Marsha Richter* is correct in saying, "Cookie-cutter approaches to retirement plan design just don't work." However, defined benefit plans for a large portion of public sector employees are just that - "cookie-cutter approaches." Quite often they help most those who are highly compensated and those who enter public service later in life.
Disproportionate rewards for some
This is not to say defined benefit plans are not needed. Some professions - such as fire protection, law enforcement and military service - need a young, physically strong work force. There should be retirement systems that encourage career transition at an age that serves both the public and individual's needs. But there are numerous examples in public sector defined benefit plans where systems were created or modified to reward people disproportionately to their term of service.
Retirement income and security should be based upon the cumulative effect of an individual's total working career. Defined benefit plans offer life-time annuities based upon some final average salary computation times a specified salary percentage times years of service. Benefit payments are often capped at a maximum percentage of final average pay. But through additional service credits that are sometimes granted for military service or other non-direct plan participation, second- and third-career people who join public defined benefit plans later in life at higher compensation levels frequently share disproportionately in retirement income distributions compared with employees who spend their entire career as contributing members to the same plan.
Defined contribution plan assets are actual earnings and contribution dependent. They require consistency of time and contributions to provide adequate retirement benefits. This consistency reward is an equity issue and is important to remember when debating the merits of one retirement plan over the other.
Private-sector employees who pay the taxes that ultimately fund public-sector defined benefit plans often do not enjoy the partial career benefit many public sector employees do as a result of defined benefit plan design, age and salary bias characteristics.
Career public-sector employees who see their retirement benefits capped out because of years of service do not see the fruits of consistent contributions and lifetime earnings on accumulated account balances defined contribution plans can offer.
Defined benefit biases
The proclamation that a defined benefit plan's "pooling of assets" is a benefit of professional money management and investment allocation methodologies is important. But this argument understates the impact of a well-designed defined contribution plan with investment options that mirror contribution and asset allocation strategies that investment consultants use to promote the value of their services.
Institutional investment consultants and money managers constantly are marketing their services to public retirement plan boards and trust managers. Public pension fund trustees are influential and have the authority to move large amounts of money. They can sometimes possibly make or break a consultant's or money manager's career. However, these services can be repackaged as educational tools and investment options to defined contribution plan members. The higher costs of operating in the individual market suggest, however, that the institutional investment community is better served when it promotes the interest of the institutional defined benefit market. This community therefore works diligently to encourage the defined benefit model over the defined contribution model. Its own costs of service are reduced with profits and careers enhanced.
Unfunded benefit increases
Benefit increases are both the bane and reward of the defined benefit plan. Benefit increases, when ad hoc in nature, are often not funded when granted. This, in turn, can lead to unfunded growth that, in effect, becomes a cost shift to future active members or causes lower employee future pay and benefit growth. The impact of this is also borne by the taxpayer in the form of either tax increases or reduced services.
Both local and state government entities are notorious for not funding "normal costs" plus "amortization of accrued unfunded liabilities" in their annual budgets. The long-term impact of defined benefit plan improvements and insufficient funding has several notable examples: Oklahoma's own Teachers' Retirement System being just one of them.
Active public employee associations and retiree associations are caught in the dilemma of trying to prove their worth to a membership by increasing today's take-home income while protecting or increasing tomorrow's benefit promise.
The argument also is used that defined benefit plans offer a secure income stream no matter what the market does. This argument overlooks how individuals can protect themselves from down markets negatively influencing their retirement benefit through use of various types of immediate annuities, deferred annuities combined with partial distributions or deferred partial settlements. These techniques, while not commonly discussed today in the defined benefit vs. defined contribution argument, offer great flexibility and the opportunity to protect one's retirement asset base from being permanently damaged from a temporary market downturn. They also allow an individual the ability to obtain retirement market enhancement options not offered to most defined benefit members.
Penalties of defined benefit plans
Just as defined benefit plans promote job stability, they also penalize those who leave public retirement plans before vesting. Young teachers and public employees who leave service to raise a family or seek additional education, and mobile employees who either don't return or return to work under a different employer's plan, often are impaired by defined benefit plan provisions. Longer-term employees who hit glass ceilings or wish to change careers are held captive or penalized by defined benefit plan provisions. Educational and public institutions often are reluctant to terminate poor-performing senior or near-retirement employees because of defined benefit plan provisions.
For a whole host of reasons, the mobility restrictions inherent in most defined benefit plans work against the taxpayers' interest. The answer to a lot of these restrictions may be seen in some of the hybrid plans and move toward newer defined benefit plan concepts. Until people get concerned enough to challenge the status quo or the taxpayer rebels to growing costs, the public sector is going to be reluctant to make any change or take on any risk.
Anyone who talks about controlling retirement system cost in the public sector is automatically labeled a radical and enemy of the public servant. People and their institutional interests mobilize to resist change. Changes are coming whether we like them or not, for that is the nature of government. Defined contribution plans have a greater role in the public sector than is recognized or allowed in today's debate. But don't forget the defined benefit plan and its hybrid variants; they, too, have a long-term purpose.
Defined benefit plans must control both their immediate cost and unfunded liability growth or they will be scrapped as having become too expensive. Public employees, their employers and the taxpayers need to actively debate and choose what is the best long-term program for their own set of needs. These interests are competitive. Society is more mobile and is changing its concept of personal responsibility. Should the taxpayer be asked to fund a more secure retirement for the public servant than he has the right to expect himself? Costs of retirement plan benefits should not be shifted to future generations. Public leaders, at the same time, should not tap plan assets to pay the current cost of government. In a perfect world, all things would balance. In today's world, all parts of the argument need understanding and debate.
*Marsha Richter, chief executive officer, Los Angeles County Employees' Retirement Association, in a June 9 Counterpoint commentary, titled "Mistaken rush to change public plans to DC."
James M. Harris is budget analyst in the Oklahoma office of state finance, Oklahoma City. The opinions expressed by Mr. Harris are solely his own and do not necessarily reflect the opinions of the office of state finance or any government entity in Oklahoma.