15 largest public pension systems are controlled by 159 people. These individuals control $761.9 billion in wealth.
If these 15 funds voted as a block they could have a substantial influence on private companies ranging from investment policy to personnel decisions.
The potential for abuse is real. An important public policy question is: "Should public pension funds be able to exert such influence?" To put the point another way, are public employees benefited and is the nation as a whole better off with more control of the private sector placed in public hands through the power of the public pension plans?
The Michigan state treasurer is the sole investment fiduciary of Michigan's public retirement funds totaling $35 billion. The issue of targeted investment - social investing - is always raised. Should the state treasurer invest in a manner that achieves certain social ideals, even if the rate of return is less, or should he structure investment policy to maximize financial return?
Decisions made by a pension fund fiduciary often come under unfavorable public scrutiny. Some question the investment choices made. As sole investment fiduciary for the state of Michigan retirement systems, the treasurer, pursuant to federal and state law, must invest the pension funds solely in the best interests of the members and beneficiaries. However, in reality, the cost of underperformance for whatever reason is ultimately paid by the taxpayer.
A defined contribution system allows the individual investor to engage in social investing if he or she so chooses. Individuals may cast their votes consistent with their views on issues by selecting some investment vehicles over others. Any reduced rate of return is realized only by the investor. The taxpayer is no longer the guarantor.
In Michigan, the treasurer is appointed by the governor. In other states, pension funds are overseen by a board appointed or elected by someone. The point is that a small group of individuals wields tremendous economic power. On an a priori basis such concentration cannot serve the total national interest compared with a system in which millions of individual decisions on where to invest the large sums of capital ultimately determine the allocation of capital.
A defined contribution system that allows each public employee the ability to direct his or her investments permits social investment decisions exactly proportionate to the individuals desiring the policy.
Budget discipline and uncertainty
Under a defined benefit system, the employer is responsible for providing current retirees with a fixed amount. To do this, future obligations are estimated and a pension fund is established. The employer usually contributes an amount for each employee based on a percentage of the employee's salary. In managing a pension fund, the employer bears the risk of changes in the economy or the plan's benefits that affect the growth of the fund's assets or its liabilities. The employer must also increase contributions if the system is changed to provide a greater benefit to future retirees.
One problem with a defined benefit plan is that if benefits are increased, such as through a change in law, future contributions must be increased to pay for the additional cost. However, it is easy to vote for an increase in benefits that need not be funded until far into the future. A defined contribution system still allows legislators to increase benefits as they wish, but it requires them to pay immediately. In fact, the only way to increase benefits is to increase contributions. The potential for spending the next generation's tax money is greatly reduced under defined contribution.
Another problem addressed by moving to defined contribution is one of budget uncertainty. One or more changing factors alone or in combination can result in a system that is underfunded: poor investment performance, large increases in wages, increased longevity in the work force, and increases in the percentage of employees vesting can result in obligations that are greater than expected. What happens when a pension system owes more to its beneficiaries than it is able to pay? For the state of Michigan, taxpayers must pay for it. Public employee pensions are guaranteed by the Michigan Constitution, which means any deficiencies must be funded with taxpayer money. Those who benefit from the system should be asked to bear the risk associated with those benefits.
The defined contribution system places the investment risk with those who receive the benefit, the employees. The taxpayer is taken off the hook.
Workers come to the workplace today with more and different skills. As a result, they are becoming increasingly mobile. The average worker 20 years ago changed jobs two or three times in his or her lifetime. In contrast, future workers are expected to make as many as eight to 10 employer changes over the course of their careers.
Such a dramatic change has significant implications for traditional methods of compensating employees. Pension systems provide workers with a strong incentive to remain with an employer by requiring employees to work for some number of years, often as many as 10, before being eligible for benefits. Therefore, an employee faces a very strong financial incentive to remain with an employer, at least until he or she is vested in the pension system. Some argue that by encouraging employees to remain with the state, the state retains "expertise." However, encouraging people to stay longer means by definition the employees are staying longer than they wish. Is government well served by encouraging large numbers of employees to remain when they wish to work for someone else?
This problem has a name: the golden handcuffs phenomenon. Employees often are "trapped" in a job because of the huge cost of leaving a pension benefit if they are not yet vested. An employee who is three, four, or five years away from being vested forgoes a large benefit by advancing his or her career and changing jobs. Many employees make a conscious decision to "stick it out" for another few years in a job they otherwise would leave. The result is a system with such a huge financial cliff that employees unhappy with their jobs must stick it out.
For the employer, the vesting period in a defined benefit plan can be a large hindrance to hiring highly skilled people. Mid- and upper-level managers who would otherwise come work for the state might be reluctant to move because they would not accrue any retirement benefits unless they stayed for 10 years. This barrier has prevented the state from attracting many qualified people from business and industry.
From an economic perspective, the features of a defined contribution plan are also desirable because they reduce obstacles to mobility in the labor market. A plan that does not pose barriers to mobility produces a labor market that can respond solely to market forces, not incentives that are institutionally imposed. A market that operates freely promotes a stronger national economy.
Certain features of the defined benefit system result in an inequitable distribution of benefits. The greatest inequity results from the vesting requirement. According to Gabriel, Roeder, Smith & Co., an actuarial firm, only 43% of persons hired remain with the state for 10 years. Therefore, as many as 57% of new hires never vest in the pension system. It is unfair that an employee who works for the state for 10 years receives a retirement benefit, but an employee who stays nine years and 11 months does not.
Another inequity arises from the formula used to determine retirement benefits. Because benefits are calculated based on the three consecutive years for which the employee's salary was the highest (usually the three years preceding retirement), two employees with very different salary histories over a long career might be entitled to the same pension benefits only because they ended up with the same salaries in their final three years of employment.
Quirks of fate can result in large variations in benefits between retirees under a defined benefit plan. Consider the example of the employee who worked for the state for 40 years. Shortly before retiring, he passed away. He was not married, so his estate received only his state-paid life insurance benefit. His heirs didn't receive any pension benefit for his 40 years of service. The philosophical question is whether payment for services rendered should be a function of how long one lives.
A defined contribution plan solves these problems. Employees vest after a short period of time. No matter when they leave, they take the accumulated benefit they have earned. nDouglas B. Roberts is treasurer of the state of Michigan and Matthew J. Hanley is legislative specialist in the Department of Treasury.