The high cost of traditional defined-benefit public pensions has become a hot-button issue as unfunded liabilities have raced out of control. For years, elected officials have guaranteed defined-benefit pension benefits (DB) to government employees but have not been adequately funding them and shifting the cost of the plans onto future taxpayers. The private sector already has realized that defined-benefit pension plans are unsustainable, and as a result, more than 80 percent already have switched to defined-contribution plans (DC) such as 401(k)s which provide employees more control over their retirement funds and allow workers to change jobs without long vesting periods.
There are several reform paths states can follow to provide substantive retirement benefits to state workers while keeping costs and future liabilities under control. One option that has been around for decades but has recently become more popular is the hybrid model. A hybrid model combines defined-benefit and defined-contribution approaches for the same group of workers. In many states, hybrid offerings have consisted of smaller DB plans used in conjunction with larger DC plans, where the larger portion of contributions have been placed. This arrangement, which has often been limited to new employees for legal and/or political reasons, allows the existing DB system to continue, placating current employees while limiting future liabilities.
Creating a viable hybrid model requires changes that go beyond simply merging DB and DC plans. To keep costs under control and refrain from diminishing benefits, a well-constructed hybrid model must also address the other factors increasing the cost of pensions, including double-dipping, benefit spiking, the lengthening of retirement years, and excessive cost of living increases for retirees.
One hybrid pension model that could serve as a model for states was created in Rhode Island in 2011, when then-State Treasurer Gina Raimondo (now governor) led an effort to reform the state’s pension system. The system had faced an unfunded pension liability of $6.8 billion and was less than 50 percent funded. The state passed the Rhode Island Retirement Security Act (RIRSA), introducing a hybrid defined-benefit/defined-contribution funding system, suspending cost of living adjustments (COLA) for retirees, and increasing the retirement age.
Under RIRSA, in addition to a hybrid DB/DC plan, Rhode Island suspended COLAs until the funding ratio for the whole pension system improves to 80 percent funded and increased the retirement age for receiving a full pension to Social Security’s age thresholds. The plan also addressed the state’s labilities problem by extending the amortization rate from 19 years to 25 years. This makes it easier for the Rhode Island government to handle pension debt payments.
Under Rhode Island’s hybrid model, employees and employers must contribute to employees’ retirement accounts, which grow over time through various investment strategies. If an employee leaves the public sector, he or she can withdraw the accumulated balance in the pension fund, which can then be used to purchase an annuity in the private sector.
While Rhode Island’s model is far from perfect, it demonstrates how a hybrid model must be paired with other common-sense reforms to succeed.
Hybrid models do not eliminate all the problems of a DB plan, but they limit the rapid growth of liabilities in the future. State policymakers should consider using hybrid plans as a viable model for reforming state workers’ pensions.
The following documents examine hybrid pension models in greater detail.
The Path to Public Pension Reform
In this Policy Briefing, Eileen Norcross and Olivia Gonzalez of the Mercatus Center at George Mason University discuss pension reform. They argue true reform must address “the inherent problems of public-sector accounting and management of pension funds and consider the benefits of defined contribution plans for public-sector workers. Reforms should be equitable for all generations, fund retirement benefits adequately, and have a plan for funding legacy obligations.”
Pension Reform Handbook: A Starter Guide for Reformers
This paper by Lance Christensen and Adrian Moore of the Reason Foundation considers many of the problems that troubled pension systems often experience. The authors also outline several principles they believe should be used as part of any pension reform effort.
Pension Reform Case Study: Rhode Island
Anthony Randazzo of the Reason Foundation examines Rhode Island’s pension reforms and concludes the Ocean State appears to have made significant strides in pension reform. Randazzo says if the state’s future leaders do not return to past practices, Rhode Island’s reforms could offer strong examples other states and municipalities could learn from.
Not So Modest: Pension Benefits for Full-Career State Government Employees
Examining the benefits paid to state and local government employees, Andrew Biggs of the American Enterprise Institute argues drastic benefit reductions for current retirees would be unfair, but reforms to make public- and private-sector pensions more equitable should be on the table.
The State Public Pension Crisis: A 50-State Report Card
This Heartland Institute report examines problems facing public pension systems, including the enormous burdens public employee pensions pose in some locations. The report ranks each state according to the operation and relative disposition of the pension plans and suggests ways states might go about solving pension problems.
The Limits of Retrenchment: The Politics of Pension Reform
Daniel DiSalvo of the Manhattan Institute examines pension reform and argues states that are serious about keeping pension costs under control are increasingly introducing defined-contribution options or hybrid plans. As more states take this step, it will become less controversial and easier for other states.
Keeping the Promise: State Solutions for Government Pension Reform
This report from the American Legislative Exchange Council describes the variety of pension plans governments use today and the advantages and disadvantages of each plan. It also provides several tools legislators can use to ensure governments can affordably fund retirement benefits for their employees.
Defined Contribution Pension Plans in the Public Sector: A Best Practice Benchmark Analysis
This white paper from the TIAA-CREF Institute “addresses best practice benchmarks for the design of public sector primary (core) defined contribution pension plans. It includes an examination of the environmental conditions and factors affecting these plans as well as general principles for the design of effective defined contribution plans. Selected public sector core defined contribution plans are reviewed against identified best practices.”
Let Employees Control Future of Retirements
Jagadeesh Gokhale and Peter Van Doren of the Cato Institute explain why the market is best-suited to relieve the fiscal pressures caused by state pension funds.
Nothing in this Research & Commentary is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit the Budget & Tax News website at https://heartland.org/publications-resources/newsletters/budget-tax-news, and The Heartland Institute’s website at http://heartland.org.
Whether sending an expert to your state to testify or brief your caucus, hosting an event in your state, or simply sending you further information on the topic, Heartland can assist you. If you have any questions or comments, contact Heartland Institute Director of Government Relations John Nothdurft at [email protected] or 312/377-4000.