Most attempts to push state workers into defined contribution plans have met with a cold shoulder, but Juneau just adopted such a scheme. Will it work as advertised? * By
Alaska Governor Frank Murkowski has succeeded where California Governor Arnold Schwarzenegger stumbled: On July 27, Murkowski signed legislation that requires public workers hired after July 1, 2006, to join a 401(k)-style retirement plan instead of the defined benefit plan that covers their fellow civil servants. In California intense opposition from police and teachers forced Schwarzenegger to back off a similar proposal earlier this year.
Pushing the bill through the Alaskan legislature was no small feat for Murkowski, a Republican who spent 21 years in the U.S. Senate before becoming governor in December 2002. Public employees plainly prefer traditional pensions to defined contribution plans, especially in the wake of the 2000'02 bear market and the blowup of Enron Corp.'s 401(k). In the ten states where new and in some cases existing workers have a choice between a defined benefit and a defined contribution plan, the overwhelming majority stick with the defined benefit plan.
Murkowski succeeded despite a dismal approval rating -- 27 percent in May -- that stems from a weak state economy, budget cuts and his naming of his daughter, Lisa, to succeed him in the Senate.
Alaska's switch to a defined contribution plan reflects the unusual confluence of a $5.5 billion pension funding shortfall and Republican control of the executive and legislative branches.
Republican lawmakers may have felt they could vote for the change because Alaska residents share in the $30.9 billion Alaska Permanent Fund and thus, like all defined-contribution-plan participants, have experience with market ups and downs. Every year 25 percent of the royalties from the state's mineral wealth goes into the fund. Since 1976 it has paid residents annual dividends. Over the past decade the payout has ranged from $920 to $1,764.
"The citizens here are used to fluctuating markets and know that in the long run they go up," says Republican State Senator Bert Stedman, a sponsor of the defined contribution legislation and the owner of a brokerage firm in Sitka.
He and other supporters argue that employees will be better off in a 401(k). "The plan serves a new population that desires portability, and it offers contribution stability to employers," contends Melanie Millhorn, director of Alaska's division of retirement and benefits. The state's contribution to the defined contribution plan will range from 10.05 percent for some public employees to 11.97 percent for teachers, including 3.0 percent for health reimbursement accounts and 1.75 percent for a retiree medical plan; employees will kick in an additional 8.0 percent.
Under the existing defined benefit plan, employees can retire as early as 55 and after as few as 20 years, receiving up to 2.5 percent of their average salary over their three best-paid years multiplied by their years of service. (Someone retiring after 30 years whose three highest-paid years averaged $60,000 would receive a $45,000-a-year pension.)
Under the defined contribution plan, employees can retire at any age and their employer contributions vest after five years. Under the existing system teachers vest after eight years and other public employees after five.
A sharp reduction in medical benefits with the new system is its starkest difference -- and the major source of savings for the state. In the current system workers get full health care coverage for themselves and their families after 25 years of service. In the new system retirees and active workers pay the full health care insurance premium until they are eligible for Medicare. After they reach Medicare age, currently 65, retirees share the cost of the premium based on their years of service. "The cost of providing health care will be lower because the insurance will be secondary to Medicare," says Commissioner of Administration Raymond Matiashowski.
Republican politicians had to play hardball to pass the pension bill. Their rallying cry in the legislature -- "Stop the bleeding!" -- referred to the defined benefit system's gaping shortfall. As of June 30, 2004, the most recent reckoning available, the state's two main retirement systems, covering 93,000 teachers and other public employees, reported total assets of $12.1 billion, versus combined liabilities of $17.6 billion, according to a March 2005 report by New Yorkbased Mercer Human Resource Consulting. Alaska's funding ratio of 68.8 percent compares with a median of 83 percent for other state plans, says Wilshire Associates.
Health care costs constituted 35 percent of the system's total liabilities, a higher ratio than for most states because Alaska is one of only a handful to prefund medical benefits instead of using a pay-as-you-go method. In a multiyear transition beginning December 15, 2005, other governments will have to prefund medical and other postemployment benefits in accord with new rules imposed by the Government Accounting Standards Board, an independent, not-for-profit organization in Norwalk, Connecticut. That will erode funding ratios of many retirement systems, increasing pressure to cut health care benefits.
Mercer had projected that if no changes were made to the current system, Alaska's pension contributions as a percentage of the state's payroll would soar from the mid-teens in 2004 to 30 to 50 percent between 2009 and the late 2020s. Last year the state contributed $1.92 billion to the retirement plans. In addition, employees chipped in between 6.75 and 8.65 percent of their salaries.
"Something had to change," says Matiashowski. "It's a two-part process. The first part was to fix the structure so we're not adding people to a hobbled system going forward. The new plan has generous benefits (the state's contribution rate), and many individuals will be better off with the defined contribution plan than the defined benefit plan. At some point we'll have to address the shortfall, possibly through higher contribution rates or an infusion of cash."
Legislators passed the bill over strenuous opposition from municipal labor unions and trustees of the teachers' and public employees' retirement plans. Gayle Harbo, a member of the Teachers' Retirement System board, says that the defined contribution plan will erode the quality and experience of the state's educators. "It will make Alaska the best training ground for people to come up to for five years, take their money and move somewhere else, where they can get better benefits and live more cheaply." As teachers in Alaska do not participate in Social Security, the advent of a portable defined contribution plan could be a further inducement for them to move to a state where they can also pay into the federal retirement plan.
Supporters of the pension bill won passage by holding the state's capital projects budget hostage. "Our lobbyists had the votes to defeat the bill in the House," says Harbo. "But when the governor put pressure on capital projects, legislators crumbled."
The bill passed 11-3 in the Senate, the votes breaking along party lines (with six senators not voting). In the House the measure passed 21-18 (with one not voting but seven Republicans voting against it and three Democrats supporting it). Although the vote was a tactical victory, it is unlikely to be reversed next year. The legislature meets only in the first half of the year, and the next election isn't until the fall of 2006; Alaska Senate Republicans who supported the bill along party lines are not expected to change their votes.
Opponents have not given up, but there is little they can do to stop the defined contribution plan from going into effect next July. Public unions worry that the new plan will not provide sufficient retirement income, and they are contemplating a legal challenge. Their arguments would likely be limited to minor provisions of the legislation, such as rules for reinstatement of medical benefits for former beneficiaries who rejoin the system. The unions plan to marshal their forces to effect political change in the '06 elections.
"This law is a huge mistake," says Frederick Nesbitt, executive director of the National Conference on Public Employee Retirement Systems in Washington. He argues that it will cost Alaska more to run its defined benefit plan because, with no new money coming in, it will have to shift more of its assets to low-yielding short-term investments to be able to make payments to workers who are soon to retire. Setting up the new plan also entails costs. "Taxpayers will have to pay more to maintain the old system and more to create the new pension system," concludes Nesbitt.
Commissioner of Administration Matiashowski disagrees: "When the dust settles, we'll have a generous program that will reduce and eliminate the volatility of the state's contributions to the retirement plans." But it may be a while before that dust settles.