Politics Seems to Drive States' Decisions to Add DC Plan

January 22, 2008 (PLANSPONSOR.com) - A recent report from the Center for State and Local Government Excellence suggests political philosophy is the biggest motivator for states that have introduced defined contribution retirement plans for public sector employees.

“Republicans value the control over investments and por­tability offered by defined contribution plans and when they have dominated the political scene they have often changed the nature of public pensions,” the report authors concluded. The researchers found that having a Republican governor and a Republican legislature increased the probability a state would introduce some type of defined contribution plan by 6%.

The authors explained why cost would not be a consideration in a state’s decision to introduce a DC offering. Public plans are relatively free from regulatory costs since the administrative expenses associated with the Employee Retirement Income Security Act (ERISA) do not apply in the public sector, and since public sector plans are not insured by the Pension Benefit Guaranty Corporation, and thus not responsible for premium payments. The freedom from regulatory costs combined with the economies of scale achieved by large state pension funds has kept the cost of admin­istering public sector defined benefit plans very low, while some studies have estimated considerably higher costs for public DC plans, the report said.

Some have argued that by switching to a defined contribution plan governments could transfer costs to the individual employee, the researchers noted. However, the study authors pointed out in the public sector where employee contributions to defined benefit pensions are already high, state and local governments might find it challenging to shift more of the cost from the government to the participant.

It has been argued that DC plans in the public sector will be more attrac­tive to new and younger workers who might value the portability of benefits, but according to the report, the data to date does not show much enthusiasm for DC plans from public sector workers or that a DC plan is a driving force in choosing employment in the public sector.

The authors’ research also suggests governments with a high percentage of union members are less likely to add a defined contri­bution plan component.

Another argument in favor of public DC plans is that people will be able to control their own investments and perhaps earn higher returns. However, over the period 1988-2004, the return on 401(k) assets averaged about 1% less than the return on private sector DB assets, the report said.

Finally, the study authors look into the theory that DC plans could solve the “funding dilemmas” of public DB plans. Without the funding requirements of ERISA and with the incentives not to fund, one might think that states have not put aside any money to fund future benefits, but the researchers point out that state plans in the aggregate in 2006 were about 90% funded

According to the report, two states – Michigan and Alaska – have DC plans that require all new hires to join. Another two states – Oregon and Indiana – have adopted “combined” plans, where employees are required to participate in both a DB and a DC plan. Eight states have retained their DB plan and offer a DC plan as an option to their employees.

The report is here .