HOW TO EFFECTIVELY REDESIGN BENEFIT PLANS TO BALANCE YOUR BUDGET CONSTRAINTS AND YOUR EMPLOYEES NEEDS. Robert D. Klausner Klausner & Kaufman, P.A.

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1 HOW TO EFFECTIVELY REDESIGN BENEFIT PLANS TO BALANCE YOUR BUDGET CONSTRAINTS AND YOUR EMPLOYEES NEEDS Robert D. Klausner Klausner & Kaufman, P.A.

2 Presentation Overview Pension restructuring and cost control is a growing issue. This presentation will address the advantages and disadvantages of Defined Benefit (DB) plans and Defined Contribution (DC) plans. Plan design and the advantages/disadvantages of plan structure vary depending on one s philosophical, political, employment, or fiscal outlook. The advantage for one plan design frequently results in a corresponding disadvantage for the other, depending on one s perspective. In the final analysis, the author believes that maintenance of a DB plan is the optimum means of providing a meaningful retirement to valued public employees and represents the most effective tool to insure a stable, well-trained, and dedicated municipal workforce. 2

3 Constitutional Protection Pension rights are protected by the Florida Constitution Art. 1, Section 10. Prohibited laws. No bill of attainder, ex post facto law or law impairing the obligation of contracts shall be passed. Once you are eligible to retire a DB benefit cannot be retroactively diminished or impaired. A DB pension benefit is guaranteed for your whole life post retirement (no matter how long you live). Florida courts have held for over 60 years that pension rights are not a mere gratuity. Pensions are a contract right which vests once you are eligible to retire. Under Florida law, the City/Plan Sponsor is ultimately responsible for making certain that the DB Plan is actuarially sound. 3

4 Pension Funding Issues 4 DB plans pass investment and mortality risk to the employer, whereas DC plan structure requires employees to assume these risks. As a result, DB employer contribution rates fluctuate over time with actuarial experience and investments. If a DB plan experiences back-toback years of poor actuarial experience, employer contributions can fluctuate dramatically. By contrast, DC contribution rates are loved by finance directors for their predictability and stable cost. DB plans can partially mitigate contribution rate volatility by using various tools including actuarial smoothing methods, adjusting and monitoring assumptions, and carefully managing asset allocations. DB plan sponsors were criticized for reducing required minimum contributions based on unusually strong investment experience during the market bubble. DB advocates have recommended adding contribution floors to maintain minimum employer contributions. SB 1128 prevents plans sponsors from reducing contributions below normal cost, but exempts FRS. See (13)

5 ADVANTAGES OF DB PLANS Guaranteed Post-Retirement Income Stability; Investment Efficiencies, Expertise, Diversification and Economies of Scale Enhance Investment Returns which Empirically are Superior for DB plans; Easier Retirement and Financial Planning Results from the Delegation of Investment Responsibilities to DB Plan Professionals and Trustees; Flexibility to Provide Disability Benefits, Early Retirement Incentives, and Recognition of Outside Service Credit. 5

6 DISADVANTAGES OF DB PLANS Cost over Sustained Declining Markets or in a Shrinking Payroll Environment; Investment and Actuarial Risks Rest on the Employer Resulting in Fluctuating Employer Contribution Rates; Actuarial and Structural Complexity; Less Portable and Less Advantageous for Non-Career Employees. 6

7 ADVANTAGES OF DC PLANS Investment Risks Rest with the Employee Resulting in a Stable and Predictable Employer Contribution Rate; Portability of DC Account Balances Is Desirable for Younger and Non-Career Employees; Inherently Simpler Plan Design and Structure Results in Lower Plan Sponsor Administrative Costs Which Can Offset Higher Investment Expenses; Empowerment/Responsibility of Employees; Possibility of Superior Returns and Intergenerational Transfer of Retirement Assets. 7

8 DISADVANTAGES OF DC PLANS Responsibility is Placed on Employees and Retirees who bear the Risk of Poor Investment Performance; Lack of Guaranteed Post-Retirement Income Stability; Individual Financial Planning Is Emphasized; On Average DC Plans Generate Lower Investment Returns and Involve the Risk of Inadequate Savings; Less Flexibility for Recognizing Outside Service and Less Effective at Motivating and Retaining Employees 8

9 GENERAL SUPERIORITY OF DB PLANS Both DB and DC plans present relative advantages and corresponding disadvantages. There is no single best solution for all situations. Both types of plans should be evaluated in the context of specific plan objective(s). While there is no single best plan design for all employers or employees, the maintenance of the current DB model is generally preferred. Abandonment or radical curtailment of a DB program is directly contrary to sound governmental employment practices. Substitution of a DC plan can exacerbate current economic burdens. Constitutional requirements mandate the maintenance of a DB program for current employees. Closure of a DB plan may dramatically increase the cost of maintaining benefits for the current workforce and retirees. At the same time, a switch to a DC plan for new employees can create new recruitment challenges. Exposing employees to market risks and denying them adequate death and disability protection is a disincentive to public employees taking the risks necessary to preserve life and property. 9

10 UNANTICIPATED COSTS OF DB PLAN CLOSURE NO SILVER BULLETS Plan closure can be particularly complex for DB plans and raises various residual plan management issues; A closed DB plan will be required to allocate any accrued unfunded liability among the static or decreasing employee base; As a result, the normal cost component may remain the same, but an increasing amortization component will result in higher overall future contribution percentages for the remaining plan members; The decreasing member base results in more volatile employer contributions; Percentage of pay comparisons in a closed DB plan become increasingly irrelevant as members retire. 10

11 LEGISLATIVE HISTORY OF REOPENING CLOSED DB PLANS Over the past several years the debate between the proponents of DB and DC plans has intensified. Set forth below are examples of retirement systems switching from DB to DC and then switching back: West Virginia closed its teacher DB plan in 1991, requiring all new teachers to join a new DC plan. According to the plan s actuary, the new private account system was more expensive than the old DB pension system. West Virginia switched back to a traditional DB plan in Participants in the DC plan switched en masse to the reopened DB plan. An effort to again close the DB plan failed in 2011; Nebraska (2000); Alexandria, VA (2004); Fargo and Grand Forks, ND (2008 and 2009) 11

12 Proposed DB restructuring solutions: 1. End Spiking - Some plans back-load compensation late in an employee s career. The Legislature effectively limited this issue in SB Plans should be reviewed, however, to determine cost drivers which are not funded over the working lifetime of the employee. 2. Second tiers - Even modest changes in benefits for new hires can provide long term cost savings. The speed at which the savings are realized is dependent on the rate of turnover of the current work force. Incentives to more senior workers to encourage retirement when eligible will speed the effectiveness of new tiers. 3. Hybrid Plans - A number of Florida governments have recognized that a DC plan alone does not generally provide an adequate retirement or a competitive compensation package. Mixing cash balance and DC plans or DB plans with a DC supplement can create a meaningful retirement with more predictable cost. 12

13 Proposed DB restructuring solutions: 4. Creative use of municipal debt - All pension plans have a significant investment in fixed income. Issuance of municipal bonds purchased with fixed income proceeds can extend the funding life of the plan. 5. Engage the employees - The long term welfare of government employees rests on the economic health of the employer. Encouraging solutions from the employees may yield surprising benefits, not only on cost but in productivity, employee satisfaction and labor peace. 6. Explore improved investment opportunities - 2/3 of the cost of a DB plan is borne by investment return. A number of plans have sought and received increased investment authority to allow a more flexible response to market conditions to immunize the plan from asset losses resulting from over reliance of traditional markets. 13

14 NEW GFOA BEST PRACTICE FOR SECOND TIERS - RECOMMENDATION At its recent annual meeting in San Antonio, the GFOA approved a new best practice for establishing new pension benefit tiers. The Government Finance Officers Association (GFOA) recommends that jurisdictions considering new benefit tiers examine the following issues: A government s authority to revise its pension benefits; the overall goals it wants to accomplish by doing so, and the effect of such changes on the workforce and the financial impacts resulting from changes to pension plan design, as well as the effects on employees. The GFOA further recommends that as governments consider new benefit tiers they solicit input from actuaries during the analysis, design, and implementation related to forecasting benefit costs, determining funding adequacy, and making decisions regarding employer and employee contribution rates. 14

15 NEW GFOA BEST PRACTICE FOR SECOND TIERS ISSUES AND IMPACTS Part 1- review the following: Identify and address legal constraints; Identify financial sustainability goals; Review total compensation and the impact of pension benefit tiers; Investigate alternative plan design options; Reconsider Other Postemployment Benefits (OPEB); Part II understand impact on employer and employees: Retirement ages, multiplier, COLAs, employee contributions, future benefit enhancements to only be prospective, purchase of service credit, anti-spiking, vesting, notice to employees and transition issues 15

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