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The National Council on Teacher Retirement held a workshop entitled "Preserving Defined Benefit Plans" on November 19, 1996.

Selected materials from the workshop are presented here:

"Preserving Defined Benefit Plans," an overview by Cynthia L. Moore, NCTR Washington Counsel

"Defined Benefit Plans Provide a More Complete Retirement Program than Defined Contribution Plans Do," by NCTR

Preserving Defined Benefit Plans
by Cynthia L. Moore, Washington Counsel of the National Council on Teacher Retirement
Washington, D.C. November 19, 1996

We're here today to marshall our resources to respond to efforts in your states to convert defined benefit plans into defined contribution plans. We will accomplish this activity in two ways:

1) We will discuss the rationale that supports preserving defined benefit plans and rebut the arguments in favor of converting them to defined contribution plans; and

2) You will be provided with materials that you can use in defending against defined contribution conversion in your states. You are free to distribute these materials as needed. Editor's Note: Materials are not attached to this document. Contact the retirement systems directly for information.

By way of clarification, we are talking about the effort to convert a defined benefit plan, which serves as the primary pension vehicle, into a defined contribution plan. We are assuming that Section 403(b) tax sheltered annuities, as a type of defined contribution plan, will continue to serve educational employees as a voluntary savings vehicle to supplement their retirement income.

Let's begin by rebutting some of the arguments in favor of defined contribution plans, specifically:

1) employee mobility; and

2) the incidence of defined contribution plans in the private sector.

Because the American workforce is not as mobile as commonly believed, defined benefit plans, which serve longer term employees, continue to work well.

We constantly hear that the American workforce is increasingly mobile. The data leads to the opposite conclusion, however. Employee Benefit Research Institute (EBRI), The Changing World of Work and Employee Benefits, April 1996 ("EBRI, 4/96"). The Employee Benefit Research Institute (EBRI) has found that the median job tenure for all workers in 1991 was 4.5 years, compared with 3.4 years in 1951. Thus, looking at workers as a whole, they are less mobile now than they were 40 years ago.

The only age group with a high rate of mobility are workers between 16 and 24 years old. In 1993, 47% of them had been at their current job for less than a year. Older age cohorts show significant drops in mobility, even among those aged 25 to 34. The percentage of workers in the various age categories who have been at their current job for less than a year looks like this:

EBRI, 4/96.

Thus, with the exception of 16 to 24 year olds, American workers are not as mobile as conventional wisdom would suggest.

Defined Benefit Plans Continue to Exist in the Private Sector, Especially Among Large Employers

Because the use of defined contribution plans has grown in the private sector and because that growth is being used to justify the conversion of public sector defined benefit plans to defined contribution plans, it is necessary to analyze the private plan data carefully. If used carelessly, it can lead one to believe that a wholesale conversion in the private sector of defined benefit to defined contribution plans is occurring. If examined carefully, it reveals that the number of defined benefit plans among large private sector employers is stable. Employee Benefit Research Institute (EBRI), "Changes in DB and DC Plans Occurring Mainly Among Small Plans," EBRI Notes, March 1994 ("EBRI, 3/94"); EBRI, Pension Evolution in a Changing Economy, September 1993 ("EBRI 9/93"). Because the retirement systems that belong to NCTR are large defined benefit plans, this finding is significant for the following reasons.

The majority of terminations of primary defined benefit plans in the private sector were in very small plans. Seventy-five percent of the plans terminated between 1985 and 1990 had two to nine participants. Because of the small size of the majority of plans terminated, a relatively low percentage of participants was affected. EBRI 3/94; EBRI 9/93.

This decrease is not unexpected. Congress made changes in the Tax Reform Act of 1986 to discourage the creation of very small defined benefit plans that benefitted only high paid individuals and not lower paid ones. The large number of terminations of such plans is evidence that Congress' goal was accomplished. By contrast, the number of very large private sector defined benefit plans remains stable. According to EBRI, the number of very large primary defined benefit plans (those with 10,000 or more participants) remained stable between 1985 and 1990. The number of plans with 10,000 - 19,999 active participants increased by 13%, and the number of plans with 20,000 or more participants experienced a slight decrease of 8%. EBRI, 3/94.

Where the number of defined contribution plans did increase in the private sector, the growth is not attributable solely to defined benefit plan terminations. Between 1985 and 1990, a decrease of 56,651 private sector defined benefit plans occurred. The number of new private sector defined contribution plans increased by 149,078. EBRI, 3/94. Thus, "growth in defined contribution plans has resulted from something in addition to plan sponsors terminating defined benefit plans and replacing them with defined contribution plans." Id. The data suggests that private sector employers that never previously offered a pension plan are now doing so through defined contribution plans because the growth of defined contribution plans has exceeded the decline of defined benefit plans.

If change is occurring among very small private sector defined benefit plans and not among large defined benefit plans, how does this finding affect NCTR members? The average number of participants who belong to an active NCTR member is nearly 168,000. Thus, the retirement systems represented by NCTR are not equivalent to the very small private sector defined benefit plans that are being terminated. Instead, they are comparable to the large private sector defined benefit plans whose numbers have not changed. In other words, defined benefit plans work well for large private sector employers and by the same token, defined benefit plans also work well for public sector employers, many of whom are quite large.

The foregoing analysis is based on data about the number of plans. Looking instead at the number of pension plan participants, defined benefit plan participation predominates. Among participants in public and private pension plans in 1991, 61.7% named a defined benefit plan as their primary plan type. EBRI, Pension Coverage and Participation Growth: A New Look at Primary and Supplemental Plans, December 1993. Fifty-three percent of all participants aged 25-30 reported a primary defined benefit plan, as did 72.4% of those aged 61 to 64. Id. Thus, the majority of workers, even younger ones, who participate in a pension plan do so in a defined benefit plan (both public and private sector employees are included in the data).

The conventional wisdom that defined benefit plans are being abandoned in favor of defined contribution plans is not accurate. Defined benefit plans continue to be used by large private sector employers and by analogy should continue to be used in the public sector where many pension plans serve large employee populations.

How Have Efforts in the Public Sector to Convert Defined Benefit Plans to Defined Contribution Plans Fared?

We have documented conversion efforts in 12 states. The most current active effort is in Michigan, the description of which is below. Editor's note: See December 18, 1996 NCTR Legislative Update, which describes the new defined contribution plan under the Michigan Public School Employees Retirement System. Implementation of the plan hinges on whether the State Treasurer can find the $6 billion needed to fully fund the system. A strong effort was mounted in the California legislature in 1996, but it died at the end of the session. Details about the various conversion efforts follow. Also listed below are defined contribution efforts that did not succeed, but that prompted the addition of features for the defined benefit plans, such as enhanced portability and ways to preserve the value of the retirement benefit for workers who terminate employment before retirement.

Arizona. A study of defined contribution plans in 1995 did not generate substantive legislative action.

California. Assembly Member Howard Kaloogian introduced AB 3252 to create the Public Employees' Defined Contribution Retirement Plan in 1996. The legislation would authorize public employers in California to offer a defined contribution plan. If a public employee's employer elected the defined contribution plan, the employee could choose whether to move to the new defined contribution plan or stay in his/her existing defined benefit plan. (If the employee is a teacher, he/she is a member of the State Teachers' Retirement System (STRS) or, if an educational support employee, a member of the Public Employees' Retirement System (PERS)). New employees would also have the choice. If an existing employee chose the defined contribution plan, the defined benefit plan would have to transfer an amount equal to the actuarial present value of his/her "accrued service benefit" to the defined contribution plan. The legislation defines the "accrued service benefit" as the present value of the employee's accrued retirement benefit earned through the date on which the transfer is made. An accrued benefit calculated in this manner would increase the value of the benefit and would require the defined benefit plan to transfer more money to the proposed defined contribution plan than might be available to cover those benefits. Although the proposal passed the California Assembly, a committee of the California Senate voted it down. A joint Senate-Assembly committee will conduct a public hearing in Fall 1996 on the issue.

Iowa. In 1996, the legislature mandated the Iowa Public Employees' Retirement System (IPERS) to study a defined contribution plan option, and/or convert the existing defined benefit plan to a defined contribution plan.

Kansas. During the 1995 session, the Kansas legislature directed the Board of Trustees of the Kansas Public Employees Retirement System to determine and analyze the effects of converting the plans it administers from defined contribution to defined benefit. The board found that "[c]onversion from the current defined benefit plans for Kansas public employees to a defined contribution plan would not result in lower employer contributions . . . Nor do they eliminate past unfunded liability, which must continue to be amortized to provide benefits previously promised."

Michigan. Editor's Note: As noted above, see December 18, 1996 Legislative Update for recent developments. Michigan is host to the most active defined contribution effort in the nation. The legislation would close the defined benefit plan and create a defined contribution plan for employees hired after a specified date. It has the strong support of Governor John Engler, a Republican. The proposal has been introduced over the past few years, but it has not received much action. The recent election gave it new life. Until the end of the year, the Republicans control both houses of the state's legislature. Starting in January, the Michigan Assembly will be controlled by the Democrats, while the Senate remains in Republican hands. The Governor believes that he can get the proposal through the legislature with the Republicans in control, but feels his chances are much lower next year with a divided legislature.

Ohio. Editor's Note: See December 18,1996 Legislative Update for recent developments. Legislation was introduced in 1996 to establish an alternative retirement plan for academic or administrative employees of public institutions of higher education that elect the plan in lieu of membership in the Public Employees Retirement System, the School Employees Retirement System, or the State Teachers Retirement System. The alternative retirement program would consist of defined contribution plans providing retirement and death benefits through the purchase of fixed or variable annuity contracts selected by the eligible employee.

Oregon. In 1995, a defined contribution plan was proposed for all employees who joined the Public Employees Retirement System (PERS) after a certain date. In the final version of the bill, the defined contribution element was eliminated. Instead, it modifies certain definitions relating to salary and raises the retirement age for general employees from age 58 to 60. (The current retirement age of 55 for police officers and firefighters stays the same.) These changes are generally effective for employees hired after January 1, 1996.

South Dakota. In 1995, the legislature approved the Portable Retirement Option (PRO) that allows short service employees in the South Dakota Retirement System (SDRS) to take all or part of their employer contributions with them if they leave employment. The PRO was in response to efforts to create a defined contribution option for higher education employees. Under the PRO, if employees work less than 3 years, they receive 75% of the employer contributions. If they work more than 3 years, they receive 100% of the employer contributions. (Vesting in South Dakota is 5 years.) Under the traditional plan, employees who leave service before vesting are generally eligible for a refund of employee contributions with interest only. Thus, a SDRS member who elects the PRO and terminates before vesting takes not only employee contributions plus interest, but also a portion of the employer contribution.

Vermont. The General Assembly mandated the State Treasurer to review the options and fiscal implications of shifting the State Employees' Retirement System and the State Teachers' Retirement System from defined benefit to defined contribution plans. A study was completed in 1996. Among other things, it found that a defined contribution plan for all new employees and for current employees who elect to participate in it will likely result in increased costs to fund the remaining defined benefit plans. A second study is now being conducted.

Virginia. The Governor has commissioned a study to determine whether the Virginia Retirement System should be converted to a defined contribution plan. If a conversion is recommended, legislation could be introduced as early as next year.

Washington. The state legislature approved a hybrid plan for members of the Teachers' Retirement System. The hybrid is called "Plan III" and will apply to teachers who join the system on or after July 1, 1996. The employer funded portion of the plan is a defined benefit, the formula of which is 1% of average final compensation times years of service. It provides a COLA of 3% a year. The employee funded portion is a defined contribution that requires plan participants to contribute between 5% and 8.5% of salary to the plan depending on their age and choice of options.

West Virginia. West Virginia has set up a defined contribution plan for its K-12 educational employees. All employees hired on or after July 1, 1991 are members of the defined contribution plan. Employees hired before then are members of the defined benefit plan.

Other Developments that Show that Defined Benefit Plans Provide Portability and Other Features for Retirement System Members

When defined contribution proponents question the portability of defined benefit plans, they overlook the extensive rights of public employees to purchase credit for service for which they are not eligible for a pension or have somehow lost the right to such credit. NCTR wanted to quantify such opportunities for teachers and undertook a survey on the purchase of service credit for out-of-state teaching service. The survey shows that 86% of retirement systems that serve teachers offer such an option. Thus, an overwhelming number of retirement systems have this option available to their teachers.

South Dakota and Michigan are pioneers in an option that makes it easier for retirement system members to purchase certain uncredited service with pre-tax dollars. Under a change made by the South Dakota legislature, a member of the South Dakota Retirement System (SDRS) will be able to purchase service credit with pre-tax dollars. Currently, the purchase of such service is with after-tax dollars. The amount of service that a SDRS member may purchase with after-tax dollars is limited under the Internal Revenue Code pension qualification rules, whereas a purchase with pre-tax dollars is not generally so limited. Thus, members will have greater portability with this pre-tax dollar purchase. The Michigan Public School Employees Retirement System will also make this option available to its members through an administrative action.

Other portability expansion in 1996 occurred in both Missouri and Virginia. Both states' legislatures authorized "retirement reciprocity," under which one retirement system directly transfers money to another retirement system on behalf of a retirement system member. The transfers avoids the need for the member to make an out-of-pocket payment as under purchase of service credit options.

Under the change, Missouri now offers "interstate portability" by allowing the retirement systems in the state to enter into agreements with comparable systems in other states for the purpose of allowing the transfer of creditable service. Virginia's new law is geared to "intrastate portability" because it allows the Virginia Retirement System (VRS) and certain local systems to enter into agreements whereby members with service in both VRS and a local plan may make a transfer and thereby consolidate their credit in one plan or the other.

Besides the portability issue, defined contribution proponents assert that a worker who changes jobs frequently loses the value of his/her projected pension benefit under a defined benefit plan. Two states addressed this issue in 1995.

In Colorado, the legislature enhanced the benefits of shorter service employees, i.e., employees who terminate PERA-covered work before reaching retirement age. Under the change, these shorter service employees have two options when they terminate. First, they can withdraw their contributions before becoming eligible for retirement and PERA will pay them a matching amount of 25% of their contributions plus interest. Second, they can leave their employee contributions with PERA until becoming eligible for a retirement benefit and have the option of withdrawing their account and receiving a "matching amount" of 50% of their contributions plus interest or receiving a life-time benefit. The matching payments therefore improve the value of the shorter service employees' benefit.

In Washington state, the new Plan III for teachers also preserves the value of a shorter service employee's benefit. Specifically, if the member separates from service with at least 20 years of service, the benefit is compounded at 3% per year from the time of separation to the date the retirement allowance begins.

Conclusion

1) Despite assertions of defined contribution proponents to the contrary, the American workforce is not more mobile than previously.

2) Defined benefit plans continue to be used by large private sector employers and by analogy should continue to be used in the public sector where many pension plans serve large employee populations.

3) Defined conversion efforts in the public sector have been generally unsuccessful. In some cases, conversion efforts have prompted the addition of new features to the existing defined benefit plans, for example enhanced portability and ways to preserve the value of the retirement benefit for workers who terminate employment before retirement.

Defined Benefit Plans Provide a More Complete Retirement Program Than Defined Contribution Plans Do

Normal Retirement. Employees earn a fixed benefit based on a formula under a defined benefit plan. Thus, the benefit at normal retirement is easily determined if the individual's average salary and years of service are known. No guarantee of a specific monthly benefit is provided under a defined contribution plan; the retirement benefit is the annuity value of the employee's account.

Early Retirement. Defined benefit plans can easily accommodate an early retirement feature. The benefit can be the normal retirement benefit reduced for the number of years the employee is retiring early. Alternatively, an employer that wishes to offer an early retirement incentive program (ERIP), with an unreduced benefit, may be able to fund it with excess assets. In the case of defined contribution plans, there are no excess assets that can be used to provide this supplemental benefit.

Disability Retirement. Defined benefit plans are designed to share risk, so disability can coverage easily be built into the total retirement program. Under a defined contribution plan, risk cannot be shared. This issue is especially critical in states whose employees are not covered by social security. Social security includes disability insurance in the event an employee can no longer work because of injury or illness. If a defined benefit plan that includes disability retirement is eliminated in favor of a defined contribution plan, employees will lose their disability program through the state and they will not have disability coverage through social security.

Death Benefits. A defined benefit plan can provide for a fixed formula death benefit. The death benefit can require that some minimum amount be paid to the beneficiary even if the deceased member's benefit was small. Under a defined contribution plan, the death benefit depends solely on the account balance. No minimum benefit can, therefore, be established.

COLAs. Besides offering early retirement, disability retirement, and a death benefit, defined benefit plans can also provide for post-retirement increases, or COLAs. They are frequently tied to the Consumer Price Index, which measures increases in the cost of living. A COLA provides a way to increase retirees' annuities and thereby help them offset increases in the cost of living. COLAs are funded either through increased employer contributions or through favorable actuarial experience, or some combination. Most defined contribution plans do not provide COLAs because it is difficult to incorporate the funding necessary to pay them. It may be possible to provide a COLA under a defined contribution plan if retirees are provided a variable annuity, rather than a fixed annuity. A variable annuity will provide differing monthly annuity amounts depending on market performance. This means that the annuity could go up in times of good market performance. By the same token, the annuity could drop if market performance declines. Market performance is not tied to increases in the cost of living, however, so a variable annuity does not provide retirees with the same inflation protection that retirees under a defined benefit plan with a CPI-based COLA enjoy.

Benefit Increases. A well-funded, mature defined benefit plan can pay for benefit increases through favorable actuarial experience. The only way to increase benefits under a defined contribution plan is to increase the account balances. This is accomplished by raising employer/employee contributions and/or by increased investment performance.

Portability. Most public sector defined benefit plans provide for purchase of service credit that allow plan members to buy credit for years in which they did not otherwise earn a pension benefit. For example, 45 out of the 50 state retirement systems that serve teachers permit members to purchase credit for out-of-state teaching service. These purchases increase the member's retirement benefit, therefore making it more valuable. Under defined contribution plans, members can take their account balances with them when they leave service. Members of defined benefit plans who leave service may take the employee contributions and interest with them. In several states, they may also take a portion of the employer contribution, which enhances portability.