Redefining Pension Benefits... A National Trend

Recent stock market volatility has had a negative impact on public pension systems and governmental budgets. Even the best managed systems have seen unfunded liabilities grow dramatically, causing governments to rethink the basket of public services provided. Many governments are also considering cuts less noticeable to the public, but impactful to public employees.

Does the tremendous need for cost cutting measures make public sector pension reform inevitable? A recent study published by the American Legislative Exchange Council (ALEC), an association of state legislators, entitled State Pension Funds Fall Off a Cliff, discusses the losses that state government pensions have taken and pushes governments to further reform their pension systems. The authors argue that the only viable long-term solution is to replace current defined benefit plans with 401(k)-style defined contribution plans for new employees.

In addition to pursuing a defined contribution approach, many governments may seek retiree benefit reductions within the defined benefit schema. Milwaukee County, for example, has included a provision in its 2010 budget extending the normal retirement age from 60 to 64 for new employees and reducing the pension multiplier from 2% to 1.6% for new employees and for future years of service for existing employees. Though this has only been implemented so far for non-union employees, it reflects the types of adjustments being sought as governments become more strapped for cash.

Demonstrating that Milwaukee County is not alone, the Colorado Senate recently passed a measure that would make significant changes to pension benefits for current and future employees, including a five-year increase in the retirement age, a reduction in the cap on inflationary increases for pension payments from 3.5% to 2%, a five-year service increase for retirement eligibility, and increases of 2% for both employer and employee contributions to the pension system. Colorado projects a savings of $80 million annually from these pension reforms.

In addition, Massachusetts Governor Deval Patrick recently filed legislation that would dramatically reform pension benefits of current and future public employees. The proposal would increase the retirement age for all state employees and cap pensions at a percentage of the federal pension limit, or roughly $85,000. In addition, pension benefits would be based on the five highest-paid consecutive years of service rather than three years to better reflect an individual’s career pay. Judges would begin paying into the system as well. The state would save an estimated $2 billion over the next 30 years as a result of these changes.

This is not to say that 401(k) plans have been off the table. On the municipal level, last October, Orange County developed a two-tier pension system that gives general employees an option between the existing defined benefit pension formula and a new hybrid pension formula. Though the new hybrid pension will have a lower benefits formula, it will also include a 401(k)-type benefit that the county would match by up to 2%. This initiative is expected to save the county a projected $10 million in the first year. Orange County has also taken on other reforms that produce more modest savings, including negotiated benefit reductions for sheriff deputies.

The trends discussed above indicate that public sector employees and retirees should brace themselves for significant reductions in retirement benefits. Whether that's fair is subject to debate, but given the severe loss of assets experienced by many public pension funds, it may well be a necessity.