States Overhaul Pensions but Pass on 401(k)-Style Plans

By: - June 21, 2011 12:00 am


This year, many states were poised to switch from traditional pension plans to a kind similar to the ones popular in the private sector. That didn’t happen. But states did cut employee benefits, raised the retirement age and increased the amount that public workers were expected to contribute to their own pensions. 

There is an easy way to shore up state pension systems, or so many leaders elected last year believed: States should move to offering 401(k)-style retirement plans. Eight new governors and numerous new legislators said they would support shifting state employees to these plans, following a move the private sector made long ago. Kansas, Kentucky, Nevada and Oklahoma appeared especially ready to make the change.   


But 401(k) fever seems to be over, at least for now. No state this year replaced its traditional fixed-benefit pension with a new plan in which employees set aside a portion of their pay and assume the risk in making investment decisions. Only one state, Indiana, implemented such a plan for new employees, but made it optional.   


Enthusiasm for the switch waned after consultants and legislative researchers told state officials that it would cost money before it saves money. That was a difficult sell at a time when many states faced their fourth consecutive year of big budget deficits.  


The problem is that changing from a so-called “defined benefit” plan to a “defined contribution” plan comes with huge transactional costs. When the old plan is closed, the employees and retirees who remain in the plan still receive their pension checks even as the number of employees contributing to the plan drops — new hires contribute to the new plan. The state has to make up the difference. In Kentucky’s case, the increased cost would be billion over 15 years. The Nevada price tag : .2 billion over the next two years.  

The Segal Company, a benefits and pay consultant, studied the Nevada proposal for the state public employee retirement system. “While many [states] find the stable cost structure of a defined contribution plan attractive,” the study concluded, “the closure of a defined benefit plan to new members would make the cost of the defined benefit plan increase significantly.” Only two states have switched to defined contribution plans: Michigan did it in 1997 and Alaska in 2005.   

While the 401(k) boom never materialized in 2011, a number of states did pass sweeping changes intended to shore up their pension systems. Lawmakers in half of the states cut benefits for current and future state workers. Nine states increased pension contributions from current employees; Florida began requiring workers to chip in for the first time. Even North Dakota, the nation’s most financially sound state, asked current employees to contribute more to their plan.  


More changes are likely to pass still: Pension proposals are pending in nearly all of the 15 state legislatures that have yet to adjourn for the year. So despite the stalled momentum toward defined contribution plans, states for the third year in a row will reduce the amount of money that government pays its workers when they retire. The cuts signal a continuing shift in the way states view retirement benefits, reversing years of increases towards a system that is less generous to public employees.  


Contributions backlash


The trend towards increased employee contributions is distinct: In 2008 and 2009, when the 2008 Wall Street financial crisis battered public pension funds, five states raised the amount workers contribute toward their pensions in each of those years. In 2010, nine states raised contributions. So far in 2011, nine states increased contributions for current employees and five states increased them for new hires. Florida, one of the last states that had not required workers to pay into the pension fund at all, ended that perk by asking workers to contribute 3 percent of their salaries per year.

Major public pension changes in 2011
Source: Stateline reporting and National Conference of State Legislatures

Increasing employee contributions is never popular, especially during sluggish economic times when many states have frozen salaries and furloughed or laid off employees. Workers inevitably see higher contributions as taking home a lower salary.  


That’s been the case in New Hampshire, where state Senator Jeb Bradley has been engaged in a yearlong battle with state and local employees. Bradley proposed to cut retirement benefits for new hires, require employees to work longer before they retire and increase contributions from current and future state workers by 2 percent per year. The blowback from labor has been so hot that Bradley jokes about needing a bulletproof vest when he appears in public.  


At one such appearance in Portsmouth recently, Bradley told an audience dominated by public workers that his plan was “tough medicine” that workers had to swallow. “A 2-percent increase is a pay cut,” replied Matt Newton, a 17-year veteran firefighter from Hampton. Later, in an interview, Newton, 43, said Hampton firefighters have not had a cost-of-living or step increase in the six years they have been without a contract. A contribution increase, he said, would mean his family would continue forgoing vacations and dinners out — “things that would put money back into the economy.”  


New Hampshire’s Republican-controlled Legislature passed Bradley’s plan earlier this month. Governor John Lynch, a Democrat, vetoed it last week after lawmakers said they planned to make technical changes to it.  GOP leaders wrote the pension bill with the changes into the state budget bill instead of attempting to override the veto.    


Legal challenges


In a number of states, the fight over pension changes may have to go to court to be resolved.  


In Washington State, for example, lawmakers voted to halt automatic cost-of-living increases for 109,000 retirees in the state’s oldest retirement plan. Similar changes enacted last year in Colorado, Minnesota and South Dakota landed those states in court when retirees challenged whether they were constitutional — generally, states are not allowed to take away a benefit they have already granted.  


The cases from last year’s legislation still have not been resolved. Washington State employees say they may sue as well; state officials say the Legislature allowed cost-of-living adjustments to end in the future when lawmakers approved the benefit in 1995.  


Michigan is another state where the courts will weigh in. Governor Rick Snyder pushed through a plan to extend the state’s income tax to public pensions. State employee groups say the state Constitution protects them from the state impairing a benefit, which they say includes the income tax exemption. The case is already before the Michigan Supreme Court.  


In Arizona, state employees are using the same legal precept to consider fighting pension benefit cuts, including higher contributions from current employees. Under a law passed this year, workers are to chip in 53 percent of contributions while the state kicks in 47 percent. Previously the share was evenly split.   


‘Something has to be done’


Pension changes haven’t been contentious everywhere. In Delaware, Governor Jack Markell formed a group of administration officials, legislative leaders and state employee union officials to endorse a plan requiring future employees to pay higher contributions for their pension and health care. The plan passed in the state Senate by a vote of 20-to-0. Vermont Governor Peter Shumlin, on his first day in office in January, met with union officials to negotiate a package of pay cuts, layoffs, higher contributions to their pension plan and additional years before they can retire. The plan passed easily.  


Likewise, Hawaii lawmakers passed major pension changes, and only one of 123 state and county bargaining units opposed the plan. Hawaii raised the retirement age, cut benefits and boosted employee contributions for new hires. It also declared a moratorium on retirement benefit increases until its pension system is 100 percent funded. “I think that was a recognition that everyone knows something has to be done,” says Michael Nauyokas, a labor lawyer in Honolulu usually accustomed to fighting benefit cuts.  


Thomas Anton Kochan, a Massachusetts Institute of Technology professor who specializes in management and labor relations, says union leaders are willing to sit down and negotiate changes with state officials to keep their pension plans solvent “We are at a potentially transformative moment in public-sector labor relations,” Kochan says. “If we address these issues in a truly transparent and collaborative way, using all the tool of modern negotiations and workplace participation, we could open a new era in a high quality public service delivery.”

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Stephen Fehr

Stephen Fehr is a senior officer with Pew’s government performance portfolio. He is a lead writer on many of the products generated by the portfolio, specializing in state and local fiscal health.