Public-sector defined contribution plans: lessons from seven governments.

• Author: Miller, Girard

This article is intended to provide a roadmap for public plan sponsors considering a defined contribution plan.

Editor's note: Many finance officers are confronted today with the challenges of establishing and maintaining effective and cost-efficient retirement plans for employees. Government Finance Review initially explored the differences between defined benefit and defined contribution programs in December 1997 in the Point/Counterpoint department of the magazine. GFOA recognizes that finance officers are looking at several options in this important area and its intention is to continue to present different viewpoints on the topic. This article makes a case for moving to a defined contribution plan. In future issues there will be articles focusing on the defined benefit plan.

Of the more than $2 trillion in retirement plan assets attributable to the public sector, a small fraction consists of defined contribution (DC) plans. Most governments continue to rely on traditional defined benefit (DB) plans as their primary means of providing retirement benefits to their employees. In the past three years, however, a number of public plan sponsors have begun to consider the feasibility of implementing a defined contribution plan of some type for their employees. This article highlights the issues, categorizes the various options available, and provides case histories to which analysts, financial managers, and policy makers can refer.

Defined Contribution Rationale

Unlike the private sector, where 401(k) defined contribution plans have become the largest pool of retirement plan assets, the public sector has been much slower to employ defined contribution plans under section 401(a) of the tax code. There are several reasons for this. First, Section 401(k) was closed to the public sector in 1986. Also, the private sector is subject to the federal Employee Retirement Income Security Act (ERISA) which imposes considerable regulatory and fiduciary responsibility upon corporate management and makes the liabilities of the pension fund a corporate financial headache; however, the public sector is exempt from such regulatory burdens. Likewise, the private sector is required to make financial contributions to the federal Pension Benefit Guarantee Corporation, while the public sector is exempt. In short, corporate CFOs have a strong incentive to shift their retirement plans into a defined contribution mode and relieve their financial statements and shareholders of the costs and the contingent liabilities of a pension plan. Governmental CFOs have no such comparable motivation.

Labor force unionization is now much higher in the public sector than in the private sector. Traditionally, organized labor has preferred to bargain for defined benefits, both as a matter of security and risk aversion on behalf of their constituents, but also as a strategic advantage in collective bargaining. Pension benefits can be distributed immediately to those who are in or near retirement, while the costs can be pushed into the future by politicians whose terms expire before then. As a result of ill-timed rhetoric by some of the political zealots advocating defined contribution plans as cost-cutting taxpayer-revolt strategies, DC plans often are perceived by labor interests as anti-worker, or anti-union. Not surprisingly, there has been resistance to implementing DC plans in the public sector where such emotional posturing has prevailed.

Defined benefit plans also have a professional constituency, that may include the retirement plan administrative team and the various professionals engaged in maintaining the DB plan - actuaries and investment advisers, for example. As one municipal treasurer said warily about DC plans, "I know that the pension fund won't go away if we install a DC plan, but there won't be as many assets, and therefore my job won't be as important." In the face of such institutional resistance, it is not surprising. that the movement some observers once expected to be a landslide toward defined contribution plans in the public sector has instead been a much slower drift. Although studies are underway in many jurisdictions, the shift to DC plans thus far is much more cautious and measured. Fortunately, however, there are now enough actual case histories to provide viable examples for others to study and, if they wish, to emulate.

Benefits of DC Plans. Public agencies that have installed defined contribution plans have been motivated by several factors. Thus far, few of the major cases have identical motivations and few of these could be deemed global. Instead, there have been local considerations that played a role in the impetus to change. Here are a few:

Social Security Opt-outs. Some of the earliest converts to DC plans in the public sector were the municipalities that elected out of the federal Social Security system and installed instead a 401(a) money purchase plan. Prior to 1986 legislation that closed the door to new 401(k) plans, some of these employers used the "(k)-plan" profit-sharing structure instead, but these are relatively rare. Instead of contribution to the federal FICA fund, these employers made comparable contributions to their employees' opt-out money-purchase DC plan. As we all know, the federal Social Security system includes a welfare and income-redistribution aspect, and as a result, it is usually the case that most employees who are enrolled in these opt-out plans can accumulate far more money over time than they will lose as a result of non-participation in Social Security. Employers also can avoid making contributions to the entire national workforce's survivors' and disability benefits and worry only about their own employees. Examples of opt-out DC plans, which are not cited directly elsewhere in this article, include the City of San Diego's plan, as well as a good number of plans adopted by Colorado municipalities, including their police and fire plans.

Controlling Future Retirement Plan Costs. In some cases, the plan sponsor has concluded that the costs of retirement plan benefits will be better controlled through a defined contribution plan, because there is no risk of an unfunded...