Government Pensions “Up There”Lessons from United States

David LindemanConsultant to OECD*

INTERNATIONAL SEMINARPENSION SCHEMES FOR CIVIL

SERVANTS AND PENSION FUNDSItamaraty Palace, Ministry of Foreign Affairs, Esplanada dos Ministérios, Brasília, Brazil,

01-02 October 2003

*Some materials are taken from USDOL studies and from Mitchell and Hustead, Pensions in the Public Sector (2001)

United States --some pension basics

Overall pension structure in US• About 96 percent of the workforce is covered by the

national pension regime (old-age, survivors and disability insurance, OASDI) – modest benefit level, actuarial adjustments after age 62,

increasing “normal” retirement age, – in OECD context, relatively good demographics

• Major exception to mandatory coverage is government workers but: – 60 plus percent of Federal workers now under OASDI – 75 percent of state and local government workers under OASDI

• At any time, about half of the private sector workforce participates in a “tax qualified” plan – Participation does not necessarily mean actively making

contributions in a 401-k style plan– Lifetime participation rates are much higher, probably on the

order of 80 percent.

United States private vs. public pension coverage• Coverage for public sector workers are higher.

According to USDOL studies, among wage and salary workers, as a percentage of the relevant labor force --

All wage and salary Private sector

Public sector

Employer sponsors plan 58 91Workers participate 43 77

Full-time wage and salary Private sector

Public sector

Employer sponsors plan 63 94

Workers participate 50 85

United States some pension basics – 3

• Pensions are significant players in capital markets –– About 4.5 to 5.5 trillion USD in 2000 in private

sector pension assets at the high point of the market.

– Another 2.3 trillion USD in state/local retirement plans.

– (Note: GDP of about 10 trillion USD in 2000). • But roughly 90 percent of all pension plans

(less than 100 members) account for roughly 10 percent of participants, assets.

Trends in Policy and Practice• Development of “CoDA” or “401-k” style plan

– Mostly depends on workers making contributions that employers then match.

– Workers almost always make their own portfolio decisions within a bounded range.

– (In public sector, 3 kinds of CODAs under sections 401-k, 403-b, 457 plans)

• Major shift from defined benefit (DB) schemes, which reflects– underlying shifts in economy (e.g., decline in manufacturing)– Academic, policy elite criticisms of “portability losses” & “tax

benefits.”– interactions of regulation and macroeconomic environment

• Trend away from DB in public sector is less pronounced– But in both sectors, even more so in the public sector, employers

who sponsor a traditional (usually DB) pension also provide a CoDA.• DB plans still hold 50 percent of the assets.

United States --Federal Civil Service

Pension Reform

Background• Federal civil servants had separate pension

scheme dating from early 1900s, a product of earlier civil service reform.– Some state and local government pension schemes

that survived Depression.– By 1960s, “comparability” in “total compensation” vis-

à-vis the private sector was the principle.• 1935/1939 Old-Age, Survivors and Disability

Insurance– In general, Federal government not covered. But in

early 1950s, military were covered prospectively – Many state/local governments, but not all, voluntarily

subscribed. About 75 percent of state and local workforce are covered.

Problems with less-than-full coverage• Gaps in disability and survivors coverage for

mobile workers. “Early-leaver” losses– Can lead to undesirable “lock-in effects”.

• Inadequate old-age benefits for some; “windfall” benefits for others.

• OASDI is re-distributional. – Unfair to exempt some relatively high paid (civil

servants) from that policy. – Especially elected political officials

• Until late 1970s, these were issues among “experts.” Public and political elites mostly unconcerned and uninterested.

• 1977/1983 Amendments changed landscape

1977/1983 Amendments• 1977 law rationalized OASDI dynamics and cut some

short-term benefits for overall budget reasons. – Also enacted two “offsets” to prevent “unintended windfall

benefits” – 1977 law also created “Study Group on Universal Coverage.”

Study Group produced report in 1980.• More famous 1983 law addressed loose ends from 1977

law, and mandated coverage of new Federal workers • Congress gave itself two years to design new pension

regime for Federal workers• Made easier by existence of study group report with

concrete design options and, as a byproduct, some capacity in one of the congressional support agencies to staff the reform.

Changing Pension Landscape• 1977 Study Group used the principle of comparability and

examined practices of “large, good employers in service sector”. Three tier approach:– Base: OASDI coverage– Usually some final pay defined benefit plan no more than 0.5

percent and 1.0 percent per year.– A defined contribution “thrift” plan.

• About the same time, IRS regulations implementing IRC “401(k)” and DOL regulations implementing ERISA “404(c)” were making thrift plans more tax-efficient and feasible to operate.– 401-k made allowed thrift plans to become fully EET– 404-c allows employers to minimize fiduciary burden by letting

worker make investment choices among at least three options. • By early 1980s, 401-k plans were becoming very popular.

Mid-80s Federal Civil Service Reform• Generally followed the logic of the Study Group Report.

– Same overall replacement rate for long tenure workers but with workers (a) participating as other citizens in OASDI benefits and costs, and (b) paying higher explicit worker contributions.

• Allowed vested workers to stay in the old Civil Service Retirement System (CSRS) or switch to Federal Employees Retirement System (FERS). New entrants and not-vested workers under FERS.– Very few switched. One exception due to special efforts.

• FERS has three components (1) OASDI coverage, (2) moderate sized occupational DB tier, and (3) 401-k style Federal Thrift Savings Plan (TSP).– Most workers focus on TSP. Only if they become long tenure

workers do they ever think about the DB piece.• TSP also extended to CSRS workers but on less generous

terms. Recently extended to military.

Acquired Rights• Acquired rights was not a large issue in Federal

civil service reform debate.– Old CSRS formula, while generous, was not

excessive relative to pension packages among comparable employers

– For switchers, it is easy to calculate hybrid formula of CSRS and FERS rights.

• 1977 social security law had already taken away “windfalls”.

• Under Federal US law, legal protection of acquired rights rarely extends to “system rights” vs. past accruals and then only on the basis of current wage or salary. – But state workers may have greater protection -- see

later discussion.

Why Did the Reform Happen?• Financing problems in OASDI in 1977/1983 made an

“experts” issue a fiscal and political issue. – Covering relatively high paid Federal workers makes OASDI’s

75 year balance look better. – Of course taxpayers and/or workers pay for this “improvement”

but that is hidden in the civil service account in the overall budget.

– Congressmen became vulnerable to charges of “unjust enrichment”.

• Precedent of military coverage• Advantages of non-coverage (“windfalls”) had been

removed in 1977 OASDI amendments. Otherwise CSRS workers were left alone.

• 401-k type pensions had become extremely fashionable.

Thrift Savings Plan• Choice among (1) equity index C fund, (2)

corporate bond F fund, and (3) Federal government bond G fund. Recently a (4) small cap index fund and (5) international index fund have added. Discussions to add a “lifecycle” option. – Decisions to change one’s portfolio have time lags

that most private 401-k plans do not have.• For post-reform workers, automatic 1 percent, 1-

1 match for next 3 percent, and 0.5-1 match for next 2 percent.

• For CSRS, allowed to put in 5 percent without matching.

Thrift Savings Plan• While the funds are technically “outside” the

government (CBO and GAO ruling), the G fund is used by US Treasury to meet the Debt Limit when the ceiling becomes constraining.

• On the other hand, the G fund has blended and less volatile rates of return that are hard to replicate in the private sector. Ideal “risk-less” investment medium – maybe better than I-bonds and TIPS options for private sector households.

• ERISA fiduciary rules apply to TSP governance.

United States –state and local plans

Unresolved Issue of State and Local Government Workers in OASDI

• Uncovered state/local workers – about one-quarter of that workforce. – Disproportionately police and fire workers plans.– Windfall limits remain a constant (and complicated)

irritant to those affected by them. Except for an effect on OASDI’s long-term balance, Congress might repeal them.

• Three barriers:– Current “privatization” debate about OASDI makes it

hard to rationally discuss further state/local coverage. – Recent trend in opinions from the Supreme Court.– Fiscal

Constitutional “cloud”• Supreme Court has gone through three

phases on constitutional issue– Until the late 1930s, Court had a “comity”

doctrine that made it to any Federal impositions on state and local governments, even in their capacities as employers.

– Increasingly accommodating 1940 to mid-1980s. – In last 10-15 years increasingly negative again

(“impair sovereign powers” test)• But did uphold Medicare coverage and law

prohibiting withdrawal from OASDI.

Fiscal Federalism Realities• Congress probably (but not 100 percent)

could find constitutionally permissible way to cover state/locals, but any such attempt would:– impose severe burdens on states/locals with

PAYG schemes (e.g., Massachusetts) and force “good” states to subsidize “bad” states.

– not be popular even among those who have funded schemes (e.g., California)

• If ever tackled, probably on a new entrant basis and without any fiscal relief to affected entities.

State/local pension landscape• Some 261 “systems” and 378 “plans”

– Systems apply to more than narrow employment group• Benefit provisions in schemes not integrated with

OASDI are more generous, but combined OASDI-supplementary scheme benefits are generally higher in total.

• As of 1996, median financing ratio of state/local plans was estimated at 91 percent (average = 87).– But serious under-funding (book reserve or PAYG

financing) in some jurisdictions, and – In some jurisdictions, liabilities are evolving at an ever

higher rate.

Beneficiary rights state/local government plans

• State and local plans are not covered by the labor law provisions of ERISA, but they are covered (via workers) by tax law provisions.

• But ironically court decisions under common law and using the “contract clause” of the US constitution often provide rights that are equal or superior to those under ERISA– In addition, some states have their own constitutional

provisions outlining pension rights for state and local government workers. But state constitutions are more like “super-laws” than hard-to-amend national constitutions.

Governance state/local government plans

• In general, governance of public sector pension schemes is similar to private sector. – Selection of trustees not without problems in terms of

competence, political patronage and ties to fund management. – Auditing and oversight could be improved in some jurisdictions.– DC plans that rely on transparent contracting-out to private

service providers and letting workers make their own portfolio choices have fewer obvious problems, but

– controversy over management of TSP’s new IT system• Public sector (and non-profit) schemes are under much

greater pressure to exercise “corporate governance” than are large private sector schemes– Private sector pension plan trustees are not inclined to tell other

private firms how to manage their businesses.