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States Consider Hybrid Plans For Funding Retirement

States are taking a closer look at hybrid DB/DC programs that offer a certain amount of guaranteed income for a reasonably secure retirement.

“While there's been much talk of putting new state and local government workers into a 401(k)-type plan, we cannot simply shift the burden of paying for retirement entirely onto the nation's 27 million state and local government workers without preserving a source of guaranteed retirement income.”

You can almost hear the bravos emanating from the hoarse throats of state and municipal public employees. The quote is from a Wall Street Journal commentary last month by Roger Ferguson, CEO of TIAA-Cref. His interest on this explosive issue can be explained by a headline from a July 6, 2010 press release: Orange County California Selects TIAA-CREF as Sole Provider for New Defined Contribution [DC] Retirement Plan.

There’s some precedent for hybrid plans among states: Nebraska's had a hybrid plan since 1967, Indiana has one for decades — as far back as 1949, and newer converts include Utah and Orange County, Calif.; the latter is being touted because the county declared bankruptcy. The question? Is this the answer to get both sides talking again?

Of course, nothing is simple. For example, New Jersey legislators concede that it would be ruinous to state finances if this were to happen overnight because the state would have to contribute its part to the DC plan, which would be traumatic under current conditions — New Jersey doesn’t have enough funds to contribute two percent to a DC plan for each employee.

The other bit of complexity is that not all hybrids are the same — there are different types for different states/cities. However, in general, hybrid DB/DC programs are less expensive and less risky for government, while the best still offer members a certain amount of guaranteed income for a reasonably secure retirement. 

“Nebraska had a defined contribution plan from 1967 to 2002 that was like a 401k and closed to new employees in January 2003, shifting to a cash balance plan,” says Ron Snell, senior fellow at the National Conference of State Legislatures, who writes that in the cash balance plan, employees contribute between 4.3 percent and 4.8 percent of salary, and the employer contributes about 7.5 percent of salary to an employee account. The employee doesn’t control investments in the account, but is guaranteed an annual return of at least 5 percent a year. The principal differences from a defined contribution plan are the employer’s guarantee of a minimum investment return and keeping control of investments.

Indiana has had a hybrid program the longest, says Snell, who writes that for decades, the state’s retirement plans for employees have consisted of an annuity savings account made up of employee contributions and a defined benefit funded by employer monies. A number of other states have adopted the same idea, including Washington, Oregon and Georgia. “Georgia adopted a hybrid system in 2009.” It provides a defined benefit and 401(k) plan for new hires and an opt-in for employees in the DB plan.

Oregon’s plan DB/DC plan was created in 2003. Washington state in 2000 kicked off an optional public employee retirement system; employees who don’t select the hybrid plan are enrolled in the DB system. 

Utah’s legislature enacted in 2010 a DC plan as one option available to state and local government employees hired on or after July 1, 2011. The alternative option is a hybrid plan.

And there’s a model elsewhere in government employment: a long-time hybrid system at the federal level, the Federal Employees Retirement System (FERS). “It has a very small DB portion and includes Social Security,” says Snell, who reminds that some states’ workers don’t pay into Social Security—the figure is about 30 percent of states’ employees, “and they’re happy to be out.”

In general, the problems at the state and municipal level vary — not all are as extreme as some cases, says Richard Hiller, vice president of government markets for TIAA-CREF. He not surprisingly agrees with Ferguson that Orange County’s hybrid system is an example worth looking at by other local and state governments on how to begin navigating their way out of public pension disaster. “The point is to provide retirement security in a financially sustainable way,” he says, still providing choices but ensuring that a lifetime benefit component is structured in to so that employees have adequate income — 70 percent or more of pre-retirement earnings.”

Orange County’s plan was rolled out May 7, 2010 and allows new hires to choose the current pension formula (2.7 percent of salary for each year worked, beginning at age 55); or the new lower pension formula (1.62 percent of salary for each year worked, beginning at age 65) – but combined with a 401K-type plan, with matching contributions from the county up to 2 percent.

Most county employees have been contributing between 11 percent and 15 percent of their paychecks to pay for their pensions. A lower pension plan means fewer contributions and more money in their take-home pay—one reason why employees may opt to switch to a hybrid plan.

However, in Orange County, existing employees haven’t been given the chance to sign up yet because allowing current employees to change retirement options would force all county workers to have to pay taxes on their retirement deductions – whether they switched plans or not. “There’s been no ruling yet,” says Hiller. “No final resolution — I think a lot of state and municipal plans are looking for that response.” County employees would have to pay taxes on cash that’s currently tax-free.

The Orange County, Calif. hybrid model mixes guaranteed income and individually owned accounts. Workers may like the portability of the plan—being able to take benefits from job to job. And states have complete budgetary knowledge in advance — the costs and liabilities are known.

“If plans are designed appropriately, pensioners will have lifetime incomes, not just accumulated assets, to maintain their standards of living,” says Hiller. “It’s good policy and good politics. There’s so much rhetoric on both sides. Here’s a place where they can meet to provide a solution.”

Ironically, as of January 31, 2011, the investment portfolio for OCERS — the Orange County Employees Retirement System — is at an all-time high, says Jenny Hom, managing director of investments: $8.7 billion.

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