By Michele Lerner

Media attention in recent years has focused on the underfunded and failing pension systems for corporate employees. In some states and localities, public pension plans, or other defined benefit plans, also are severely underfunded, creating concern that taxpayers will be forced to pay higher taxes to finance the retirement of thousands of government employees.

"Underfunding is a bit of a misnomer, because it sounds like more of a problem than it is," says Keith Brainard, research director at the National Association of State Retirement Administrators (NASRA). "Even though most states' pension plans are underfunded, people need to realize that pensions are paid out over time, and these plans can accumulate assets over time to meet the payouts. While the funds still need to increase their assets through contributions and investment returns, not everyone retires at once and needs their income at the same time."

Brainard says that about 70 percent of state and local government pension programs together are funded at 80 percent or higher, the benchmark that is generally considered an adequate funding level.

"Plans that are funded at 50 percent to 60 percent definitely have a problem," Brainard says, "but you have to look at this on a case-by-case basis. In some states, such as Florida, the pension plans are actually overfunded, while in others, such as Illinois, the pension plan is in terrible shape."

Jack VanDerhei, a research director at the Employee Benefits Research Institute (EBRI), predicts that raising taxes to fund government pension plans will depend on other factors in addition to the funding level of the plan.

"Increasing taxpayer contributions to state pension plans will be less a function of underfunding than a function of each state's overall financial picture," VanDerhei says.

Brainard says that taxpayer contributions to government pension plans represent a minority of the funding for these plans.

"Investment income is the largest source of funding for state and local government pension plans," Brainard says. "Three-fourths of the funding comes from investment income and from employee contributions. During the 22 years leading up to 2004, just one-fourth of the funding for these pension funds came from taxpayers. Most people don't realize that public employees are required to make a contribution from their salaries toward the pension fund, at least 5 percent of their income."

Making a Switch

As the private sector has moved away from defined benefit programs and into defined contribution programs, such as 401(k) retirement funds, some government programs have also begun to adjust their retirement plans. According to VanDerhei, the federal government shifted away from its extremely generous defined benefit plan, at least for new employees, as of Jan. 1, 1984.

"Before 1984, the Civil Service Retirement System (CSRS) was badly underfunded, so the system was split into two parts, the Federal Employees Retirement System (FERS) and the Thrift Savings Plan (TSP)," VanDerhei says. "For employees hired after Jan. 1, 1984, the retirement system includes both a defined benefit plan (FERS) and a defined contribution plan (TSP)."

Federal employees hired prior to January 1, 1984 have the option of remaining with the original defined benefit plan (CSRS) or transferring to the new hybrid system.

VanDerhei says that if the federal government attempted to shift to a retirement system based completely on a defined contribution plan, which he does not believe is likely to happen, the backlash from unions representing federal workers would be extremely intense.

According to NASRA, approximately 90 percent of state and local government employees participate in a defined benefit plan as their primary retirement benefit. The other 10 percent rely on a defined contribution plan. Some government workers rely on a hybrid plan, the most common type including two separate plan types, a traditional defined benefit plan combined with mandatory participation in a traditional defined contribution plan.

State Decisions

The National Governors Association (NGA) policy position on Public Pay and Pension Plans Policy of March 1, 2006, supports states' adoption of a balanced retirement program. "The combination of a defined benefit plan and a supplemental deferred compensation plan meets the goal of supplying adequate retirement income for employees at a reasonable cost to taxpayers," the policy position states.

According to NGA, more than half of the cost of pensions is covered by investment earnings, with the rest financed through employee contributions and revenue from state and local taxes.

"There's a lot of talk about making changes to defined benefit programs and a lot of press attention about the pension funds in various localities being underfunded," says Ed Ferrigno, vice president of Washington affairs, Profit Sharing/401(k) Council of America (PSCA). "But there's also a lot of institutional pressure from unions and service providers to keep defined benefit programs. There's no question that the government programs will lag behind the private sector in moving out of the defined benefit model into a defined contribution program."

VanDerhei points out that as states experience financial difficulties, one of the ways to attempt to fix the problem is to make changes to the state government employees pension plan.

"The problem is these changes get into how to save the state money, not what is the best vehicle for retirement income for the employees," VanDerhei says.

According to Brainard, California's Governor Arnold Schwarzenegger proposed closing the state defined benefit pension plan to all new employees, but ultimately withdrew the proposal because of adamant opposition. In Alaska, the state government succeeded in closing the defined benefit program to all new hires beginning July 2006, replacing it with a defined contribution plan.

Buck Consultants, a globally integrated consulting, outsourcing and processing business, conducted a "Benefit Review Study of the Nebraska Retirement System" in 2002 and found that the defined contribution plan left state employees poorly prepared for retirement, Brainard says. The state chose to close that plan and open a hybrid plan with elements of both a defined benefit and a defined contribution plan.

"A lot of states and localities are recognizing that defined benefit and defined contribution plans don't have to be polar opposites," Brainard says.

Hybrid plans may be the answer that saves consumers from paying higher taxes in some states to resolve the underfunding of pension plans.

Since so few states have converted to a straight defined contribution plan and the experts do not anticipate the federal government converting to such a system, hybrid plans seem to be the solution most governments will choose to support the retirements of their employees.