Most state and local governments offer their employees defined benefit (DB) retirement plans, which guarantee steady income for the remainder of the beneficiary’s life. This is in contrast to many private sector jobs where DB pensions are scarce, as most have transitioned to employee-managed defined contribution (DC) plans, in which the employee is responsible for managing their retirement assets personally (e.g., 401(K)). When the Great Recession left many state and local governments short on revenue, the accompanying stock market bust added salt to their wounds by taking its toll on their pension plans. On the bright side, the Florida Retirement System (FRS) has been called a poster-child for how a state should run its employee retirement plans, as its obligations were still 86% funded in 2012 as opposed to 74% nationally.
FRS assets, managed by the State Board of Administration, amounted to $143 billion in state fiscal year (SFY) 2012. Though the FRS formally accounts for little state spending each year, nearly half of plan beneficiaries are public school teachers, and so the employer contributions from school boards are indirectly tied to state funding. Florida relies heavily on property tax revenue for K-12 schools. When property tax revenues fall, more of their funding must come from the state’s general revenue. Employees in the FRS have the option of participating in either a DB or DC plan, with the DB plan being the traditional option. The DB plan has been offered for over 40 years and still accounts for 83% of total FRS membership, though this share has been slowly declining since the inception of the DC option, as shown in Figure 1.
Source: Department of Retirement, FRS Annual Reports, various years.
Most private business in America dropped the DB option because of a legal change that requires them to use a low discount rate to calculate the value of their liabilities. In many cases, employees don’t mind because in a DC plan they gain control of the assets, meaning that financial ruin for their employer doesn’t cost them their retirement savings. From the perspective of the Florida taxpayers, the important question is “which option lets Florida maintain any given level of service at the lowest cost?” Though it may sound simple enough, it is a rather complex issue.
First, it is far less likely for a municipality to declare bankruptcy than a private business—though try telling that to a lifelong employee of the City of Detroit—and even less likely that a state such as Florida would fail to meet its pension obligations in the foreseeable future. Aside from the fact that a state can draw from its taxpayers if needed to meet its obligations, the FRS system is well funded. In fact, for about a decade, the FRS Pension Plan was overfunded, and has only dropped below 100% through the financial crisis, as shown in Figure 2. This is quite impressive considering the extreme shock to Florida’s real estate market, and given the fact that with no income tax the indirect reliance on property taxes for balancing the state budget is magnified. Only New York had a higher funded ratio of its state retirement system than Florida in 2012, and even so the difference was a mere 1%. In addition, Florida’s unfunded liability per capita was far below that of New York’s—$1,050 vs. $2,412—and well below the national average of $2,882. Assuming the continuing recovery of financial markets (which has been strong) and the continuing recovery of real estate markets (which has been sluggish), Florida could presumably get this ratio back above 100% soon.
Figure 2: The FRS Pension Plan Funded Ratios, 1985-2012
Source: State Board of Administration of Florida, Investment Report 2012.
DB plans pool risk both across cohorts and across individuals within a cohort. This pooling is much more extensive for large state level DB plans like the FRS. Localized shocks that have trivial effects on a large state across many generations may have large effects on a single city or even more so a single private employer over a single generation. With a large state risk is effectively pooled over many generations with a very large number of taxpayers in each generation. Because of this, and because of the potential for taxpayers to backstop the pension plan if needed, the risk associated with the DB portion of the FRS is effectively pooled over many generations of all taxpayers of the fourth (soon to be third) most populous state in the nation.
This risk pooling leads to a major advantage of the FRS DB option: the ability to maintain a riskier pool of assets and thereby generate a higher average annual return. The stock market crash was enough to push many average investors to the sidelines, and some have yet to regain the stomach for equities. However, those that maintained their positions have regained all of their losses and then some. On the other hand, other investment classes haven’t fully recovered, such as real estate. The argument here is that history has proven time and again that given enough time riskier investments such as domestic and global stocks yield higher annual returns than fixed income and cash.
While a risk averse but wise individual can widely diversify the finds in their DC plan through investing in broad mutual funds, for example broad index funds, lacking time machines they cannot diversify over cohorts and so optimally switch to less volatile investments as they get closer to retirement. However, the multi-generational nature of the pension fund means that it can maintain its riskier positions as long as it has cash on hand to pay its short-term obligations. Perhaps it can even pay those obligations with cash being deposited by current contributors, assuming the contributions outweigh the required payouts. This means the DB plan can maintains a higher rate of return indefinitely than is possible for the best run individual DC accounts. Pooling assets also means a bigger pot of money, which enables access to more financial vehicles and the ability to attract greater talent to manage them. In the end, from this perspective the FRS DB is superior to the DC option, assuming employees can trust the state to manage the funds appropriately, to make sufficient contributions each year, and to make up any shortfalls from other sources when absolutely needed.
Ignoring vesting requirements for now, the DB FRS option provides two potentially important, distinct but related, advantages in hiring. First, most individuals are risk averse, meaning they would prefer a somewhat lower guaranteed pension payment to one that is expected to be a bit higher on average but is subject to uncertainty. Even if the DC and DB options maintained the same average rate of return and had the same average pension payout, workers would prefer the DB option. Second, any given average level of pension payment can be sustained at a lower cost due to the higher rate of return. Therefore, Florida can, on average, hire a given worker for a slightly lower salary and/or make lower retirement account contributions on their behalf than the typical private firm with only DC pension plan.
A relatively generous seeming DB pension may simply represent a decision to tradeoff a lower salary during the working years for a more generous pension financed through this higher average rate of return on assets with taxpayers saving money in the process. According to the Florida Department of Management Services the average annual benefit for a regular FRS retired employee was only $18,066 in 2011. On first impression, this may seem too meager to represent much of an advantage from the DB plan. But what constitutes a generous pension is relative. Someone with 30 years of service (regular risk class) whose average salary over their highest paid years (counted in the benefit calculation) was $38,000 would draw approximately this benefit. If they retired at age 62, they would likely draw another $12,000 to $15,000 annually from social security—depending on other factors. Thus, they would draw a guaranteed income in retirement that was over 80% of their highest years of compensation while working. Conditional on making it to age 62, a man has approximately a 60% chance of living into their 80s and a woman has approximately a 70% change, making this quite attractive to many when considered relative to the annual compensation earned while working.
Vesting requirements are a complication. Those enrolled in the DB plan are only eligible for benefits after 8 years of service as of the start of SFY 2012. Employees who leave state employment before completing these 8 years lose access to these resources. Further, even if an employee planned to spend their entire career working for an FRS participating government or agency, the fear of a layoff before vesting occurs makes the DB plan less attractive.
This means there is an advantage to offering a choice between DB and DC options in the FRS—those who are not reasonably certain they will remain in FRS-eligible employment can choose the DC option and retain ownership of their contribution if they change jobs. It means there is a further advantage to a hybrid system that allows employees on the DC plan an option to transition to the DB option if they do remain with the state for a long enough period of the time—of course potentially requiring an additional buy-in contribution from the employee depending on the level of assets in the employees DC account.
In SFY 2012, employees were required to start contributing 3% of their salaries into the FRS. In this context is should be clear that an eventual consequence will be the need to pay the equivalent of 3% higher salary to continue to compete with private employers for the same employees at the same level. Of course, while new employees will require this higher compensation, some of those currently in the system are essentially locked in, and so their earnings including their pension will ultimately support a lower lifetime standard of living than they might have expected when they elected to participate in the FRS DB plan.
In the interest of completeness, we note that there is disagreement about the proper pension discount rate to use in evaluating the solvency of the FRS or other government employee DB plans. Importantly, this question is very different for a state than for a private company, since the employees bear the risk in a private company but taxpayers bear the risk for a state. Currently, the FRS rate is 7.75%, which we think may be a bit too high, but only slightly. This, however, is a topic for another entire discussion. More may information, on the appropriate discount rate and the FRS more broadly, may be found here, and also in section 4 of Tougher Choices, a report we authored which was recently released by the LeRoy Collins Institute.
While it may be best for private businesses to rely on DC plans, the issue is more complex for state and local governments. The choice between DB and DC plans currently offered FRS employees seems to give employees and taxpayers the best of both worlds—giving employees the freedom to choose what is right for them given their future career path and giving taxpayers the ability to maintain any given level of service at a lower expected cost. While some states have failed to maintain the solvency of their DB plans, that is not the case for the FRS. Aside from what amounts to quibbling over details, Florida has gotten the FRS right.