The Unintended Consequences of Benefit-Tier-Related Pension Reforms
By: Jonathan Scarpa, Segal
A decade or more after common pension reforms that created lower-cost, less generous benefit tiers for public employees, there is increasing pressure to reverse those changes. This article explores the unintended consequences of those reforms on employee behavior, morale, and the broader impact to help understand why this trend is occurring now.
This is an excerpt from NCPERS Summer 2024 issue of PERSist.
In the wake of the global financial crisis of 2008 and 2009, many public pension plans adopted reforms intended to address rising pension costs and improve funded levels. One common approach was to create less valuable, lower-cost benefit tiers for new hires. Often, these new benefit tiers included some combination of adjusting retirement ages, the period of compensation in which a benefit is determined, and the benefit multiplier (the percent of salary replaced for each year of service).
Applicable for new hires, these changes alone did not reduce a plan's then-current unfunded liability. Rather, cost savings were expected to be realized over the long term as members of the new benefit tier gradually phased into the active population.
Backpedaling on reform
Fast-forward fifteen years and we have seen increasing pressure to reverse the benefit reforms. Some plans have already done so, while others are proposing legislation or at least considering it.
At the time of enactment, it was clear these changes would reduce member benefits. What may not have been as clear was the influence the changes would have on employee behavior and morale as well as the resulting broader impact.
The most critical point to remember is the historical value public employees place on retirement benefits. Those benefits are an essential component of their working career. And the importance of defined benefit plans is not limited to employees. For employers, the plans and their individual provisions represent valuable attraction, retention, and workforce-management tools.
Multiple layers of impact from reform
On the surface, descriptions of benefit tier reductions do not always capture the true impact on members. Digging deeper to quantify the impact helps to illustrate why these changes can influence employee behavior in unexpected ways.
Consider a sample plan that increased the final average compensation period from three to five years and decreased the benefit multiplier from 1.75% to 1.50% per year of service. For a member of the new tier entering the plan at age 30 and retiring at age 65, the percentage of salary replaced at retirement decreases from 59% to 50%.
However, this example does not consider a potential elimination in benefit subsidies prior to normal retirement age. Changes like this were common and can exaggerate the difference highlighted above. To illustrate this, consider the same plan that also added a modest 3% reduction in benefits per year of retirement below age 65 for the new benefit tier. In this scenario, the same member retiring at age 60 would have a decrease in the percent of salary replaced at retirement from 51% to 36%.
Understanding the full picture
These examples highlight the material loss in benefits for a career public employee. If a public employee were to remain in the system, they must supplement their retirement income with personal savings to close the gap, delay retirement, or do both. Considering the value public employees place on retirement benefits, this situation can create a negative impact on morale. This drop in morale is a partial motivation for the push from public employee organizations to reverse the reforms implemented years ago. The timing of this trend, a decade or more after reforms, is relevant because members in the newer, less generous tiers represent an increasingly larger percentage of the working population.
Alternatively, members may be incentivized to leave the plan for either a similar public job that provides a more attractive benefit or the private sector. Numerous recent studies have shown increased member turnover among plans that have implemented significant benefit reductions, highlighting a direct link between benefit levels and employee behavior.
There are several outcomes of high attrition felt by the employer, the public, or both. When a member leaves employment, an employer must allocate resources to hire and train new employees. Attracting new employees may prove to be difficult given the less-attractive benefit levels. Higher attrition also results in a less-experienced workforce and may contribute to a loss in the quality of public services. This may be especially true in industries where a significant amount of expertise is required, like public safety employees and teachers.
Finding the balance
The balance between benefit levels and the cost of funding them is delicate. The reforms adopted over a decade ago were intended to manage the cost of public pensions. However, in retrospect, the unintended consequences of benefit-tier-related changes on employee behavior, morale and the public plan environment require understanding and consideration.
Bio: Jonathan Scarpa, FSA, MAAA, EA is a Vice President and Consulting Actuary in Segal's New York Office, where he works with statewide and local public retirement systems. His responsibilities include presenting to boards of trustees and other audiences, reviewing actuarial valuations, conducting experience studies and managing special projects for public sector retirement systems. Examples of special projects include analyzing benefit design changes, evaluating legislative proposals and helping clients navigate complex funding and solvency issues. Mr. Scarpa is a member of Segal's New York Region Experience Study Committee and Segal's Public Plan Report Committee that ensures valuation reports meet client needs and adhere to actuarial standards.