Defined contribution plans
Pensions, Public Pensions
PENSIONS, PUBLIC PENSIONS
Distinction between government and private pensions
Employees in the public sector—those working for state and local governments and the federal government—are in a number of respects better situated with respect to employer-provided pensions than are employees in the private sector. Virtually all full-time public sector employees participate in employer-provided pension plans. This contrasts with the private sector, where only about half of the full-time workforce participates in a pension plan at any given time.
State and local government pensions are predominantly defined benefit pensions—few state and local employees participate in defined contribution plans. Until the mid-1970s, private pensions were also predominantly defined benefit pensions. Since then, defined contribution pensions have grown in importance, while defined benefit pensions have declined, and by the end of the twentieth century defined contribution plans were more prevalent in the private sector than defined benefit plans. This trend has not occurred in the public sector, creating a significant difference between pensions for public sector employees and those for private sector employees. The difference in pension type is important for employees because in defined benefit plans the employer bears the financial risk associated with their funding, while in defined contribution plans the risk is borne by employees.
As well as having less financial market risk for employees, pension plans for public sector employees tend to be more generous than plans in the private sector. Most employees in state and local government are covered by plans permitting retirement at age fifty-five or earlier, frequently with just five or ten years of service required. The majority of state and local government employees (62 percent) are in plans that provide postretirement increases, most of which (73 percent) are provided automatically. These increases are intended to compensate retirees for increases in the Consumer Price Index (CPI), though they are typically capped at either a portion of the CPI change or an absolute ceiling. In contrast, only 7 percent of private sector plan participants in medium and large firms are in plans offering postretirement increases, and fewer than half of these participants are in plans where the increase is automatic. Public sector employees, however, usually pay part of the cost of defined benefit pension plans through their own contributions, which is uncommon in the private sector.
Differences in regulations covering public and private pensions
Private pensions are regulated by the federal pension law called the Employee Retirement Income Security Act of 1974 (ERISA). This complex law, which has been amended numerous times, is the second longest law in the United States—only the tax code is longer. It is administered by three federal agencies: the Labor Department, the Internal Revenue Service, and the Pension Benefit Guaranty Corporation. The Labor Department administers sections of the law relating to the fiduciary responsibilities of plan sponsors and service providers. The Internal Revenue Service administers sections relating to allowable and required contributions and to tax deductions for pensions. The Pension Benefit Guaranty Corporation administers sections relating to the pension benefit insurance it provides for defined benefit plans.
The only pension plans not covered by this law are those for government employees and employees of religious organizations. State and local government pension plans and pension plans for federal government employees are subject to considerably fewer regulations, and public sector employees consequently have different, and generally fewer, legal protections. Many attempts have been made to bring state and local government plans under federal jurisdiction through introduction of legislation that would establish a public sector equivalent to ERISA. State and local government pension plans, however, continue to be regulated primarily by individual state and local governments. They are not subject to the regulations administered by the Labor Department and the Pension Benefit Guaranty Corporation. Government employees are subject to restrictions administered by the Internal Revenue Service concerning maximum allowable contributions and maximum allowable benefits, but the limits are generally higher than for the private sector. While state and local government plans are not subject to ERISA's reporting requirements, they must follow the financial measurement and reporting requirements imposed by the Governmental Accounting Standards Board (GASB). Private sector plans must follow the accounting requirements imposed by the Financial Accounting Standards Board (FASB).
At least in one respect, many employees in public plans have greater legal protection than do employees in private plans. Approximately half the states have either a state constitutional provision, a statutory provision, or past court rulings stipulating the right that the future accrual of pension benefits cannot be reduced for current employees. This right is not provided to private sector employees or employees in the federal government, where pension plan provisions can be modified to reduce the future accrual of pension benefits. Because of this right for many state and local government employees, pension reforms in those sectors tend to result in tiered pension plans, where a reform only affects newly hired workers, with previously hired workers maintaining their participation in the nonreformed plan.
Because state and local government plans are generally subject to fewer restrictions, they can have features that are not allowed in private plans. Thus, they serve as a laboratory for experimentation in plan designs that would not be allowed under current federal laws for private sector plans. For example, the pension plans for public employees in the state of Indiana provide for a rate-of-return guarantee for the defined contribution plan that is backed by the fund of the defined benefit plan. Such an arrangement would not be allowed in the private sector because it would violate the ERISA requirement that defined benefit plan assets be used only for the purpose of providing benefits from that plan.
Unlike the private sector, where all workers (except employees of religious organizations) are automatically covered by Social Security, state and local governments have the option of not choosing Social Security coverage for their employees if their employees are already covered by a state or local government retirement plan. State and local governments whose workers are currently not covered by Social Security can continue to exclude them from Social Security. For those workers, the public pension plan provided tends to be more generous than for private plans because it also replaces Social Security. State and local government employees not covered by a public retirement plan are automatically covered by Social Security. Since 1983, state and local governments can no longer terminate Social Security coverage for groups of employees already participating.
Types of plans for federal government workers
Federal government workers hired before 1983 are covered by a different retirement income system than are those workers hired later. The Civil Service Retirement System (CSRS) (for workers hired before 1983) consists primarily of a generous defined benefit plan. Retirement benefits are available at age fifty-five for workers with thirty years of service. Under special circumstances, workers may retire at age fifty with twenty years of service, taking a reduction in benefits of 2 percent per year for every year they are younger than age fifty-five. The retirement benefits are fully indexed for inflation after retirement, which is also done by Social Security but which is rarely, if ever, done by private sector pension plans. The CSRS was started in 1920, and thus predates the Social Security system, which began in 1937. Before the federal pension reform in 1983, federal government employees were the largest group of employees not covered by Social Security.
These workers may also participate in the Thrift Savings Plan, which is a defined contribution plan. They may contribute up to 5 percent of their salary to this plan, but they receive no matching contribution from the federal government. The Thrift Savings Plan has grown rapidly, and, because of the large size of the federal workforce, is expected to eventually be the largest pension plan in the United States.
Employees hired after 1983 receive retirement benefits structured similarly to those for employees of large corporations in the private sector, through a system called the Federal Employees Retirement System (FERS). They are covered by Social Security and contribute to it just as do private sector workers. Because they participate in Social Security, they are covered by a considerably less generous defined benefit plan than are federal workers hired earlier. However, they may contribute a higher percentage of their salary to the Thrift Savings Plan, and they receive an employer match for their contributions. Several other systems cover particular groups of employees, such as diplomats (State Department), intelligence operatives and researchers (Central Intelligence Agency), and central bankers (Federal Reserve Board).
Management and funding issues
State and local government retirement programs are typically administered by independent governmental agencies. A plan's board—made up of elected, appointed, and ex officio members—holds the fiduciary responsibility for the plan and manages it. The board's management responsibilities include hiring staff, approving expenditures, and ensuring that reporting requirements are met. The board also typically influences actuarial assumptions and investment policy.
Private pension plans are subject to funding rules set by federal law that govern the minimum and maximum allowable levels of funding. In contrast, the funding requirements of public plans are not governed by federal law, but may be set by state law. Public sector pension plans have typically been considerably less well funded than private pension plans, though there has been a long-term trend towards improved funding in the public sector. Public sector employers have less incentive to fund their plans, since they do not receive—or need—the tax deduction private employers receive for doing so. Public employers also have less need to fund their plans, since the pension plans are backed by the power of the public sector to tax, and public sector jurisdictions typically have little risk of bankruptcy. Given this security, employees have less incentive to monitor or urge improvements in plan funding. However, advance funding can lower the cost of the plan to the employer by allowing a share of benefits to be financed by investment earnings. Consequently, advance funding, at least for state and local governments, has come to be seen as a fiscally responsible policy.
Investment of public sector pension funds
At the end of 1999, state and local government employee pension funds held $3.0 trillion in assets. To put this figure in perspective, private-employee funds held $4.9 trillion, and life insurance companies held $3.1 trillion. Both private and public pension funds were invested primarily in credit market instruments and in corporate equities (see Table 1). The balance of these assets is different, however, with public funds holding 67 percent of assets in corporate equities, compared with 50 percent in private funds. The share of state and local plan assets held in equities has increased dramatically over the past several decades, rising from only 3 percent in 1960 and 17 percent in 1970.
A given plan's investment policy will reflect its objectives, applicable statutory restrictions (if any), and the board's control over investment decisions. For example, for many years West Virginia prohibited its state pension plans from investing in equities, and many plans continue to limit investments in various types of assets. However, since the 1980s, many state legislatures have replaced the restrictive "legal lists" of allowed investments with a more flexible standard of prudence. This trend allowed many plans to take advantage of the stock market's strong performance during the 1990s, reducing the effective cost of plan maintenance for sponsoring governments and contributing to many plans' current strong funding status.
Importance of states in affecting behavior of firms and stock market outcomes
The growth of state and local government pension assets has led to an appreciation of their economic and political power. Many state and local government employees' pension plans have consequently been active in social investing. This term refers to investment decisions where an investor or money manager factors in ethical or social priorities. Social investors are concerned with such issues as companies' environmental records, treatment of employees, behavior in foreign markets, and connection to controversial products such as tobacco.
Private sector pension plans are prohibited from making investments designed to further socially desirable purposes at the expense of the plan's rate of return. State and local government plans are not subject to this restriction and consequently have been more likely to engage in social investing. However, some social investors also believe that firms that behave ethically are likely to provide a better investment return than those that do not, and, indeed, returns in many social investment funds have exceeded those in many standard indices. Moreover, while state and local plans are not subject to the ERISA requirement that plan assets be invested using the "care, skill, and diligence" of a prudent individual acting "solely in the interest of plan participants," most public plans have adopted similar language.
Many institutional investors—prominently public pension plans, but private plans as well— are also concerned with the governance of publicly traded corporations. Governance concerns include the election and independence of directors, including the disclosure of sufficient information for investors to ascertain independence; the appointment and conduct of board committees; the allocation and exercise of shareholder voting rights; board composition and accountability to shareholders; and the level of director and management compensation. Many state and local government plans pursue these and other governance concerns as a way to protect plan assets and increase return on their investments as part of their fiduciary obligations.
Sophie M. Korczyk John A. Turner
See also Consumer Price Index and COLAs; Employee Retirement Income Security Act; Pension, Plan Types and Policy Approaches; Retirement Planning.
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PROFIT SHARING. The U.S. Department of Labor defines a profit-sharing plan as a "defined contribution plan under which the plan may provide, or the employer may determine, annually, how much will be contributed to the plan (out of profits or otherwise). The plan contains a formula for allocating to each participant a portion of each annual contribution."
Annual cash bonuses, particularly to white-collar or administrative workers, have a long history in Europe. Plans to distribute a percentage of profits to all workers appeared in the United States shortly after the Civil War. These plans were largely confined to medium-sized family or paternalistic companies and never became widespread before their general abandonment during the Great Depression. The difficulties encountered in such plans were formidable: many employers feared the effect on prices and competitors from a public disclosure of large profits; it was hard for managers to see how a share in profits could raise the productivity of many types of labor; workers feared that a promise of a bonus based on profits was in fact an excuse for a low wage, antiunion policy; and most working-class families preferred a reliable to a fluctuating income. As a consequence, when unions became strong in the manufacturing field after 1940, their leaders proposed fixed fringe benefits such as group insurance, pensions, or guaranteed annual wages, rather than profit sharing.
An allied movement, particularly popular in the prosperous 1920s, was the purchase of stock in the company by employees. Management offered easy payments and often a per-share price lower than the current market figure. It was hoped, as in the case of profit sharing, that such plans would reduce labor turnover and give workers a stronger interest in company welfare. The decline in value of common stocks in the Great Depression to much less than the workers had paid for them, especially when installment payments were still due, ended the popularity of employee stock-purchase plans.
Annual bonuses in stock, cash, or both continued in many companies as an incentive to employees in management positions. Especially when managerial talent has been scarce, as in the booms of the mid-1950s or 1960s, options to buy large amounts of stock over a span of years at a set price were used to attract and keep executives.
In the 1960s, the Supreme Court ruled that professionals could incorporate, which meant that they could also take advantage of retirement benefits that paralleled plans available to people working in corporations. In 1963, Harry V. Lamon, Jr. drafted the first master Keogh plan, a tax-deferred retirement program for self-employed people and unincorporated businesses.
The Employment Retirement Income Security Act was passed in 1974 to protect retirement plan participants. This act established numerous reporting and disclosure rules and provided additional incentives for Keogh plan participants. Another important element of the act was the establishment of employee stock-ownership plans.
Retirement plans were simplified by the Revenue Act of 1978, which, among other changes, established the 401(k) retirement plans. A contributor to a 401(k) plan is not taxed on the income deposited in the year it was earned; the money is taxed at the time of withdrawal.
While each of the legislative changes over the last third of the twentieth century addressed different elements of profit sharing plans, the overall focus has shifted from a clearly defined benefit to defined contribution.
Allen, Everett T. Jr., et. al. Pension Planning: Pensions, Profit Sharing, and Other Deferred Compensation Plans. 8th ed. New York: McGraw Hill/Irwin, 1997.
"Profit Sharing." Dictionary of American History. 2003. Encyclopedia.com. (July 25, 2016). http://www.encyclopedia.com/doc/1G2-3401803412.html
"Profit Sharing." Dictionary of American History. 2003. Retrieved July 25, 2016 from Encyclopedia.com: http://www.encyclopedia.com/doc/1G2-3401803412.html