This article originally ran on June 2, 2014.
By Michael A. Webb, TGPC, AIF™, CEBS
Editor’s Note: We have been aware of the many changes taking place in a number of states which may substantially reduce the pension benefit for participants. This creates considerable opportunity in using voluntary plans to fill the gap. This article examines those changes on a state by state basis, which NTSA members can use as a first step in understanding the state pension system in each specific state. Our thanks to Mike Webb for his extensive coverage of this issue.
Hardly a day goes by when the pension troubles of one state or another are financial-page, or even front-page, news. Only slightly less frequent are announcements from individual states of planned reductions to pension benefits, such as elimination of cost-of-living increases for retirees, or increases in employee contributions in order to close large funding gaps in their traditional defined benefit plans.
However, a number of states have taken it a step further, moving away from a traditional pension arrangement to a hybrid plan, such as cash balance, a combined DC/DB arrangement, or even moving to a DC plan entirely for certain employees. In addition, some states have actually utilized nontraditional programs for several years, providing models to other states where such strategies are newly implemented.
This article attempts to provide a state-by-state review of nontraditional alternatives to a DB plan. One word of caution: this is an area of constant change as states continue to deal with their pension deficits, new officials are elected, etc. Thus, it is possible this article may be out of date in a few areas as soon as you are reading it! In addition, though I have made every effort to provide an accurate assessment of nontraditional state pension provisions, since the author is not local to each state it is possible that someone with more local knowledge may be aware of additional facts that I have missed. Thus, I would welcome any reader input that would enhance this effort to provide current and accurate information in all states.
As of this writing, there are 21 states, plus the District of Columbia, that currently sponsor, or plan to sponsor, alternatives to a traditional DB model, as follows:
Practice Pointer: Advisors who work with employees who participate in state retirement systems can likely add value to these relationships by keeping constantly updated as to state pension reform in the states in which they do business.
States that Currently Maintain DC Arrangements
Alaska — all employees hired after June 30, 2006 participate in a DC plan (employees hired before that date participate in a DB plan). It is a 401(a) plan with a mandatory 8 percent employee contribution and a 5 percent employer contribution (7 percent for teachers). Since it is a 401(a) plan, elective deferrals are not permitted in this plan, though there is a separate 457(b) plan available for such contributions. The DC plans are administered by a single third-party provider; the state self-administers the DB plan for pre- July 1, 2006 hires.
Colorado — all employees hired after Jan. 1, 2006 may choose between the state’s DC and DB plans (before 2006, there was only a DC option for elected officials that was implemented in 1998). If employees fail to choose a plan, they are defaulted into the DB plan, though they may switch from the DB to DC plan (and vice versa) up until the end of the 5th year of participation. The DC plan is a 401(a) plan with a mandatory 8 percent employee contribution (state troopers and bureau of investigation agents must contribute 10 percent). Employer contributions range from 10 percent-13.6 percent. Again, elective deferrals are not permitted to the 401(a) plan, but there is both a 401(k) and 457(b) plan available for such deferrals. However, not all employees are eligible for the 457(b) plan. A single third-party provider administers all of the DC plans; the state self-administers the DB plan.
District of Columbia — The District was one of the first jurisdictions (Washington, D.C. is not a state, but is a distinct jurisdiction) to convert to a DC plan as the primary pension plan for its employees as all employees (excluding police officers, firefighters, teachers, and civil service employees) hired on or after Sept. 30, 1987 were enrolled in the a DC plan. The DC plan is a 401(a) plan with a 5 percent employer contribution (5.5 percent for detention officers); unlike most public DC plans, there is no required employee contribution. There is only a 457(b) plan available for elective deferrals. There is a single third-party provider for both DC plans.
Florida — employees hired on or after Jan. 1, 2002 or later can choose between the state’s DC and DB plans (there was a third hybrid option introduced along with the DC plan in 2000, but that is now only available in limited circumstances). If employees fail to choose a plan, they are defaulted into the DB plan, though they may switch from the DB to DC plan (and vice versa) at any time. It is a 401(a) plan with a 3 percent mandatory employee contribution and employer contributions that range from 3.3 percent-11 percent. Again, there are no elective deferrals in the 401(a) plan, though there is a 457(b) plan available for such deferrals. A single third-party provider administers the 401(a) plan, while there are six different providers for the 457(b) plan; the state self-administers the DB plan.
Indiana — an anomalous state in that they have had a combination DB/DC plan since 1955(!), but recently new hires (as of March 13, 2013) were permitted to join a DC plan only. If a new hire fails to make an election within 60 days of employment, he/she is defaulted into the hybrid DB/DC plan. In addition, existing hybrid plan participants may NOT switch to the DC plan. The DC plan is a 401(a) with a 3 percent mandatory employee contribution (note that employers can choose to contribute some or all of this 3 percent amount on behalf of the employee) and a discretionary employer contribution (4.7 percent in 2014). Also, unlike 401(a) plans in other states, the plan allows for "pick-up" voluntary pretax contributions of up to 10 percent pursuant to a one-time irrevocable election under 414(h). There is also a separate 457(b) plan for elective deferrals. Both DC plans are administered by a single third-party provider; the DB portion of the combination plan is self-administered.
Michigan — this state’s primary plan has been a DC plan for some time, as the DB plan has been closed to new hires since March 31, 1997 (except for teachers, but they were switched to a hybrid plan in 2010, with an additional option of a DC plan for hires made on or after Sept. 4, 2012). In addition, existing DB plan participants could have switched to the DC plan in 1998, and in 2012 were required either to commence a 4 percent contribution to the DB plan or switch to the DC plan (as an aside, lower court ruling have stated that the 4 percent contribution is unconstitutional, but the case is still under appeal, and the 4 percent continues to be deducted). Those who did not make an election were automatically converted to the DC plan. At present, DB plan participants may NOT switch to the DC plan. Unusually, the DC plan is a 401(k) plan rather than a 401(a) plan, with a 4 percent base contribution and a dollar-for-dollar match up to 3 percent (total employer contribution of 7 percent). Employees are automatically enrolled in the 401(k) at a 3 percent deferral level. Additional elective deferrals may be made either into the 401(k) or a 457(b) plan. The DC plans are administered by a single third-party provider; the old DB plan is self-administered. (Ed. Note: While governmental employers are NOT eligible to establish new 401(k) plans, such plans established before May of 1986 are grandfathered — that is, can be continued.)
Montana — Since 2002, all employees (except teachers, who are covered under their own retirement system) have had the option to elect a DB or a DC plan. If an employee does not choose a plan within 12 months, he/she is defaulted into the DB plan. The DC plan is a 401(a) plan, with a required 7.9 percent employee contribution, and a 4.19 percent employer contribution. Again, elective deferrals may not be made to the 401(a), but there is a 457(b) plan available for such deferrals. Both DC plans are administered by a single third-party provider; the DB plan is self-administered.
North Dakota — Employees hired on or after Oct. 1, 2013 (except teachers and highway patrol, who are covered under their own retirement systems) may elect a DB or a DC plan. If an employee does not choose a plan within six months, he/she is defaulted into the DB plan. The DC plan is a 401(a) plan, with a required 7 percent employee contribution (state employers have the option to “pick-up” these contributions under Code Section 414(h); see Indiana description, above), and a 7.12 percent employer contribution. Additional deferrals may be made to a 457(b) plan. The 401(a) plan is administered by a single third-party provider, while the 457(b) plan utilizes 8 vendors. The DB plan is self-administered.
Ohio — Since 2002, new Ohio employees have had the option to choose between three plans: a DB plan, a DC plan, or a combination plan where employer contributions go into the DB plan while employee monies go into the DC plan. If an employee does not choose a plan within 6 months, he/she is defaulted to the DB plan. Employees can change from one plan to another, with certain restrictions (see links below). There is a required 10 percent employee contribution (11 percent for teachers, 13 percent for law enforcement) and a 14 percent employer contribution (9.5 percent for teachers, 18.1 percent for law enforcement and public safety employees) for all three plans. The DC plan is a 401(a) plan which cannot accommodate elective deferrals, but there is a 457(b) plan available for such deferrals. All plans are self-administered except for the DC components of the teachers’ plan, which are administered by a single third-party provider.
South Carolina — Certain segments of the state workforce have been able to choose between a DB and a DC plan since 1987. Currently, all employees except local government employees can choose between the two options (local government employees have a DB option only). If an employee does not choose a plan within 30 days, he/she is defaulted to the DB plan. Employees can change from the DC plan to the DB plan during the first five years of employment, but not from the DB plan to the DC plan. The DC plan is a 401(a) plan, with a required 7.5 percent employee contribution (increasing to 8 percent on July 1, 2014), and a 5 percent employer contribution. The state also offers 457(b) and 401(k) plans for elective deferrals, since the 401(a) cannot accommodate such deferrals. There is a single third-party provider for the 401(k)/457(b), while there are four providers for the 401(a) plan. The DB plan is self-administered.
Utah — All employees hired on or after July 1, 2011 may choose between a DC plan and a combination DB and DC plan (in the latter, employer contributions are split between the two plans). Before that date, there was only a traditional DB pension plan. If an employee does not choose a plan within one year, he/she is defaulted to the hybrid plan. Employees CANNOT change from one plan to another. The DC plan is a 401(k) plan, with no required employee contribution, and a 10 percent employer contribution (12 percent for police and fire). Additional elective deferrals may be made to the DC plan, as well as 457(b) plan, and an IRA option. All of the plans are self-administered.
Note that, in addition to the above states, West Virginia maintained a DC plan between 1991 and 2005, but returned to a traditional DB in 2005.
States That Currently Maintain Combined DB/DC Arrangements Only
(Ed Note: Indiana, Ohio, and Utah are NOT included here, as they have standalone DC plan options as well and are thus listed above.)
Georgia — As of July 1, 2009, the state converted from a traditional DB plan to a combination DB/DC plan (except for teachers, who are covered under their own retirement system). Those hired on or after July 1, 2009 were enrolled in the hybrid plan, with those employed before that date being given the option to convert to the hybrid plan or remain with the traditional DB plan. Employees must contribute 1.25 percent to the DB plan. The DC plan is a 401(k) with no required contribution; there is a match of 3 percent of the first 5 percent of elective deferrals. Though there is no required contribution to the DC plan, new hires are automatically enrolled at an elective deferral level of 1 percent (5 percent for employees hired after July 1, 2014. Additional elective deferrals may be made to the 401(k) or to a 457(b) plan. The DC plans are administered by a single provider; the DB plan is self-administered.
Oregon — Beginning Jan. 1, 2004, all employees transitioned from a traditional DB plan to a combination DB and DC plan where employer contributions go into the DB plan while employee monies go into the DC plan. The DC plan is of an unknown type (likely a 401(a), but nothing on the website states the plan type explicitly) with a 6 percent mandatory employee contribution. Unusually, investments in the DC plan are directed by the state, as opposed to participant-directed. A 457(b) plan is provided for additional elective deferrals. Both the DC plan and 457(b) plan are administered by the same third-party provider; the DB plan is self-administered.
Virginia — this state introduced a combination DB/DC plan for those hired 1/1/14 or later, where employer and employee contributions are split between the two plans. Existing traditional DB plan participants were permitted to opt into the new plan, but only until 4/30/14. The DB plan requires a 4 percent employee contribution. The DC plan is a 401(a) plan where a there is a 1 percent mandatory employee contribution as well as a 1 percent employer contribution. Employees may make additional elective deferrals of up to 4 percent and receive an additional 2.5 percent in employer matching contributions, for a total employer match of 3.5 percent (all matching contributions are directed to the 401(a)). A 457(b) plan is provided for the elective deferrals of up to 4 percent (since the 401(a) cannot accommodate such deferrals), as well as any additional elective deferrals. In an unusual arrangement, all plans are administered jointly by the state and a third-party provider.
Washington — Since 2000 (and, for teachers, since 1996) employees have been able to choose between a traditional DB plan and a combination DB/DC plan where employer contributions are allocated to the DB plan and employee contributions to the DC plan. Employees who do not make an election within 90 days are defaulted to the hybrid DB/DC plan. Certain employees have the ability to transfer from the DB to hybrid DB/DC plan once a year, but cannot transfer back to the DB plan. The DC plan is a 401(a) plan where a there is a minimum mandatory employee contribution of 5 percent, though employees can choose from among a menu of higher mandatory rates (up to 15 percent), some of which automatically escalate at certain ages. A 457(b) plan is provided for elective deferrals. The 401(a) plan is administered by a single third-party provider, while the 457(b) plan is administered by a different third-party provider. The DB plan is self-administered.
States That Currently Maintain Cash Balance or Similar Pension Plan Designs
Kentucky — New hires on or after Jan. 1, 2014 were enrolled in a cash balance plan (employees hired before that date continue participation in a traditional DB plan). Employees must contribute 5 percent to the plan (8 percent for police/fire), and the employer contribution is 4 percent (7.25 percent for police/fire). An additional 1 percent must be contributed by the employee to a health insurance fund for retiree medical benefits. The minimum interest credit is a 4 percent with additional interest credited at the rate of 75 percent of any excess average actual return above 4 percent over the previous five-year period. There are 401(k) and 457(b) plans for additional elective deferrals. The DC plans are both administered by a single third-party provider; the cash balance plan is self-administered.
Nebraska — This state took the unusual step of transitioning from a DC plan to a cash balance plan in 2003 (however, teachers and other public school employees, as well as judges and state police are covered in traditional defined benefit plans). New hires on or after Jan. 1, 2003 were enrolled in the cash balance plan, and DC plan employees have been provided with periodic opportunities since that time to transfer to the cash balance plan. Employees must contribute 4.8 percent to the plan, and the employer contribution is 7.5 percent. There is an interest credit based on the federal mid-term rate plus 1.5 percent. The minimum credit is 5 percent, which is the current rate since interest rates are so low. There is a 457(b) plan for additional elective deferrals. Unusually, a single third-party provider administers both the DC and the cash balance plan.
States That Currently Have Traditional DB Plans but Plan to Transition to an Alternate Model
Kansas —The state has enacted legislation to transition from a traditional DB to a cash balance plan for most of its employees hired Jan. 1, 2015 or later. There was a bill in the legislature to implement a DC plan instead of a cash balance plan for such hires and replace the cash balance plan legislation, but that bill did not make it out of committee.
Illinois —The state has enacted legislation that includes, among other major pension changes, an option for employees (capped at 5 percent of all pre Jan. 1, 2011 plan participants) to make an irrevocable election to switch from the existing DB plan to a new DC plan. The effective date for these changes was to have been June 1, 2014, but the implementation has been delayed by the courts as of this writing.
Rhode Island — Legislation was enacted to transition from all employees from the current traditional DB plan to a combination DB/DC plan, effective July 1, 2012, but litigation has repeatedly delayed implementation.
Tennessee — Legislation was enacted mandating that all employees hired on or after July 1, 2014 participate in a combination DB/DC plan. Existing employees, who participate in a traditional DB plan, are unaffected by this legislation.
The remaining 29 states currently sponsor a traditional DB plan and have not enacted any legislation to transition to an alternative model, though there are discussions in almost every state to reform these traditional pension plans in some manner to address funding shortfalls. These states are, as follows:
|| North Carolina
|| New Hampshire
|| New Jersey
|| West Virginia
| New York
|| South Dakota
* 2015 budget includes DC plan for new hires, but legislation has yet to be enacted
** Texas is composed of several retirement systems. Two systems — The Texas County & District Retirement System and the Texas Municipal Retirement System — offer cash balance plans for counties, municipalities, and some local agencies such as public utilities.
Note that some of these states do provide a nontraditional option for small segments of their population; for example, California offers a cash balance plan for part-time employees and adjunct faculty. Such plans are disregarded for purposes of this review.
In addition, public university system employees in most states have the option to choose a DC plan as well, often a 401(a) and/or 403(b) plan sponsored by the university. And, of course, school district employees often have a 403(b) plan as an elective deferral option, in addition to the state 401(k)/457(b) options described above.
The most direct effect of the migration from traditional defined benefit plans to alternative models in the state systems is on those employers and employees who participate in such systems and the advisors who work with such individual and entities. For employees with limited resources, the increased employee contributions of DC and other alternative plans will likely impact their ability to make elective deferrals to 403(b)/457(b) plans. On the flip side, many of these alternative plans are quite complex, and thus may create additional opportunities for the savvy advisor.