The Organization for Economic Cooperation and Development adopted a series of recommendations from its Council for the Good Design of Defined Contribution Plans last year. The first recommendation is "Design DC pension plans that are coherent with their long-term purpose and role in the pension system."
Over the last several decades, the purpose and role of DC plans in the U.S. private sector has changed rapidly. Private firms have greatly reduced their use of defined benefit plans as a primary retirement plan offering, and the commensurate proliferation of the 401(k) plan has resulted in many, especially young American workers, relying only on a combination of Social Security and independently accumulated DC wealth. This transformation has not occurred in the public sector. While some states and municipalities have shifted to a hybrid DB/DC approach, and a few, like North Dakota in April, have eliminated their DB plan for new employees entirely, DB plans remain the primary source of retirement benefit in most government retirement systems.
So why pay attention to public DC plans? In short, because their long-term purpose and role in state and local systems is evolving in response to the changes in the benefits DB plans provide. Since 2009, nearly every major public pension system in the country has undergone some type of pension reform. While many of these reforms have not included wholesale structural changes, a recent analysis conducted at the National Association of Government Defined Contribution Administrators reveals that two-thirds of public retirement systems have reduced their DB benefit, even for full-career employees. Although these policy changes are often subtle, the changes in the calculations used to compute these DB benefits will have a material impact on the monthly check a retired government employee will receive. As depicted in a chart on page 6 of the NAGDCA report "Quantifying the Effects of Pension Reform on Public Employee Benefits," where Tier 1 represents the first tier created in the retirement system and Tier X represents the current benefit each government is offering to attract new employees, the median reduction between Tier 1 and Tier X plans is about 15%.
A similarly focused report from the National Institute on Retirement Security and Aon — "The Real Deal for the Public Sector" — concluded that, "While the combination of Social Security, a pension and retiree medical benefits covers much of an employee's needs at retirement, that combination alone is not sufficient to meet total needs. If offered a supplemental DC savings plan through their employer, such as a 457 plan, the average public-sector employee should strongly consider setting aside additional savings for retirement."
Further, the report noted that accumulating sufficient retirement savings is growing more challenging for younger generations, specifically, and purports that, among the challenges of increased longevity and expected higher medical costs, "the impact of changes to plan designs and benefit offerings in recent years will be borne disproportionately by younger cohorts of workers, who will participate in tiers of pension plans with less generous benefits."
Unlike the revolutionary change from DB to DC in the private sector, this diminishment of public-sector DB benefits is a slower evolution that largely has gone unnoticed. Unless this changes, public employees will suffer the consequences.
Recent research offers a glimmer of hope. In September 2022, NAGDCA partnered with the Employee Benefits Research Institute and J.P. Morgan Asset Management to conduct an analysis of the saving and spending habits of 37,000 public-sector households. As detailed in the resulting research report — "Spending and Saving Behavior of Public-Sector Defined Contribution Plan Participants" — households whose retirement system had shifted to a hybrid or primary DC plan spent less and saved more than their peers with a primary DB plan. This makes sense, given that this population should expect a reduced guaranteed retirement benefit.
Unfortunately, this analysis also found that households with a primary DB plan spent and saved at the same rate, regardless of their time in the plan and if their system had experienced a significant reduction in benefits in the recent past. This means newer public employees can expect to receive a smaller DB check in retirement than current retirees, but they are not saving commensurately in their DC plans to compensate for that reduction. This point becomes even more important when considering that more than one-quarter of public employees do not participate in Social Security.
Within the world of state and local government pension systems, with tremendous variation across geographies, what contribution to retirement preparedness should DC plans be expected to make? How can that contribution be realized? These are the questions state and local government pension systems need to thoughtfully address to ensure the proper deployment and use of DC plans consonant with their role and purpose in the retirement system.
At NAGDCA we will be working to help answer these questions. Whatever the conclusions, it's clearly time to recognize the imprudence of ignoring public-sector DC plans. In the current environment, the purpose and role of these plans in a coherent public-sector retirement system has changed: Their inclusion is no longer optional.
This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.