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STANFORD GRADUATE SCHOOL OF BUSINESS — For most private sector workers in the United States today, very little is guaranteed in old age. Beyond Social Security, retirement income depends largely on how well workers do in accumulating and managing their own retirement savings through 401(k)-style plans. By contrast, employees of state and local governments are far more likely to be covered by defined benefit plans that guarantee a fixed-pension income, regardless of the workers’ actions.

This dichotomy has helped fuel an outcry as state and local governments face mounting pension obligations. Public retirement systems nationwide have at least $3.5 trillion in pension liabilities, of which 23% is unfunded, sparking calls for public pension reforms.

Change is already underway. Like the private sector did years ago, the public sector has started to embrace self-directed defined contribution plans, according to a recent research paper. The trend will likely accelerate as financially beleaguered state and local governments come under more pressure to rein in their pension costs, says the paper’s coauthor John Beshears, assistant professor of finance at the Stanford Graduate School of Business.

“We’ll see the public sector move from the defined benefit model to the defined contribution model,” says Beshears. “Responsibility for retirement security is being shifted to public sector workers. This will leave them facing greater uncertainty over retirement income security.”

The researchers documented the types of plans offered by state, county, and local governments. They looked at the different savings outcomes that can occur with defined benefit plans, defined contribution plans, and hybrid ones. Defined benefit and hybrid plans often give participants a pension equal to at least 70-75% of working salary, an amount generally considered adequate for retirement. Yet, the researchers warned that this pattern does not necessarily imply that public sector compensation is more generous than private sector compensation. Instead, it may be that public employees tend to receive lower pay while in the workforce and more income in retirement, compared with their counterparts in the private sector.

The paper, “Behavioral Economics Perspectives on Public Sector Pension Plans,” appeared in the April issue of the Journal of Pension Economics and Finance and was co-written with James J. Choi of Yale, and David Laibson and Brigitte C. Madrian, both of Harvard.

The traditional pension, or defined benefit plan, guarantees a fixed retirement income based on a formula that typically considers the employee’s final pay rate and years of service. The employer decides how much to set aside and where to invest the money, bearing the investment risks. In a defined contribution plan, such as a 401(k), the employee shoulders the responsibility and risk, deciding how much to contribute, where to invest, and how much to draw once retired.

There are more than 2,500 public pension systems nationwide. While 401(k)-style plans long ago overtook fixed pensions in the private sector, traditional pensions still dominate at all levels of state and local government. But 11 states, including Alaska, Michigan, Colorado, Florida, and Ohio, plus Washington D.C., now have primary retirement plans that include some defined contribution component, according to the researchers.

Public pension funds have come under intense new scrutiny. State and local governments face budget crises and mounting concerns about paying for future obligations to retirees. What’s more, “pension envy” has emerged toward public workers perceived to enjoy more generous and stable retirement prospects than many private sector workers. There are frequent media reports about public employees retiring with fat retirement packages or abusing the pension system. Politicians have campaigned on taming public pension costs and stamping out abuses.

The research paper described retirement prospects for a hypothetical “Joe the Bachelor,” a public sector worker who is single. The researchers looked at how much of Joe’s pre-retirement income would be replaced under different scenarios, such as a varying numbers of years in the public sector. This key “income replacement ratio” measures how well someone can maintain their lifestyle once retired. To get the ratio, they compared Joe’s after-tax retirement income, including Social Security, in his first year of retirement to his after-tax salary in the final work year minus his mandatory retirement contributions that year.

With a fixed public-sector pension, Joe received more income replacement than a typical single individual would get retiring from the private sector with an employer-sponsored retirement plan. If Joe finished with a salary of $50,000 a year and was in a plan with at least some defined benefit component, his income replacement was close to or greater than the 70-75% income replacement rate most experts consider sufficient in retirement.

Beshears was surprised to find that even within the universe of public sector defined benefit plans, there is significant variation in savings outcomes. Joe, after working for 35 years in the public sector, would have 79% of his income replaced in Maine, compared with 150% in Pennsylvania. “This notion that public pensions are monolithic is not the case,” says Beshears.

However, high-income replacement for public retirees does not necessarily mean that the public pay package is more generous than the private one, Beshears warns. There is a “tradeoff” between current pay and retirement income, he says. It appears that public compensation is more “backloaded” than in the private sector — in other words, public employees are paid less while working but relatively more once retired. “What we’re really finding is that the mix is different. We should think about compensation packages in a holistic way,” Beshears says.

Previous research by Beshears and others suggests that many people are not well-equipped to take charge of their retirement savings. They may lack financial literacy or make mistakes such as procrastinating, chasing after past returns, or giving too little weight to relevant information such as fund management fees. They also are heavily influenced by a plan’s default settings, such as automatic enrollment and contribution levels. “People are willing to let automatic pilot take over,” comments Beshears.

As the public sector moves toward self-directed retirement savings, individual behavior and choices will matter more than with fixed pensions. Government employers will be challenged to get plan features and default settings right in order to offset participants’ mistakes and biases. “If you shift to a defined contribution structure, you’re still providing an opportunity [to save for retirement]. But there’s no guarantee employees will take advantage of it. It underscores the importance of how defined contribution plans are designed,” says Beshears.

— Maria Shao

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