Virginia House Speaker William J. Howell recently announced a plan to create a new commission to study the possibility of shifting the state’s pension system from a traditional defined benefit pension model to a 401(k)-style defined-contribution model. The Virginia Retirement System (VRS) is the 22nd largest public or private pension fund in the United States and 49th largest in the world with 660,000 members, retirees, and beneficiaries. Howell argues reform is needed for two reasons: The state’s unfunded liability for state employee and teacher pensions, estimated at almost $21 billion, has grown out of control; and the system needs added flexibility and portability for new employees as major employee turnover looms in the near future.
In 2010, Virginia received a grade of “C” in The Heartland Institute’s 50-State Pension Report Card. Virginia made several attempts to reform its pension system since 2010. In 2012, the legislature adopted a reform plan that requires new employees to pay more into their retirement plans. State employees are required to contribute 5 percent of pay toward their retirement benefits. Only 1 percent of the mandatory employee contribution goes into a 401(k)-style defined-contribution plan controlled by the employee; most goes into the defined-benefits system.
In addition to the 1 percent mandatory employee contribution into the defined-contribution plan – which the state matches with 1 percent – employees have the option of contributing an additional 4 percent of their pay. The state will match additional employee contributions up to 1.5 percent. Only 9 percent of employees enrolled in the hybrid plan are making additional voluntary contributions, according to the Roanoke Times. The Times found around 28,526 employees are enrolled in the hybrid plan, compared to around 312,000 active employees in the two defined-benefit plans.
Moving Virginia’s pension system to a defined-contribution model puts the commonwealth on a path towards lowering costs and improving flexibility. All newly hired public-sector workers should be moved to defined-contribution pension plans and current workers should be given the option of transferring into a defined-contribution plan. Workers covered by defined-benefit plans own and control their pensions and can change employers without losing their accrued benefits. Defined-contribution plans also benefit taxpayers because the pension plan burden does not rise automatically due to cost of living adjustments (COLAs) and is more transparent, avoiding the accounting gimmicks governments currently use to hide the liability.
The underfunding of government pension programs is made worse by regulators overestimating the value of future investments and the rate of return they can expect from the investments held by the pension fund. For years, in addition to regular tax revenue, pension funds relied on assumptions of strong investment returns to allow them to reduce yearly government contributions to the funds. VRS currently has an assumed rate of return of 7 percent; in 2015 it realized a return of just 4.7 percent. Decreasing the expected rate of return has budget consequences. By lowering the assumed rate of return, which is used to determine the present value of benefits that will be paid to retired workers in the future, pension fund regulators will increase the reported level of unfunded obligations.
In the short term, per-year pension payouts should be capped, the retirement age should be raised, double-dipping and benefit spiking should be eliminated, realistic rate of return assumptions should be used, and pension systems should be protected from borrowing and fund raids. In the long term, pension fund sustainability will require governments to follow the private sector’s lead and switch workers from defined-benefit pension systems to defined-contribution systems. Only then can states and localities eliminate the burden of future pension liabilities, avert the pension crisis, and make budgeting more predictable.
The following articles examine state pension reform from multiple perspectives.
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 in the 50 states and suggests ways states might go about solving their pension problems.
Pension Plan Reform in Virginia
Robert Carlson of the Thomas Jefferson Institute suggests Virginia move toward a combined retirement program, part defined benefits and part defined contributions. Such a balanced system would make the commonwealth’s costs lower and more predictable while providing attractive benefits to employees.
The Momentum Grows: Virginia Creates Mandatory Hybrid System
Adam Schwiebert of the Buckeye Institute discusses Virginia’s 2012 public pension reform legislation. “The end result is a plan that saves taxpayer dollars, spreads out investment risk, limits runaway liabilities, and provides a reliable source of retirement income for government retirees. While hybrid plans may not provide the savings or simplicity of pure defined-contribution plans, they are a strong first step in reining in runaway defined-benefit pensions.”
A Review of Defined Benefit, Defined Contribution, and Alternative Retirement Plans
This paper from the Texas Pension Review Board outlines plan design options and presents potential reforms and case studies based on changes already enacted in other states. The interests of the sponsoring entity and the plan participant are considered when evaluating how best to ensure participants are financially prepared to retire while maintaining the long-term solvency of the plans.
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.
Research & Commentary: Defined Contribution vs. Defined Benefit Pensions
John Nothdurft, director of government relations at The Heartland Institute, provides a bullet-point comparison of defined-benefit pension and defined-contribution retirement plans.
Research & Commentary: Public Pensions and the Assumed Rate of Return
Heartland Institute Senior Policy Analyst Matthew Glans examines the problems facing state and local pension funds, how assumed rates of return affect pension fund debt, and proposals to change the projected rates of return on pension fund investments.
Fixing the Public Sector Pension Problem: The (True) Path to Long-Term Reform
Richard C. Dreyfuss of the Manhattan Institute examines various state pension reform efforts and recommends states borrow a page from the private sector by shifting to defined-contribution plans: “Under such plans, to which employees as well as employers may contribute, investment risk is borne by plan members, not by taxpayers. A majority of Fortune 100 companies have already adopted such plans. Only 16 percent of large companies still offer their retirees medical coverage. By sharing a complex of risks with the beneficiaries, states and municipalities would be able to devote far more of their time and resources to the more immediate concerns of today’s voters and taxpayers.”
The Gathering Pension Storm: How Government Pension Plans Are Breaking the Bank and Strategies for Reform
The Reason Foundation tackles the looming crisis created by states’ continued use of defined-benefit pension plans, offering solutions and explaining why the current system is a disaster in the making.
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 Web site at http://news.heartland.org/fiscal, The Heartland Institute’s Web site at http://heartland.org, and PolicyBot, Heartland’s free online research database, at www.policybot.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 a topic, The Heartland Institute can assist you. If you have any questions or comments, contact Heartland Institute Government Relations manager Nathan Makla at [email protected] or 312/377-4000.