Pension U-Turn

West Virginia switches Teachers’ Retirement System back to defined benefits.


During a fraught period in which many states have dangerously underfunded their public pension plans, West Virginia is trying to go the other way. Since taking office in 2005, Governor Joseph Manchin III, a fiscally conservative Democrat, has plowed $1.4 billion in one-off contributions into his state’s Teachers’ Retirement System, determined to boost the plan’s long-woeful ratio of assets to liabilities. As of July 1, 2008, funding had risen from 21 percent to a healthier, if still anemic, 50 percent.

Even as many U.S. corporations are freezing or ditching their traditional pension plans — and public entities are trimming their benefits — Manchin and West Virginia have set themselves an even more difficult, and somewhat counterintuitive, task: to switch school workers back to their original defined benefit plan nearly two decades after encouraging them to shift to a defined contribution scheme. Beginning in 1991 all new school workers were directed to the defined contribution plan, and about 10 percent of the system’s 40,000 existing teachers, cooks, custodians and other school service workers voluntarily made the change. Then, in 2005, West Virginia returned to enrolling new employees in its defined benefit plan. The next year school workers voted to end the defined contribution plan altogether, but a state court ruled that vote unconstitutional. Last July, after prevailing in a series of legal challenges from school employees, the state gave the kind of concessions the plaintiffs had been seeking anyway. It allowed longtime defined contribution participants to reclaim their traditional pensions, reinstating their benefits based on years of service and final average salary, as though they had remained in the plan all along.

“It’s a sweet deal, it’s almost heaven,” says Sandy Gay, who retired last year after 34 years as an elementary school teacher. She had agitated for the change for years. “I couldn’t have retired otherwise. I’d probably have dropped dead in the classroom — not a pretty sight for a seven-year-old.”

The switch is no freebie: Teachers and other school personnel must surrender the balances in their defined contribution accounts. That’s good enough to earn 75 percent of benefits. To get a full pension, employees have to make a supplemental contribution — about $14,000 in Gay’s case. That’s small change for a monthly check that will be about double the $1,300 she would have received had she bought an annuity with her accumulated defined contribution savings.

All in all, the policy shift is a calculated gamble by West Virginia. School workers and their powerful unions may be elated, but the move will nearly double — to some 35,000 — the number of active members in the defined benefit plan, dramatically increasing liabilities, requiring additional, and costly, state infusions to close the funding shortfall and putting the onus of achieving strong investment returns back onto the state.

Wary of worsening the state’s funding gap, Manchin admits that he was initially skeptical about the switch, which had been pushed with growing political force by teachers’ advocates as evidence mounted that many school workers faced an impoverished retirement and might be forced to turn to the state for aid. The governor came to embrace the plan thanks in part to favorable actuarial analyses. Last spring a study by the New York–based Public Resources Advisory Group, commissioned by Manchin, projected that the transfer would cost the state about $20 million; in August, after it turned out that the 15,000 or so individuals transferring were younger than expected, the actuary for the Consolidated Public Retirement Board, which administers benefits for West Virginia’s eight public pension plans, calculated that the state would actually save $22 million in up-front costs.


“When they told me that going back to defined benefit was actually going to help us, it didn’t make a lot of sense,” Manchin tells Institutional Investor . “But the facts really lend themselves to [the switch].”

The trouble is that those facts — West Virginia’s assumptions and calculations — were established in happier times. The recent meltdown of global markets makes the state’s estimates, based on July 1 data, seem pretty optimistic. Like many pension funds, TRS assumes annual asset growth of 7.5 percent. Between July 1 and December 31, 2008, the plan received some $686 million transferred from defined contribution accounts. Even so, total TRS assets fell $237 million, to $3.1 billion. As a result, West Virginia will need to increase its total contribution to the retirement system from $290 million to $332 million for its fiscal year ending June 30, 2010. Thus the state begins the switch back to pensions not with a small windfall, but unexpectedly in the hole.

“I guess you could look at it from that standpoint,” concedes Manchin, who is also a trustee of the West Virginia Investment Management Board, which manages funds for TRS and other state plans. “But you also could weigh that against what I would be paying out in health care, food stamps and subsidized housing if they remained in the defined contribution plan. It’s a catch-22.”

One lawmaker says it’s hard to understand how anyone ever expected the shift to a defined benefit plan to be profitable for the state. Because West Virginia now bears investment risk, its contribution rises if returns fall short, as they have recently — even more so because the number of active members has nearly doubled. Indeed, says Dan Foster, a Democrat who helped push through the legislation as head of the State Senate’s pensions committee, the projections of up-front savings derive from a process that involves “smoke and mirrors that only an actuary can understand.”

IN THE END, WEST VIRGINIA’S decision to reinstate the defined benefit plan goes beyond economics and reflects the troubles the state has had with pension money for a long time. The system has been plagued by a history of chronic underfunding, a scandal involving the governor’s uncle and Wall Street investment banks, and allegations that teachers were hoodwinked into opting out of the defined benefit plan in the early 1990s. “Where all the accountability [for the state of the pension system] lies nobody will ever know, but there’s a shared accountability,” says Foster, who immersed himself in pension issues after joining the State Senate in 2004.

In 1989 the governor’s uncle, A. James Manchin, then the West Virginia state treasurer, resigned after impeachment proceedings began for what a report by special prosecutor James Lees found to be “extremely speculative” trading in long-term U.S. Treasury bonds. Beginning in 1985, Manchin and two of his deputies had tried to boost returns — not only in the retirement funds but also in the government’s $2.4 billion operating budget. By 1987, after Manchin had doubled down on bad bets, West Virginia had lost $287 million. In 1989 the state sued Morgan Stanley, Salomon Brothers and other Wall Street firms, alleging that they had encouraged the trading by using illegally “aggressive” sales tactics. After seven years all of the suits had been settled out of court. The state recovered a total of $55 million, $20 million of it from Morgan Stanley.

By 1991, with a funding ratio of just 8 percent and a nearly $3 billion shortfall, West Virginia’s retirement system was nearly broke. The reason: chronic underfunding, which dated to its establishment in 1941. By the late 1980s, an actuarial analysis of the state’s pension funding needs concluded that employers should be required to contribute 9.5 percent of their payroll to the retirement system. Yet the state was putting in less than 2 percent. Politicians had also raided the assets of the pension fund to pay general state obligations.

“There was some fear that the state was going to have to start actually paying people’s pension benefits out of general revenue,” says Bob Brown, executive secretary of the West Virginia School Service Personnel Association, who helped lead the charge to reinstate defined benefit plans.

In 1991 the state made the decision to push employees into the defined contribution plan. “The market was booming, and it sounded good,” explains Brown. Legislators also adopted more-stringent funding rules, agreeing to make supplemental contributions to reach full funding over a 40-year period ending in 2034.

Altogether about 4,000 or so existing workers opted out of the defined benefit plan in the early 1990s. Many did so expecting juicy market returns. Others feared that with the defined benefit plan in such bad shape, they would never see their benefits. Such fears were unfounded, of course: Teachers’ accrued benefits were guaranteed by the state. West Virginia also made the switch enticing, offering to boost members’ take-home pay by reducing their retirement contribution to 4.5 percent of their salaries from the 6.0 percent they had been kicking in. The state would make up the difference, boosting its contribution to 7.5 percent to bring the total to 12 percent, equal to what went into the defined benefit plan.

Still, it’s arguable how informed many of those switching into the defined contribution plan were. Although the Consolidated Public Retirement Board had committed to providing advice, most of those considering transferring received guidance only from salespeople from the Variable Annuity Life Insurance Co., now part of American International Group, according to David Haney, executive director of the West Virginia Education Association.

Valic recruited and trained a sales force made up of former school superintendents, coaches and other insiders. Toting then-novel laptop computers, the salespeople met prospects in teachers’ lounges, giving the impression they were representatives of the retirement system, teachers say. “The Valic guy kept going over everybody’s financial matters and saying, ‘You’ll be much better off if you go into the defined contribution plan because you’ll be able to invest your money,’” recalls Gay.

“It was exactly the same story from the panhandle to the southern tip of the state,” says Haney.

Not surprisingly, the most popular investment choice of those transferring was a Valic fixed annuity, not any of the six other options, which included bond, growth, balanced and money market funds from Merrill Lynch & Co., Federated Investors and others.

As the ’90s wore on, the collapse of the dot-com bubble crushed fund balances because retirement allocations to stock funds had increased during the decade. Teachers, among the most powerful political groups in the state, began to worry that members of the defined contribution plan wouldn’t have enough to retire on. In 2002, newspaper reports blamed the government for having engaged Valic. The articles charged that the insurer’s agents had misrepresented the annuity, engaged in high-pressure sales tactics, failed to disclose that they were insurance agents and implied that no retirement money would be available in the defined benefit plan then offered by the Teachers’ Retirement System. The same year, West Virginia insurance commissioner Jane Cline investigated the allegations and cleared Valic of any wrongdoing.

But the issue remained salient, and when Joe Manchin ran for governor in 2004, he pledged to close the defined contribution system and reinstate all of its members in the defined benefit plan. Manchin’s original approach called for conversion of all members of the defined contribution plan, which lowered the projected cost. In 2005 he signed legislation reopening the defined benefit plan to new hires and leading the way toward merging the defined contribution plan into it. The merger ultimately failed, however, because the bill required all members to convert if a majority voted to do so — an all-or-nothing result that was attractive to the state because costs would be both lower and more predictable. In March 2006 a majority voted in favor of merging the systems, but hundreds of members sued because they wanted to keep their money in the defined contribution plan. In early 2008 the State Supreme Court ruled in their favor, saying the forced conversion amounted to an illegal taking of assets. The merger was off. The total membership of the defined contribution plan, which included 15,000 who opted for change and 5,000 who didn’t, was stranded in the scheme whether they wanted to be there or not.

Quickly regrouping, legislators in March 2008 fashioned a bill that would pass muster with the State Supreme Court. They agreed that only those who elected to convert would have to do so but specified that at least 65 percent of the active plan members would have to cast a vote in favor, because lower participation rates would impair the economics of the switch. If more than 75 percent favored the transfer, then any supplemental cost to members to get 100 percent of their benefits instead of 75 percent would be greatly reduced. These thresholds of 65 percent and 75 percent were necessary to ensure that the state could afford the transfer.

Crafting a bill with so many variables was mind-bending, says Senator Foster, a general and vascular surgeon with degrees from Harvard University and the Stanford University School of Medicine. “You’re trying to educate people and trying to figure out the psychology about how they’re going to go as well as trying to look at the dollars and cents and not knowing how you’re going to end up,” he explains.

Rushing to complete a vote before the June 30 fiscal year-end, teacher and school-service organizations barnstormed the state, educating members about their options. In early June the votes were tallied: Nearly 80 percent of all active members had chosen to transfer. Surprisingly, the group included a greater-than-expected number of younger employees and a smaller-than-expected number of older workers.

The savings the state anticipates stem from several factors: First, the $686 million that individuals held in defined contribution accounts that they transferred into the defined benefit plan, which represented an average of nearly $46,000 per person. Second, a yet-to-be-determined amount of supplemental contributions will be paid in by June 30 of this year. If those transferring choose not to make a supplemental payment, they will receive only 75 percent of the full pension benefit, which is equal to 2 percent of the employee’s final average salary times the number of years of service. Most are expected to make supplemental contributions to receive their full defined benefit. The cost of that contribution is equal to 1.5 percent of an employee’s pay during his or her years in the defined contribution scheme compounded by 4.5 percent annually. According to the Consolidated Pension Retirement Board actuary, should all transferees elect to make supplemental contributions to receive their full benefits, their funding ratio as a group would be 83 percent — far higher than that of legacy members. As a result, the actuary estimates, the state’s contribution for those moving back to the defined benefit plan will fall to 4.01 percent of payroll annually from 7.5 percent.

All of these assets and savings are then projected to compound at an annual rate of 7.5 percent. And presto: The conversion will yield estimated savings of $174.3 million in net present value, compared with $151.4 million in the net present value of new liabilities coming onto the books. The bottom line: The state saves almost $23 million in net present value.

All that assumes, of course, that the retirement system’s assets return 7.5 percent annually over the long term. There’s lots of ground to make up. In calendar 2008 investments returned minus 29.1 percent — a result that is slightly worse than the negative 26.6 percent median return for public plans monitored by Northern Trust. H. Craig Slaughter, executive director of the West Virginia Investment Management Board, says returns have suffered from a legacy of ultraconservative allocations. It wasn’t until 1997 that the fund got legislative authority to buy equities, and 2007 before it was allowed to invest in private equity, hedge funds and real estate. The fund achieved its target allocation of 10 percent in hedge funds in August. But it has placed less than 1 percent in private equity and real estate, far short of its 10 percent targets. “We couldn’t invest in some pieces that made all the difference in the world. It’s been a little frustrating,” Slaughter says.

Going forward, Slaughter is confident of achieving 7.5 percent annualized returns. But, he concedes, “there’s a huge hole to climb out of that may prove politically difficult for the state.”

Indeed, although strong coal prices have swelled tax revenues in recent years, creating reserves that will help the state boost its pension contribution next year, the outlook is decidedly darker, especially given sharp declines in prices for coal and other resources that play a large role in West Virginia’s economy.

For Gay the calculations were a lot simpler — and far more certain. By surrendering the funds in her defined contribution account — $122,000 as of June 30, 2007 — and paying the supplement of $14,000, she receives an annual benefit of some $29,000 — about double what she would have gotten by converting her savings into an annuity, she says. The state has loaned her the $14,000 and is deducting payments from her retirement check until it’s paid off.

“I could pay it all now, but I hate to wipe out my savings completely,” she says. “If I pay it off in three or four years, it will be less than a car payment, and then I’ll get an automatic raise in my retirement.” For now, at least, it seems doubtful the state will fare as well.