Mixing it up: Exploring hybrid pension systems

The economic downturn has thrown even the most fiscally prudent governments for a loop. Dollars are stretching thin and new approaches to employee compensation are spreading across the nation. In light of the effects of the economic downturn, and as a measure to prevent similar fiscal vulnerability in the future, governments are particularly honing in on the manner in which they provide pension benefits. Everything from employee contributions, to retirement ages, to benefit levels are being reconsidered.

One concept receiving new attention is the use of hybrid pension systems. Hybrid pension systems are not new, but a lack of regulatory guidelines and several legal ambiguities suspended interest. In the last few months, greater clarification of federal guidelines for establishing hybrid plans has taken place. This may be what is needed to reinvigorate the hybrid conversation. Just this week, California’s Little Hoover Commission has suggested such a shift for California’s pension system.

Unlike private sector employers, most governments have stayed loyal to "defined benefit" pension systems. In such a system, regardless of the pension fund’s investment earnings, an employee can have confidence in receiving a certain pension payment upon retirement. This approach shelters government employees from unfavorable economic realities and requires the government to shoulder all the risk. When exposed to the downside of the risk, governments typically reallocate money away from other public service areas to appropriately fund their pension systems.

Most employers in the private sector have responded to market declines by switching to "defined contribution" (usually 401(k)) plans, which put the risk on the employee with benefit levels dependent on investment results. Many governments have contemplated similar moves, yet wrestle with whether or not switching to defined contribution plans will eliminate one of the key attractions to government employment and whether those plans provide for appropriate retirement security for their employees.

With federal regulations now better established for hybrid systems, pension options could be less polarized, a sentiment echoed in this Wall Street Journal article. Hybrid pension systems have gained traction because they remove some of the risk from governments, providing them with more shelter from poor stock market returns. However, unlike 401(k)-style systems, hybrid systems do not transfer the entire burden to employees. The risk is spread, instead, between both the government and its employees. This compromise could serve as a tool to both lessen the impact of market decline and protect an attractive benefit of public sector jobs.

There are various forms, but hybrid systems have the same basic composition – part defined benefit (usually a lower fixed benefit than the prior defined benefit plan) and part defined contribution. Benefits are viewed as hypothetical account balances and the accrued balance is portable, meaning it can be moved when an employee leaves government service to 401(k)s of his/her subsequent employers.

Hybrid plans often differ in the defined benefit formula, employer and employee contributions, and participation (voluntary or mandatory). The degree of shared burden, savings, and appeal depends on plan characteristics in addition to how those components differ from the current or proposed alternative and the subset of employees to which the change will apply. The Little Hoover Commission provided several examples of hybrid plans currently in place at the federal, state and local government levels, including Washington, Utah, and Orange County, California, shown in the table below:

Given that market uncertainty has caused defined benefit pension systems to significantly strain public services, as well as fierce public pressure to put public sector compensation in line with that of the private sector, hybrid plans are likely to continue to attract the attention of policy makers across the country. That attention has not taken shape in Wisconsin, however, with hybrid plans having yet to be picked up in the swirl of discussion surrounding local pension reform.

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.

Searching for pension solutions

As state, local and municipal governments confront the reality of huge losses in their pension fund assets and grimly assess the impact on future budgets, many will pursue innovative or even radical solutions, including some that likely never would have seen the light of day in ordinary times.

Out of Pittsburgh, for example, comes word in the Pittsburgh Post-Gazette of a proposal by Mayor Luke Ravenstahl to lease the city's 11 downtown parking garages, and perhaps its parking meters and neighborhood lots, in order to generate cash to pay down a large chunk of the city's $600 million unfunded pension liability.

The article notes a significant potential downside: a large increase in downtown parking rates. The mayor responds, however, that while he would like to "protect parkers", he must look out for "city taxpayers and pensioners" first. He goes on to add that while it is uncertain this effort will be successful, a parking lease could be "another piece of the ultimate...plan for the long-term legacy costs for the city of Pittsburgh."

Here in Milwaukee, meanwhile, the news keeps growing worse for the county's pension fund. Poor investment returns have reduced the market value of the fund by more than $500 million during the past year, and the unfunded liability now stands at more than $900 million.

Even if the county proceeds with its plan to issue Pension Obligation Bonds (POBs) - which a report before the Finance and Audit Committee next week indicates is still on track (see a previous blog post on POBs here) - that would only cover about $400 million of the outstanding liability, leaving the fund still vastly underfunded. In fact, the combination of POB debt service and costs associated with current and future pension fund liabilities could require an $80 million contribution in the county's 2010 budget, which is $32 million more than the amount allocated in 2009.

Will Milwaukee County officials respond with a plan for their long-term legacy costs and might such a plan involve selling, leasing or otherwise identifying new ways to make money off existing assets? During 2009 budget deliberations, the county board showed little interest in that approach, rejecting a proposal to study a long-term lease for General Mitchell International Airport, and also rejecting much smaller initiatives to lease the O'Donnell Park parking structure and install parking meters on Lincoln Memorial Drive.

Whether these types of strategies are the best or only options for the county certainly is debatable. As we have blogged previously, asset sale and lease proposals should be held up to a rigorous litmus test to ensure the public interest is served. The Chicago Tribune also has reported that Chicago's fascination with asset sales and leases has driven up costs for consumers.
But desperate times do call for desperate measures, and an $80 million pension payment in next year's budget certainly qualifies as desperation time for Milwaukee County. Selling or leasing county assets may or may not be a practical and correct answer, but with several months to go before the 2010 budget process begins, it is critical that this and other creative options at least be discussed as part of immediate bi-cameral planning for another substantial pension hit.