Is Nebraska's Cash Balance Pension a Model?
Nebraska takes an approach to managing its public pension system that is unusual among the states. It does not offer its employees and legislators a traditional fixed-benefit pension or a health care plan when they retire.
Instead, Nebraska state employees hired since 2003 join what public pension analysts call a "cash balance" retirement plan , which includes features of both a traditional defined benefit pension and a 401(k)-style system. The hybrid plan is getting new attention from other states searching for alternatives to the decades-old defined benefit system whose cost is rising as Baby Boomers retire and pension portfolios recover from record losses during the Great Recession.
Kansas, Maryland, Montana and Pennsylvania lawmakers took a look this year at proposals shifting from traditional pensions to cash balance plans. Though none was approved, interest in cash balance systems continues because lawmakers looking to slash public pension costs are discovering that their preferred alternative — changing from a traditional defined benefit to a 401(k)-style plan — is initially too expensive or faces strong opposition from politically powerful labor unions.
"It is a heavy lift from a policy standpoint," says Pennsylvania state Representative Scott Boyd, a Republican who is sponsoring a bill to require newly hired state employees to join a cash balance plan. "But if you had asked me a year ago whether we would have cut the state budget by $1 billion [in fiscal 2012], I would have said that was a heavy lift, too. It's a new day out there."
Cash balance plans, which are more prevalent in the private sector, are a compromise between defined benefit and 401(k)-style plans. Under the typical defined benefit pension system, the state government and employees contribute to the plan at a fixed percentage set by the legislature. The retirement system manages the investments and assumes the risks. Upon retiring, employees receive guaranteed monthly checks for life based on a specific formula based on final average salary, number of years worked and age.
In a 401(k)-style plan, also known as a "defined contribution" plan, an employee contributes a percentage of his salary to an individual account and chooses where to put the money from a menu of investment options. The state government also contributes to the account, but when an employee retires, he receives only what has accumulated; once the money is spent, it is gone. The system rewards those who have made the wisest decisions about their investments at the right time, and those who put in the full amount allowed.
A hybrid plan
Nebraska's cash balance plan borrows from both approaches. Workers and the state both are required to contribute to individual accounts, which retiring employees have the option of choosing as an annuity, lump sum, rollover or a combination of those. The state retirement agency manages the investments and guarantees a minimum annual rate of return. For employees, that eliminates the risk of making ill-advised choices — or that a market downturn could wipe out their retirement savings.
In Nebraska's case, the state chips in $1.56 for every dollar workers contribute to their accounts. The state promises that each account will earn at least 5 percent a year, which is called the interest credit rate . When investment returns are strong, and the plan meets minimum funding requirements, the state retirement board may pay an annual dividend to the employees in the plan — although the dividend and interest credit rate cannot exceed 8 percent. Nebraska does not finance automatic cost-of-living increases but employees have the option of paying for those out of their retirement accounts.
Advocates say the cash balance system offers several advantages for state workers. One is that it is a better fit for today's young employees, who are more likely than past workers to change jobs and want to take their vested retirement accounts with them. Another is the guarantee of a no-worries fixed rate of return and the possibility of a dividend in good years. Finally, the state manages the investments in the plan, lifting that burden from employees who generally lack the knowledge and discipline to direct their money.
There are upsides for state government, too. Because pension payouts are not determined by formulas, gone is the possibility of employees "spiking" their final salaries through overtime, sick leave, promotions and eleventh-hour raises. In addition, because the cash balance benefits are predictable from year to year, lawmakers are not tempted to promise workers future benefit increases in lieu of pay raises — a favorite political tactic that can help solve an immediate budget crisis but adds to the retirement system's long-term liabilities.
Advocates of cash balance plans say that taxpayers also benefit from the increased transparency in their state's public pension plan. There are no surprises in a cash balance system; taxpayers know exactly what the state is contributing each year to workers' retirement accounts. And the relatively modest interest credit rate could deflect criticism that public sector employees receive overly generous retirement benefits. In fact, Pennsylvania's cash-balance plan legislation, if enacted, would set the interest credit rate even lower than Nebraska, at 4 percent. For states with traditional defined benefit plans, switching to a Nebraska-style plan could save a good deal of money. Maryland officials estimate that changing to a cash balance system could slash state pension contributions by nearly $1 billion a year by 2013. The Democrat-controlled legislature rejected that proposal, opting instead for higher contributions from current and future state workers. Lawmakers said that alternative was adequate to strengthen the retirement fund.
Delegate Andrew Serafini disagrees. "My fear is what they settled for was a minor change," says Serafini, the Republican who sponsored the cash-balance plan bill. "We're going to have to change the structure. Private industry can't afford to run these defined benefit plans. What do we know that they don't?"
Enough to retire on?
Nebraska officials cannot point to a dollar amount they have saved since the cash balance plan went into effect eight years ago. But that is because they were switching from a 401(k)-style defined contribution plan, whose costs already were lower than a defined benefit plan, to the hybrid system. Still, there is no question Nebraska has kept its retirement costs lower than most states by not paying for retiree health care and having the cash balance plan. The state's public pension plan historically has been among the best funded in the country, though it suffered substantial losses along with every other state when the market nosedived in 2008 and 2009.
The acceptance of cash balance plans may turn on whether states believe the hybrid system provides an adequate retirement income. When Nebraska made the change, it was not to cut costs. The legislature was more concerned that state and county employees, who belonged to the 401(k)-style plan, would have less money in retirement than schoolteachers, who were part of a traditional fixed benefit plan along with judges and state police.
Julie Dake Abel, executive director of the 10,500-member Nebraska Association of Public Employees union, says the cash balance system and lack of a retiree health care plan puts Nebraska workers at a disadvantage compared to states with traditional fixed plans. State employees are working longer or retiring from the state and getting another job because their pension accounts are inadequate, she says. "While having the cash balance option is good, it still doesn't return enough to give people a sufficient retirement," Abel says.
A commission studying Maryland's public pension system found that while the cash balance system deserves consideration, a state worker earning $40,000 a year and saving the maximum allowed would run out of money 13 years after retiring. "Cash balance plans save money for the state but at the expense of the employee," says Sue Esty, assistant director of the Maryland chapter of the American Federation of State, County and Municipal Employees.
Some cash balance advocates say state workers may have little choice in the future because 401(k)-style plans offer even less in the way of retirement security. "401(k)s do not work," says Mark Paul, senior scholar and deputy director of the California program at the New America Foundation . "They leave public workers with all the investment risks. Managing the money is too hard. The cash balance plan has the best characteristics of both alternatives."