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.