If more confirmation is needed that defined benefit plans are dinosaurs, it comes from California's Little Hoover Commission, which concluded in a recent report that the current system, at least in the public sector in California, is unsustainable.
“California pension plans are dangerously underfunded,” said the commission report, released in February. The report says excessive pension benefits formula further burden pension plans that “already are unsustainable” and “contributed to an unsustainable pension environment.” It sets out a series of recommendations “to put the state's pension plans on a path to sustainability.” It proposed replacing the current defined benefit plans for public employees in California with a more affordable and stable hybrid system combining elements of defined benefit and defined contribution structures.
That recommendation by the commission — formally called the Milton Marks Little Hoover Commission on California State Government Organization and Economy — was based on thorough research and testimony from diverse constituencies, and could profitably be followed coast to coast and worldwide.
Some public funds are well-funded, but even some sponsors of those plans have considered, or are considering, benefit cuts and contribution increases, or even moving to defined contribution plans because of concern about the sustainability of the DB plans.
For more than a decade, corporations have been curtailing or terminating their defined benefit plans. The biggest and most significant recent one was General Electric Co., which closed its well-funded defined benefit plan to salaried employees hired after Dec. 31, 2010. New salaried employees instead will receive a new contribution equal to 3% of eligible pay to their GE 401(k) account.
“Pension (cost) has been a drag for a decade,” Jeffrey R. Immelt, GE's chairman and CEO, said at an investor outlook meeting Dec. 14 announcing the change. “Costs have grown, driven by non-cash amortization, which has distorted ... in many ways the operating performance of the company.”
Corporations can move more quickly than public-sector sponsors to curtail DB plans to trim costs and improve sustainability. But they can't easily come up with new varieties of replacement plans, although a generation ago they developed 401(k) defined contribution plans. That needed the blessing of both the Internal Revenue Service and Department of Labor.
Pension engineering is an area where the public sector has an advantage over corporations. Unconstrained by ERISA (although still under IRS rules) the public sector has more latitude to experiment in creating retirement programs, and could serve as an incubator of new ideas for financing retirement income.
The Little Hoover Commission was not just a messenger of bad tidings, dissecting the problems and attributing blame for the deep underfunding of the current systems. It produced a set of recommendations, including for an alternative pension structure “that can put the system on a path to sustainability.”
That key recommendation is a hybrid plan. It retains the defined benefit formula at a lower level and combines it with an employer-matched 401(k)-style defined contribution plan to provide an adequate retirement income.
It is a system of shared risks and responsibilities between the public-sector employees and the retirement plan sponsors, that is, ultimately, taxpayers. The two sets of constituents share investment risk, contribution risk and benefit risk.
That balance is what is lacking in the current defined benefit and defined contribution structures. Each represents an extreme on the retirement income plan spectrum. Neither can provide both affordability and security.
Virtually no employer is starting a DB plan, according to the Pension Benefit Guaranty Corp.'s latest data. Of 656 plans started in 2008, 381 of them have five or fewer participants, and mostly are for professional groups. Only 18 of the new DB plans have 100 or more participants, the largest having only 1,045.
Orange County is testing the commission's model, as Pensions & Investments reported June 28, as an option for new employees and is seeking an IRS ruling to allow existing participants the option to choose the hybrid plan. The 401(k) part of the hybrid is risk-managed to protect participants.
At the same time, the growth of the DB part has to be restrained to try to keep it from becoming unaffordable to taxpayers. The commission recommends submitting all pension increases to voters, who would be supplied with detailed actuarial estimates, in the respective jurisdictions. The hybrid plan will give participants more of a stake in the market and an understanding of its role in pension financing.
The systems have to reform. They can't invest their way out of the problem as they have attempted to do.
“A public pension ... is not a get-quick-rich investment” that banked “on high fund returns and an aggressive investment strategy,” causing employers to fail to contribute sufficiently, the report noted. “Investment losses in 2008-"09 certainly shocked the system.” But other factors contributed “to an unsustainable pension environment.” These factors include the temptation for politicians to increase public employee numbers and compensation while also reducing the minimum retirement age, which have ballooned pension liabilities.
While states have more flexibility to create new retirement programs, they will have a tough time changing the status quo.
“The system won't be easy to change,” the commission noted. “With the reforms. recovery is possible, though it will take decisive action through the Legislature, and potentially, the courts, to make it happen.”
A new sustainable pension system with employees and sponsors sharing risks and responsibilities is the best course to secure future retirement income.