Flemming: Ditch ‘defined benefit’ approach, adopt ‘defined contribution’ or hybrid plans for pensions

By David Flemming

A dozen years ago, a Vermont pension reform committee recommended that the state look into switching the way it structures its pension plans for new hires in the future. Today, with a $5.7 billion unfunded liability that is growing with no end in sight, we’ve reached “the future.”

David Flemming, policy analyst at the Ethan Allen Institute

The time has come for Vermont to consider switching its state pension programs from a “defined benefit” approach (where retired employees receive a guaranteed amount from the government) to a “defined contribution” program for new hires, where both the state and employees contribute into an investment fund that the employee can manage.

Hybrid plans are another sensible option that combine features of both the defined benefit and defined contribution structures.

The logic behind the switch makes sense. Defined benefit plans are 20th-century relics that are trying to operate in a 21st-century world. More and more, governments and businesses have abandoned them entirely because they lock in excessively generous promises.

Defined contribution plans, on the other hand, guarantee retiree control over their own investments and a fixed rate of contributions from the employer. They provide flexibility without breaking the bank.

State Treasurer Beth Pearce has been critical of these defined contribution plans. However, that remains in contrast to the advice of leaders like former governor Jim Douglas and pension expert David Coates, who strongly support a change. It also raises the question as to, if these defined contribution plans don’t work, as Pearce alleges, why have more and more states switched to adopting them?

According to Ethan Allen Institute research, roughly a dozen states have moved in the direction of defined contribution or hybrid plans for new hires over the last two decades (with many states having such structures prior to the last 20 years).

Data from the Pew Charitable Trust suggests that, as of 2019, roughly 75% of these states have a better “funded ratio” for their pension system than Vermont does. That is, the proportion of pension assets that covers outstanding pension liabilities is higher in these states.

We can dive even deeper and look at states that have recently implemented reforms toward a defined contribution or hybrid approach and see that these states are doing exceptionally well.

In 2014, Virginia created a hybrid plan for all new state employees. Its funded ratio was previously worse than Vermont’s, at less than two-thirds of liabilities covered by assets. But from 2012 to 2019, its funded ratio rose by 12 percentage points, a strong indicator that pension reform is working.

Tennessee followed the same path as Virginia, and today it has a 107% funded ratio, meaning that it has more than enough assets to cover its outstanding liabilities. In contrast, in 2012, Tennessee had a 92% funded ratio. Today, it has one of the five strongest pension systems in the country.

Oklahoma made its new defined contribution plan mandatory for all new hires (closing off its defined benefit plan) in 2015. Unsurprisingly, its funded ratio rose from 65% in 2012 to 86% today, one of the largest jumps in the nation. Even Connecticut (which just moved to a hybrid system in 2017) has seen its pension system stabilize.

Put another way, of the top five best-funded pension systems in the country, only two have mandatory defined benefit plans like Vermont. Of the bottom five pension systems, the majority have defined benefit systems.

Meanwhile, Vermont’s funded ratio declined from 70% in 2012 to 64% in 2019.

Here’s another secret some don’t want you to know. Vermont already has a defined contribution plan for a small, exclusive group of state employees, such as elected officials and their staff. What’s its unfunded liability? Zero.

Workers would benefit under a defined contribution or hybrid plan, with better portability of benefits, a shorter vesting period, and control over where their funds are invested. So why is the state of Vermont limiting even the option of choosing a defined contribution plan to just its highest-ranking state officials?

To stop the bleeding and secure the future of its pension system, Vermont must follow the lead of its peer states that have already taken action to move to a defined contribution or hybrid system for new hires. At the very least, Vermont should give state employees the choice to select a defined contribution plan, rather than being boxed into what the state tells them.

Vermont lawmakers can take all the half-measures they want, but without structural pension reform, the trajectory of the state’s finances is on a dangerous path.

David Flemming is a policy analyst for the Ethan Allen Institute. Reprinted with permission from the Ethan Allen Institute Blog.

Image courtesy of Wikimedia Commons
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4 thoughts on “Flemming: Ditch ‘defined benefit’ approach, adopt ‘defined contribution’ or hybrid plans for pensions

  1. Yeah, a great way to impoverish all the Americans who have labored to fatten the bottom line.

    The problem with “defined contributions” is that it puts the onus of protecting one’s pension on oneself. Now of course I realize that all of us are skilled investors able to read a balance sheet or prospectus and subscribe to the very best investors’ guides– but maybe we should be thinking about all those ignoramuses who don’t read this blog, like the ones who believed their mortgage broker before 2008 and consequently became homeless.

    To settle for a “defined income” pension means handing another piece of one’s paycheck to the employer who can then use it as he sees fit right up to the moment of retirement. If he’s honest (and every firm on Wall Street is of course!), he will put it into a solid-gold fund which will pay the employee every penny put in– and the profits to the employer. If he’s dishonest, well, Bernie Madoff set the example. And of course in every bad outcome, employers will expect the US government to pick up their mistake and pay out to the poor retiree a few pennies on the dollar.

    Few people understand that raising taxes 3% on Vermonters who earn 45 times the average income erases the state’s present “pension crisis.” How much does a 3% raise represent to any of us? For me, it’s the cost of a very nice meal for four once a year– the cost of a meal which represents much better end-of-life security for someone who helped tote the load for all of us during their working life, in government or out.

  2. Re: “The time has come for Vermont to consider switching its state pension programs from a “defined benefit” approach (where retired employees receive a guaranteed amount from the government) to a “defined contribution” program for new hires, where both the state and employees contribute into an investment fund that the employee can manage.”

    Bingo! Read no further. Get Vermont taxpayers out of the investment management business.

    • And use at least part of Vermont’s $10 Billion Covid windfall to pay down the current ‘unfunded’ liability. If a legislator balks at taking these obviously wise steps on behalf of their Vermont constituents, they must be asked why. Could it be that the legislature considers the Vermont pension funds the same way the U.S. Congress treats the Social Security Trust Fund – as a bank account from which to borrow to fund extracurricular spending?

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