The Evolution of Public Sector Retirement Plans: Lessons for State-Facilitated Retirement Savings Programs

By Matthew Petersen

The public sector is associated with one thing when it comes to retirement: the defined benefit (DB) plan. However, over the past two decades, state and local governments have been quietly grappling with an evolution in the fundamental forms of their retirement benefit systems. Questions about risks and guarantees, growth and security, hiring needs, and budget constraints have bubbled in the background of a slowly but widely changing constellation of state and local government retirement systems. In short, the question for governments has been, “What can we provide with a DB plan, and what should be the expectation of the employee to fund their own defined contribution (DC) account?”

This question has driven governments to get creative. Every state has enacted some sort of pension reform since the Great Financial Crisis of 2008. As with any innovation, the results have varied widely. Some state governments have completely eliminated their DBs while others have made minor changes to contribution rates, cost of living allowances, and salary multipliers. As I showed in a paper last year, the median DB benefit decreased by more than 15% for employees entering the newest tier in retirement systems nationally, assuming the employee reaches full retirement criteria.

The evolution of state and local DB plans has triggered a complementary shift in the role of the DC plan for government employees. Conversations about automatic features, investment strategies, and retirement income options are now common in a space that was previously seen as simply “extra money.”

Meanwhile, the private sector has been struggling with a similar evolution, but in reverse: DB plans have all but gone away, and the DC plan now must play the role of retirement security provider while creating growth through consistent compound returns over time. The goal seems to be to make the DC plan look as much like a DB plan as possible, with the important caveat that the participant assumes all the risk of investment performance, sequence of returns, longevity, and the many other ways a lifetime of saving can be undermined.

This is a tall order. However, my goal here is to make the case that, by balancing the elements of DB and DC plans, the public sector offers a different paradigm through which to understand the essential aspects of building a successful retirement plan. I make the case here because I believe it is something especially important for state-facilitated retirement systems to consider, as they start their journey into uncharted territory.

Lesson 1: Success Starts with Access

A recent Morningstar report showed that, among all industries analyzed, public sector employees were projected to be most likely to achieve a secure retirement. DB plans play a major role in this, given that they eliminate longevity risk — but access is a key variable that is often overlooked. With very rare exceptions, all public employees have access to either a DC plan, a DB plan, or some combination of the two. Nearly all of these plans have at least one mandatory component and set a minimum contribution rate.

While mandatory participation in private sector plans is not politically feasible, employers should have a mandate to offer a plan in an employer-based system, as John Mitchem aptly described in this blog last month. The most effective way to do this is through the current proliferation of state-facilitated IRA programs. Currently, 20 states have created programs; that number should be 50.

As my members understand well, the culture in Mississippi is different from the culture in Maine, and tailored communication and operations are essential in building a successful program in each state. Auto-IRAs should be equally localized and accessible to employers and employees as public sector DC plans. If employees were automatically enrolled into state-facilitated IRAs in all 50 states, the access advantage the public sector currently enjoys would disappear, and retirement outcomes would improve across the country.

Lesson 2: Sound Investments Cannot Solve Everything, but They Can Help

In a DC plan, smart asset allocation makes a compounded difference. As we have shown in a recent study through our data partnership with the Employee Benefits Research Institute (EBRI), a partnership we call the Public Retirement Research Lab (PRRL), public sector accounts, which generally favor target date funds and equities, weathered the pandemic and continued to grow. However, as we have also shown, underlying factors like gender play a surprisingly strong role in asset allocation decisions.

Automatic and mandatory features are the most effective means of overcoming the long menu of individual biases that can slow the growth in DC retirement accounts. Much has been written about this, so I will not go into detail here, other than to note that public plans with automatic features have higher balances, contributions, and participation rates. Like mandatory public sector plans, state-facilitated programs are well-positioned to default employees into advantageous funds and, in concert with a tightly monitored investment menu, create easier paths to success.

Lesson 3: Lifetime Income and Loss Aversion

People love DB plans. Public employees are willing to take to the streets to protect them in a way that would never happen with a DC plan. Why? To me, there are three reasons. First, they take no effort — no one asks a DB participant to make decisions about investments, contributions, or payouts. Everything is set from the beginning, and the employee knows exactly what they get if they work another year.

Second, all the risk is assumed by the plan sponsor. If the market goes up or down, those are problems for the government and professional investment team to solve. The employee will receive a monthly payout commensurate with their salary, years of service, and the terms of the DB plan at their time of employment — no matter what, for the rest of their life.

Finally, and a point that is often missed, DB accounts are never expressed as a balance. In a past life, I was a pilot in the Air Force. I left the service at 13 years, seven years short of the 20 it takes to receive a full pension. As I was leaving, a finance officer said, “If you leave now, you don’t get anything, but if you stay seven more years, you get a pension that’s worth something like $3 million.” It did not make me stay, but it certainly gave me pause. I had never thought of it in those terms.

Now, what if he had said, “If you stay seven more years, we’ll give you $3 million tomorrow”? That would have been a very different conversation with my wife. Yet, that is how a DC plan is built for participants: In the best case, they nurture it their entire careers. It is a point of stress and joy, and if everything goes well, they have a nice sum at the end. The near consensus in the industry now is that the employee should then take a significant portion of that balance and trade it in for a few thousand dollars a month.

The Federal News Network publishes the number of Thrift Savings Plan millionaires annually. Unsurprisingly, there is no commensurate list for the number of people who reached a $5,000 per month pension. It just feels less exciting.

How do we make the case for income?

Perhaps one area of tangible improvement could be the way account balances are communicated. Mandatory income disclosures from the Department of Labor are a good start, especially if they are the focus of the participant statement. In the end, though, a secure stream of lifetime payments should be the goal for most people (assuming they do not have a robust DB plan). Until we can provide that through a DC account, in a way that participants understand and want, we all have work to do.

Lesson 4: None of This Really Matters Without Portability

In another PRRL study, we demonstrated that public employees tend to stay in their jobs longer than workers in the private sector. This is not surprising because the DB plan provides a longevity incentive, and public employees often start public service later in their careers, perhaps in search of stability.

According to that research, employees in the private sector change jobs every four years. That is a lot of rollovers. My wife had seven different jobs while I was in the military, and I will admit (a bit sheepishly) that she still has five separate 401(k) accounts. We have rolled a couple together, but good grief, is it a process. Retirement systems in many countries, like Australia and the UK, have the advantage of national accounts that follow employees between employers. The U.S. does not have that luxury. Therefore, asset leakage and gaps in participation become our biggest hurdles.

This is a problem in the public sector as well. While many employees stay longer, they face the same daunting process when they leave in rolling their assets into a new plan and continuing their progress. The auto-portability consortium is an innovative model for moving assets, and we need more recordkeepers to join. State-facilitated IRAs have an advantage if an employee moves within the state, but we should also remember that people leave states. A move from Illinois to California, and later to Colorado, ideally would not cause disruption in contributions if the person works for companies participating in the state systems. Currently, that is not the case.

Lesson 5: Policy Matters, but a Strong Plan Sponsor Is Just as Important

Wider adoption of auto-portability and increased access are important matters of policy. It will take innovation across the industry to create DC retirement income solutions, but one clear lesson for me is that the quality of the plan sponsor truly matters.

In my organization, I work with the most competent and dedicated group of individuals you will find anywhere. I take great pride in that fact that making them better at their job is all we do. A competent plan sponsor knows their constituency and puts the pieces in place to make participating employers and employees successful. As state-facilitated systems start on their laudable journey of closing the access gap in the U.S. retirement system, the professionalization of administering the plan will be a key to success.

Conclusion

As state-facilitated retirement savings programs are implemented across the country, there are some important lessons from the public sector plan experience. All workers deserve access to ways to save for their retirement. We know that well-managed plans that use automatic and mandatory features can significantly increase participation and improve outcomes. Public sector plans have some important lessons to share when it comes to improving plan outcomes, and we’re ready to help others facing such challenges.

However, when it comes to defined contribution plans, we all have much more work to do to make retirement accounts portable and offer workers lifetime income solutions that can produce a reliable stream of income in retirement.

Matthew Petersen is Executive Director of the National Association of Government Defined Contribution Administrators (NAGDCA).

September 2024, 24-05