Thoughts on McDonnell’s VRS ProposalPolicy

By Melissa Kenney

Governor McDonnell is committed to meet the challenges of the underfunded VRS system, but his approach doesn’t go far enough for true reform. Ultimately the defined-benefit plan should aim to be phased out and replaced by a defined-contribution plan.

Indeed, the burden of paying retirement benefits affects more than just budget numbers. The defined-benefit system, which is the method currently used in Virginia, guarantees an income stream to beneficiaries in retirement, whether or not its assets and performance can shoulder those costs. These plans are pre-funded by monies set aside for the worker and then invested. Such a system inherently puts the taxpayer at risk, because it shifts the investment risk from employee to employer (the state); inevitably the taxpayer will be liable for any shortfalls when the plan doesn’t hold enough assets to cover payouts. This is called being “underfunded” – our current situation – and it presents a long-term challenge to state policymakers.

An additional serious downside to the defined-benefit plan is that most of the general public is unaware of their obligation to cover state benefits. This allows both the means and the motive for abuse by lawmakers and politicians who promise generous benefits without necessarily having the ability to fund those promises.

Thanks to boom years and good investments in Virginia, we have achieved decent rates and funding – much, much better than some states such as California, New York, and Illinois. However, due to the very nature of the defined benefit-plan, one can never know how well or poor the investments will perform in a given year or set of years; such volatility becomes a liability in down times as we have seen here.

The best thing to do when facing shortfall then, is to take an internal review and work on reform, as Governor McDonnell has done. He rightfully recognizes that the cost saving from only focusing on new hires is modest, and that it is necessary to include current workers in his reform proposals.

The COLA reforms will achieve minor gains. McDonnell also proposes upping the employee contributions from 5-6%, coupled with a 5% pay raise to offset the contribution. But at the end of the day, it comes out to be a 1% pay cut to cover the cost of something that is considered “free”.

The biggest missed opportunity, however, is the “optional hybrid” for current employees and new hires. He leaves open the defined-benefit plan as the default, rather than making it the exception and nudging the system into a more fiscally sound, alternative plan. And the hybrid is not a true defined-contribution plan that would help ease the obligations due to come.
I would offer to Governor McDonnell the need for deeper, more meaningful reform: instead of a hybrid option, offer to current and future employees a defined-contribution plan more in the style of a 401k.

In government, an employee works under a contract that exists for a specific time period. Their obligation is to provide their services in return for certain compensation and benefits during that time. But that’s it — they are only covered for the period of the current contract. However, unless a new contract specifically continues that same program into that next contract, the employee should not be entitled to any additional accruals. Most importantly, once a contract ends there is nothing on the table. There is nothing to prevent any new contract from offering less that the prior contract, especially where pay and benefits of the prior contract might have been overgenerous.

Therefore, drawing a clear distinction between benefits that have already been rightfully earned (under past and current contracts) and future benefits (to be paid under future contracts) we have the opportunity to focus on what exactly we offer as a pension method in the future — and can smoothly introduce a different pension system to all renewing and newly offered contracts starting after a certain date. This protects all –retiree, worker, and taxpayer– and help create a better, more sensible and sustainable retirement system.

Moving toward a defined-contribution plan for all employees should be a long-term goal. Most private sectors have abandoned the defined-benefit model for the better defined-contribution system. This approach puts the investment risk and investment rewards in the hands of the individual. Merely fiddling around, as Governor McDonnell has proposed, only addresses the high pension costs and the current deficit, but does not adequately address the fact that taxpayers are still at risk in the future because the volatile defined-benefit model is still in place.

Furthermore, because of the Great Recession and its effect on the VRS, if Virginia does not embrace this time and opportunity to rid herself of the unending and astronomical pension obligations inherent in the defined-benefit plan, she is unlikely to do so in the future. Once we enter a boom period again, the sting become lessened as the money flows more freely – until another downturn.

The challenges are not insurmountable, but the timing is urgent. By focusing pension reform foremost on benefits not yet earned, and employees not yet hired, we do not those harm those who have served and are serving our Commonwealth faithfully. Rather, we are adapting to the situation at hand, protecting our citizens, and planning better for the future of Virginia.

  • William Bailey

    I would like to comment on your VRS views without being too negative or critical. I think you are being unfair to Gov. McD.

    I do not believe you have read or fully understand the General Assembly’s JLARC report that was released on 12 December 2011. In that taxpayer funded and GA mandated report, it makes things clear that current prior to 1 July 2010 employees have an “implied contract” with their employers that prevents major changes in the VRS funding. It also factually states that drastic changes such as a defined contribution plan to VRS may increase the cost to the taxpayers by up to nearly a BILLION dollars! That is why I see Governor McDonnell making changes in the manner in which he has proposed and you have criticized.

    Frankly if he try’s to change the entire system: 1) Virginia gets sued by the employees which the state is likely to lose costing taxpayers millions, 2) the drastic changes you propose according to JLARC are likely to cost the taxpayers tens of millions up to a billion more AND 3) what “conservative fiscally responsible republican” wants to explain or be held responsible for un-necessary spending to make those changes? R or D nobody wants to waste taxpayer dollars making changes to VRS that end up costing millions more…

    Additionally the JLARC report finds that going to a “defined contribution” benefit program undermines funding of the current Defined benefits system raising the actuarial costs that must be funded by the state and localities decades from today. If you have employees putting money in a defined contribution plan, the money belongs to the employee and doesn’t fund the necessary contribution to the defined benefit plan which therefore increased the actuarial rate passed on to the locality to sustain the DB plan until the last retiree dies. In a nutshell, you have duel retirement plans and not enough money to fund either one. That is a formula for disaster. IMO: Gov. McD is doing the best he can within the law and being fiscally responsible in the process.

    Additionally, we are taking about a retirement fund with 54+ billion dollars in it that has only been fully funded at the VRS (Governor appointed board) managers recommended levels four out of the past twenty two years. That is the problem… The State of Virginia failed to fund its own established rules and retirement system!

    Looking at the big picture, funding the VRS properly for the past twenty years would have prevented the current “self inflicted crisis.” Now we have a crisis when in reality, this could have been avoided.

  • Nathan Miller

    William,

    I can’t agree with you more. The problem isn’t with VRS, it is with the General Assembly who decided not fund it properly for so many years.

    As you said, this crisis could have easily been avoided.

  • Mike Barrett

    William may be correct to point out that past Governor’s and members of the General Assembly failed in their duty to contribute to VRS; ok, got that. Now what do we do? Fact is, the fund will not be sufficient even if no defined contribution plan is offered. This is about long term sustainability, and if we don’t learn from the past, we will repeat it. The number of private corporations that have been destroyed under the weight of unfunded retiree obligations need not be enumerated here; the point is, even those who support employees must realize that continuation of the same policies will lead to disaster.

    If we stay on the same VRS path, more and more city/counties will turn to contract labor instead of employees; contract labor who will work for less pay and less benefits. Already, a taxpayer group here at the Beach has called for all city and school board blue collar employees to be replaced by contractors. It behooves representatives of employees to work for a solution or they will be swept aside by taxpayer groups who will advocate for another way of accomplishing the same objective.

  • William Bailey

    Mike: I believe you are making a mountain out of a mole hill as the current defined benefit VRS account is funded to survive for decades at its present level. Read the JLARC report. It isn’t going to run out of funds to pay retirements for a very long time even at the current “crisis” level.

    If the VRS actuarial rate is fully funded by the state and localities, the unfunded liability/deficit will come down before we reach an unsustainable position. The state and localities employees are not private corporation workers and are not permitted to make huge annual salaries as is common outside of government. The state and local city/schools employees are being used as pawns in this financial game…

    Frankly this “got to switch the retirement from DB to DC scam” has been concocted to reduce the cost to localities so those funds can be used on other construction projects that are being eyed by developers and business associations.

    While I might support VRS changes once the state and localities pay back what hasn’t been funded into VRS for the past two decades, I do not see that as an option. At worse, the localities costs should never be passed onto the employee work force to reduce the localities VRS costs. If VRS is in a crisis, then the localities cost should be the actuarial rate plus what the state employees and local employees hired after 1 July 2010 are contributing.

    Crying “unsustainable” while cutting the cost paid to VRS by the localities or creating a defined contribution plan both undermines the funds into VRS and is counter productive to the “unsustainable” argument. Can’t make it sustainable if you do not pay your bill…

    The solution is simple: The state and localities must pay the required VRS actuarial rate. The bill is due and you can’t pass it off to the workers to pay. Changing the system to a defined benefit system simply increases the VRS necessary funding actuarial rate and will cost the taxpayers tens of millions more in the long-term. Even Gov. McD understands that point and that is why his proposals reflect the need to increase funding to VRS and make minor technical changes that save dollars.

    I’m sure it isn’t what the “pass VRS costs onto the employees back“ crowd wanted to hear, but that is exactly what the General assembly JLARC report found and concluded.

  • Jamie Jacoby

    The defined-benefit retirement plan is a dodo bird.

    “one can never know how well or poor the investments will perform in a given year or set of years; such volatility becomes a liability in down times as we have seen here.”

    One can be assured that the projected 8-10% historic annual rates of return will not be achieved, and that any projections based on them are doomed to disappoint, unless one does not inflation-adjust them and the Bernank starts printing like a madman.

    All one really need to understand is that middle class, middle aged people are largely doomed to never “retire.” Eleven years ago, the S&P 500 was higher than it is today. If one factors in even the government’s ridiculously understated inflation numbers, in ten years anyone “invested” in the broad stock market has LOST more than 40% since 2001. The 401(k)s / IRAs / Nest Eggs / retirement savings of the middle class are gone. You are eleven years older and have lost ground; do you understand?

    If one looks at a long term S&P chart and then understands that the thirty years of recent “growth” has been entirely debt-fueled, that the debt bubble is now over, and the marginal utility of debt is now negative (or nearly so), then one understands that the party is over. I’d be happy to prove those points to anyone who wishes to dispute them. I already get grief on these pages for my long posts, but say the word and I’ll be happy to prove it as long as someone will read it and discuss it with me.

    So where is one to get 8% annual returns? Recent articles in RTD cherry-picked dates and said “wow, look at those returns on VRS!” That is child’s play and too easy to refute.

    Charles Hugh Smith: Habituating to Contraction

    http://www.oftwominds.com/blogjan12/habituation-contraction01-12.html

    “If we scrape away the rhetoric and bogus statistics, at heart the current fantasy that the U.S. has “decoupled” from the global economy and will remain an island of “permanent prosperity” in a sea of recession boils down to this belief: the Federal government “won’t let us stay in recession.” In other words, it’s within the power of the Central State to make good every loss, guarantee every debt, maintain the Empire, solve every geopolitical challenge and find technological or military solutions to potential energy shortages. All we need is the “will” to force the government to use its essentially unlimited power to “fix everything.”

    A people conditioned to this expectation will have great difficulty accepting that their government has already done everything possible, and that these stupendous debt-based expenditures are simply not sustainable going forward. Some problems are not fixable by more government intervention;”

    If you believe that the taxpayers will sit idly by, losing their lifestyles and retirements while government employees get taxes raised to fund their own retirements, in the face of ever-increasing underfunding, I have a bridge I want to sell you.

    30-somethings: please wake up. Please.

  • William Bailey

    Interesting comment. It might be a dodo bird but it isn’t going to be extinct for at least the next 40-60+ years. I hope most readers realize the young employees who are hired today are going to be working until they are 65 years old or longer. And then maybe they live to be age 70+. Example: a twenty year old gets hired today (2012) in Richmond and he teaches school until his regular retirement at age 65 (2057) then draws his VRS defined benefit until he dies at 70(2062). What to do if the worker lives to be 90 (2082)? As you can see, there is no quick fix to the defined benefit unfunded liability issue except to fully fund the state’s VRS actuarial set rate. The defined benefits retirement that is in place today will still need to be fully funded for decades to come

    The defined benefits system we are discussing is going to around for a very long time even in its current state. No amount off “crisis management” is going to stop the employees who are already in the system from finishing out their local city/school/state career before claiming their earned benefits. Unsustainable, sustainable or not, this defined benefit bird isn’t going anywhere. You can make changes for future employees but those changes will not remove the liability that the state and locality’s have to face when it comes to VRS and defined benefits.

    For a retirement plan that needs to be replaced, most of us will not be alive when the projected unfunded crisis occurs… And the state and locality’s still need to fully fund the VRS retirement they offered their employees when they recruited and hired them to take the job.