Taking risks out of the state pension plan

Published May 2, 2014

By Tom Campbell

by Tom Campbell, Exeuctive Producer and Moderator, NC SPIN, May 2, 2014.

North Carolina has been fortunate to have honest and trustworthy State Treasurers. Current Treasurer Janet Cowell is no exception. The present discussion over public pension plans focuses on three central issues, namely who is making investment decisions, what influences are affecting those decisions and how much risk is being taken?

The numbers are staggering. North Carolina public retirement programs currently manage $86 billion in assets for some 900,000 current and retired state and local public employees. The Treasurer has sole responsibility for making investment decisions.

There are two concerns with our current system. First is how much risk is being taken, with the second being how much influence is exerted on the decision-maker?

Contributions by governments and by public employees won’t fully fund pensions so investments must make up the difference. Playing it too safe, with money-market funds and municipal bonds, won’t provide enough returns to fully fund pensions. Investments like derivatives, junk bonds and speculative real estate might provide higher returns but they are highly risky and might lose money. Risk-reward decisions for an individual are much different from those for 900,000.

Big banks and investment houses desperately want the state’s investments and history demonstrates they will offer campaign contributions, luxury vacations, cars, homes and under-the-table cash to influence those decisions, small prices easily recouped by big investment management fees. Michael Lewis’ recent book, Flash Boys, reminds us of the lengths to which Wall Street will go to secure and place these investments.

Having more than one person make investment decisions only spreads the risks to a larger number. And who would be appointed to such a board and how would they be selected? Laypersons would be required to spend large amounts of time learning and keeping up with markets, for which someone would have to compensate them, or else they would be dependent on the advice of the State Treasurer or her investment advisors. If professionals were on the board they would likely have built-in conflicts of interest. So just having more people doesn’t eliminate much risk.

The best solution is to convert from a defined benefit to a defined contribution plan that gives each employee the power to make his or her own investment decisions. Corporate America and many public and non-profit organizations made this switch years ago.

Public employees currently receive a defined monthly benefit upon retirement, based on a complicated formula that includes how many years they worked and their highest salary for the last few years of work. Under a defined contribution plan each employee would have their own private investment account, with both the state and the employee making contributions. The employee could choose from a range of investment options and make investment decisions based on risks they were willing to assume. The amount each received at retirement would be based on how much was in the account. While it would not be equitable to convert to such a plan for retirees and current longer-term employees we can and should convert those not currently vested and all new hires to the defined contribution plan.

This takes the Treasurer off the hot seat, removes risk to the legislature and taxpayers and puts the responsibility directly on the employee, where it belongs. It resolves all three current state pension plan concerns.

May 2, 2014 at 10:07 pm
Gary Arrington says:

Sorry, Tom, but as a Human Resources specialist for over 30 years, I saw many organizations switch from a defined benefit plan to a defined contribution plan. Not once did I see the employees really come out for the better under such a scheme. You're right, many public and non-profits made this switch years ago, not for the benefit of the employee, but to reduce their pension costs.

Almost all non-profits (and many for-profit) organizations are run by a board of directors, which, according to your thinking, puts more people at risk and forces them to spend huge amounts of time learning about the business. Yet a board bring diversity and new ideas, and guards against corruption, tyrants, and run-away egos. An independent investment group would benefit the state retirement plan in the same way.

May 3, 2014 at 6:37 pm
Henry Belada says:

Tom, I am a retiree and when I started to work I had no idea how to invest, or care to invest. I just wanted my pay check and do my job safely and back the next day. Thousand of state workers want a safe retire plan and the best is the defined benefit. When the stock market drop in 2008 it took about 4 years to recover from the lost. If I was going to retire then my retire play would drop with the defined contribution plan. The defined contribution plan would take money away for the defined benefit now. All state workers have an option to increase their retirement plan with the 401K, IRA and ROTH account or some other extra plan if they want to.

May 4, 2014 at 8:13 am
tom murray says:

Do you know how much the average 401k plan participant has in his account? About $45,000! How can anyone retire on that? Your column is extremely ill-advised. The demise of the defined benefit plan in American industry is a tragedy, and the switch to 401k (defined contributioin plans) has been sold as a bill of good to workers under the rubrics "simple" "easy to understand" "flexible" and so forth.

People are borrowing against their 401k plans to buy homes, pay college tuition etc, and for many, their fund balance at age 65 will be pitiful indeed

It has yet to be shown how anyone, anyone, can afford to retire simply on Social Security and a 401k plan.

May 4, 2014 at 2:55 pm
Victor Schoenbach says:

I agree with nearly everything in your column except the conclusion. Yes, a defined contribution plan "takes the Treasurer off the hot seat, removes risk to the legislature and taxpayers, and puts the responsibility directly on the employee". But why is that "... where it belongs"? Risk is inherent in retirement planning, and diversification is a primary strategy to manage risk. Employees are better served by the diversification in a combination of a defined benefit plan and an individually-managed (401k/403b/IRA) account. Each method has advantages and risks. But most employees can better attend to media investigations of conflict of interest than navigate the complexities of investment vehicles and financial sales pitches. It is easy to see why switching from defined benefit to defined contribution is preferred by the employer, and the danger of catastrophic failure (e.g., Detroit pensions) is a serious concern with defined benefit plans. But the diversity of outcomes from individual investing means that a significant number of employees will be worse off, possibly much worse off, and opportunities for abuse by investment advisers will be ample.

May 5, 2014 at 12:27 pm
NC SPIN says:

Victor, state employees and others think the Treasurer has too much authority and power over investment decisions. Putting every employee in charge of making his or her investment decisions. If they don't like Treasurer Cowell's decisions they can assume the risk and make their own choices. Isn't that only right?

May 5, 2014 at 12:37 pm
Gary Arrington says:

No, that's not right. It doesn't have to be all black or all white. An independent board handling the investments would be an all-round better solution than either of your alternatives.

May 8, 2014 at 6:47 pm
Lewis Armistead says:

In the old compensation formula, state workers were willing to take a lower-than-market salary in return for more generous benefits, in particular a more liberal work-life balance, excellent health benefits, and a more secure source of income upon retirement.

The more liberal work-life balance has been diminished over the past few years with massive numbers of job vacancies, staggeringly high turnover in the white collar occupations, and duties shifted to existing employees that prevent them from enjoying that work-life balance. Many state employees work far more than the 8-hour day.

The excellent health benefits are now anything but. Truth be told they are quite average, on par with what can be procured from any other company also paying its employees market wages.

And now the secure source of income is on the chopping block. While new employees should have a choice on whether they want to invest in a 401(k) or the state pension plan, the policymakers need to understand the the state worker formula is going to be destroyed with a conversion to a 401(k) wherein the risk of loss lies with the individual. All of the benefits of working for the state government are gone, yet they still believe they can pay their employees the same below-market wages as were paid when the benefits were better. They can't have the cake and eat it, too. If you cut the overall compensation package, be prepared to raise the salaries for the underpaid occupations, or prepare for the truly dysfunctional government people like to harp about. The era of government simply being comprised of paper pushers is at an end. There are now classes of highly skilled professionals that are the sinews of state government functionality, and they need to be compensated accordingly, lest they all be lost to the private sector.

There's the dilemma - pay a lot of incompetent people less, or pay a few competent people more.