Final report: Joint Legislative Study Committee on Defined Contributions Option.

              FINAL REPORT
JOINT LEGISLATIVE STUDY
COMMITTEE ON DEFINED
CONTRIBUTIONS OPTION
DECEMBER 1998lJANUARY 1 999
L
Committee Report
Joint Legislative Study Committee on Defined Contribution Option
Introduction
During the second regular session of the 43rd Arizona Legislature, the issue of offering a
defined contribution retirement option to employees ofthe state and political subdivisions of the state
was raised and discussed. Various bills were introduced establishing such an option, but concern was
expressed over technical difficulties with the bills. The bills were later amended to establish a
legislative committee to study the defined contribution retirement option during the interim. The bills
were heard but did not pass. Noting the significance of the issue, the President of the Senate and the
Speaker of the House of Representatives appointed an ad- hoc committee to study the defined
contribution option.
Committee Charge
On May 28, 1998 the President of the Senate and Speaker of the House of Representatives
appointed the following members to the Joint Legislative Study Committee on Defined Contribution
Option:
Senator Scott Bundgaard, Co- Chair Representative Michael Gardner, Co- Chair
Senator George Cunningham Representative David Armstead
Senator Tom Patterson Representative Wes Marsh
The President and the Speaker charged the Committee with studying and making recommendations
regarding the statutory, administrative and procedural changes necessary to implement a defined
contribution retirement option for both state employees and employees of political subdivisions.
According to the appointment letter, the recommendations should address ail advantages and
disadvantages of a defined contribution retirement option for the state of Arizona, its political
subdivisions and members of the various state retirement programs. The Committee's report is due
by December 1, 1998 and the Committee is dissolved from and after December 3 1, 1998.
Committee Discussion
The Joint Legislative Study Committee on Defined Contribution Option met twice during the
interim. At the first meeting, the Committee took testimony from the Arizona State Retirement
System ( ASRS) Board and its actuary; the manager of the Public Safety Personnel Retirement System
( PSPRS), the Corrections Officers Retirement Plan ( CORP) and the Elected Officials Retirement Plan
( EORP); representatives from both Great West Benefits Corporation and Americans for Tax Reform;
and representatives of the Fraternal Order of Police ( FOP) and the Professional Firefighters
Association ( minutes attached).
The actuary for the ASRS presented a series of hypothetical defined contribution models and
discussed how each would impact the ASRS plan, the state and employees ( Executive Summary
attached). Members of the committee debated the various assumptions built into the models. The
representative from Great West presented material supportive of defined contribution ( DC) plans ( see
attached), although he cautioned that such plans are not right for all employees. Americans for Tax
Reform also spoke in favor of DC plans, reviewing previous testimony their representative made
before the Senate Finance Committee in the Spring. The plan administrator for PSPRS, CORP and
EORP commented on the issues of cost, portability and state liability as they relate to the smaller
retirement plans. Finally, the representatives of the FOP and Professional Firefighters Association
expressed concern over converting their retirement plans to DC plans. Committee members made
the observation that such conversions could be done in a way to ensure voluntary participation only.
At the second meeting, the Committee began by discussing proposed recommendations
( minutes attached). Members debated the merits of defined contribution and defined benefit ( DB)
systems, particularly as they relate to employee benefits. While some members argued that evidence
presented to the Committee at the previous meeting showed that DC sytems, relative to DB systems,
actually penalize high performing employees, other members maintained that this is not true. These
members claimed that all employees win under a DC system due to the portability function. They
hrther argued that if a DC plan is offered as an optional plan, employees win because they are given
a choice.
Members also debated the constitutionality of the Legislature adopting a DC plan, based upon
changes made to the state constitution by Proposition 100 during the November 1998 election.
( Attached is a memo prepared by Legislative Council addressing this issue and distributed at the
meeting.) Finally, the Committee voted on its recommendations, with the minority stating it would
submit a minority report ( attached).
Committee Action
The Joint Legislative Study Committee on Defined Contribution Option adopted the following
recommendations:
p 1 Require ASRS, CORP, PSPRS and EORP employers to offer an optional DC plan to
employees, effective July 1,2000. ( New and existing members will choose either enrollment
in the existing DB plans or the new DC plan.)
2 The new DC plan shall offer ancillary benefits similar to those offered by the existing defined
benefit plans, i. e., survivor and health benefits and long term care disability.
/ 3. Require the Department of Administration ( DOA) to administer the new DC plan through a
procurement contract with multiple administrators as determined by rule.
Require DOA to recommend to the Legislature employer and employee contribution rates.
j/ 5. Members of the new DC plan will be vested in the plan after one year.
J, 6. Require existing DB plans to transfer to the new DC plan the present value of " accounts" for
members switching to the new DC plan -- principal, interest and growth.
7. Require a complete fiscal analysis to be performed, evaluating both the impact of the
proposed DC plan on the existing DB systems and on the Department of Administration.
s ARIZONAS TATER ETIREMENTS YSTEM
3300 NORTH CENTRAL AVENUE P. O. BOX 33910- PHOENIX, ARIZONA 85067- 3910 LeRoy G~ lberison
PHONE ( 602) 240- 2000 TOLL FREE OUTSIDE METRO PHOENIX 1- 800- 621- 3778 D~ rector
7660 EAST BROADWAY BOULEVARD. SUITE I08 . TUCSON, ARIZONA 8571 0- 3776
PHONE ( 520) 628- 5 170
EXECUTIVE SUMMARY
Watson Wyatt Worldwide Presentation
Defined BenefiVDefined Contribution Projection Models
Introduction
The Arizona State Retirement System ( ASRS) Board asked the Plan actuary, Watson Wyatt
Worldwide ( Watson Wyatt), to study the impact of the potential implementation of a defined
contribution ( DC) plan as an option to the current ASRS defined benefit ( DB) plan. Watson Wyatt
developed computer models to project outcomes under various scenarios in accordance with generally
accepted actuarial principles and ASRS actuarial assumptions.
Methodology
Watson Wyatt modeled four scenarios to study the impact on the ASRS financial health, employer and
employee costs and employee benefits.
o Scenario 1 : Status Quo - no optional DC plan created;
o Scenario 2: Moderate option - DC plan contribution rate equal to DB rate up to 4 % of pay. plus
contributions to the long term disability and health insurance premium benefit plans;
o Scenario 3: Low option - 3.34 % of pay to a DC plan ( employer contribution includes
contributions to the long term disability and health insurance premium benefit plans;
Scenario 4: High option - 7 % of pay to a DC plan ( employer contribution includes contributions
to the long term disability and health insurance premium benefit plans
Assumptions
o The study analyzed the impact on employee benefits for 12 hypothetical employees hired at four
different ages and having three different rates of average salary increases.
Ages 25. 35.45 and 55.
Salary increases: a low performer ( average salary increase of 2 % per year), an average
performer ( 4 % per year) and a high performer ( 6 % per year).
o The projections assume an investment return of 8%, except that the rate for the DB plan is reduced
to 7 % when projected negative net external cash flow exceeds 5 % of assets.
o The models project employee election rates between the DB and DC plans based on level of
employer contribution and age of the electing employee.
Conclusions
o DC options other than the high option may save employers money, but benefit levels likely will be
reduced for many employee classifications.
o DC plan alternatives reward the shorter- service employee over the longer- term employee.
o The DB plan rewards high performers most and DC plans favor low performers.
o Employees who become disabled and survive to their normal retirement date will receive
significantly lower post- LTD benefits under the DC alternatives.
o Creation of an alternative DC plan initially is beneficial to the funded status and contribution rate
of the DB plan, but may lead to funding and negative cash flow problems and higher contribution
rates.
o If investment return remains favorable, the Status Quo will be even more cost advantageous.
o Future DB excess earnings COLAS may be difficult to sustain with presence of DC options.
o The stand- alone health supplement plan for DC plans must define how the supplement will work
when DC member elects a lump sum distribution.
o It is possible to increase short- term benefits under the current DB plan at a modest increase in cost
by adding a cash balance overlay feature.
Scenario 1 : Status Quo
o The current DB plan will become marginally underfunded ( 99 %) after 20 years.
o External cash flow will not become an asset allocation problem.
o The contribution rate will level out at 5.5 % to 5.6 5%.
Scenario 2: Moderate Option
o External cash flow will become a problem for the DB plan: exceeds 5 % of assets after 9 years and
over 8 % in 2 1 years.
o In early years, DB contribution rate may drop to very low levels if it is tied to the DB contribution
rate, producing an inadequate rate in the DC plan.
o The DB plan contribution rate eventually will exceed 6 % of pay.
o The DB plan will become underfunded three years later than under Status Quo.
o Once the DB plan becomes underfunded, the underfunding will increase rapidly because of
changes in asset allocation that will be necessary.
o This scenario initially will save employers money, but will cost more after about 7 years and
eventually by more than $ 35 million per year.
o DC contribution rates are greater than current DB plan rate, but produce consistently higher
benefits only for the low performers at young ages. Most career employees will receive lower
benefits.
Scenario 3: Low Option
o The DB plan underfunding occurs two years earlier than in Status Quo.
The DB plan funding ratio drops to 91 % after 25 years.
o Negative cash flow for the DB plan exceeds 5% of assets after 12 years, but will not exceed 7 %.
o The DB plan contribution rate exceeds 6 % after 18 years and exceeds 7 % after 23 years.
o Once the DB plan becomes underfunded, the asset allocation problem will cause underfunding to
increase rapidly.
o This scenario always will save employers money, because of the low employer DC contribution
rate ( 1.6 %), but employee benefits under the DC plan likely will not be adequate.
o DC contribution rates are comparable to current DB plan rate, but there is a significant decrease in
benefit levels.
Scenario 4: High Option
o The DB plan remains overfunded through out the study period.
o Negative cash flow for the DB plan exceeds 5 % of assets after 3 years and 8 % after 17 years.
o The DB plan contribution rate varies little from Status Quo.
o This scenario will always cost employers more because of the higher DC contribution rate.
o Total employer contributions exceed Status Quo by $ 14 million in first year after transition: by
$ 1 7 1 million in 2022.
The composite employer contribution rate for the DB and DC plans exceeds Status Quo by 1.0 %
to 1.2 %.
o Even at the high DC contribution rates, the high performer has lower benefits.
o Low and average performers may develop higher long- term retirement benefits under the DC plan.
S EADDO\ R'IE. ECCTI\. E SL'\ fSfARY doc
Arizona State Retirement System
Defined Benefit 1 Defined Contribution
Projection Models
Executive Summary
November 1998
tson Wyatt
World wide
General Description
( continued)
a Scenario 2 - 4+% DC
)) An alternative DC plan with a moderate employer
contribution rate.
)) Employees contribute 5.25% of pay to DC plan and
0.49% of pay to LTD plan.
)) Employers contribute 4.00% of pay to DC plan,
0.49% to LTD plan, and 1.25% of pay to a health
insurance premium supplement plan for DC plan
participants.
)) Total employeelemployer rate is 5.74% of pay.
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Key Assumptions
Election rates of DB versus DC plan will vary by
employees' age and will differ depending on the
level of the employers' DC contribution rate.
There will be a transfer of assets from the DB
plan to the new DC plan for current DB plan
participants who elect to change plans.
General Observations
( continued)
a The DB plan has no cash flow problems as long
as there is no alternative DC plan.
a Initially, the DB plan's cost will go down if an
alternative DC plan is created.
)) The DB plan's liabilities will be reduced by more than
the amount of assets transferred to the DC plan.
General Observations
( continued)
)) A lowering of investment return expectations will
cause the cost of the DB plan to increase in terms of
a percent of pay to a higher level than under the
status quo.
Because of the cash flowlinvestment return
issue, Scenario 2 - 4+% DC and Scenario 4 -
7.00% DC will eventually cost employers more
than Scenario 1 - Status Quo.
General Observations
( continued)
Only Scenario 3 - 3.34% DC will save employers
money.
)) But it represents a significant decrease in benefits for
longer- term employees.
The DC alternatives will benefit the low
performing employees the most.
)) Especially if they are hired at younger ages.
0 The high performing longer- term employee is
hurt most by moving to a DC plan.
General Observations
( continued)
The average performing employee will be better
off under the DC plan in the early years of their
career but worse off in the later years of their
career.
a The employee hired at an older age is much
better off under the current DB plan.
For employees in the DC plan who become
disabled and survive to retirement age, the DC
plan will not provide adequate benefits when
the LTD benefit ceases.
Great- West
Dehed Benefit vs Defined Contribution
Considering Your Options
Scott K. Baker
Regional Vice President
Government Conversions Market
Great- West Life h Annuity Insurance Company
August 1998
.
CHAPTER 1: DEFINED BENEFIT TO DEFINED CONTRIBUTION: ISSUES OF CONVERSION .................... 4
FACTORS IN COMPARING DB TO DC ............................ - ..-...... - .... ......................... 4
Benefit to Benefit Equivalence .................................................................................................................... 4
Present Value. ............................................................................................................................... ............. 4
Net Present Value ............................................................................................................................... ....... 4
THE SHIFT FROM DB TO DC .................................................................................................... 5
HOW DB PLANS ARE DIFFERENT FROM DC PLANS ..,.....,..... ,. ................................ 6
Public Policy ............................................................................................................................... ............... 6
Portability ............................................................................................................................... ................... 6
- . Fkribiiity ............................................................................................................................... .................... 6
Investment Risk & Return ..................................................................................................................... 6
WHICH RETIREMENT PLAN BEST SERMS .......................................................................... 7
CHAPTER 2: WHAT IS A 401( a) DEFINED CONTRIBUTION PLAN ............................................................. 7
Contributions. ............................................................................................................................... ............. 9
Vesting ............................................................................................................................... ........................ 9
Portability ............................................................................................................................... ................. 9..
Investments ............................................................................................................................... .............. 10
Loans ............................................................................................................................... ....................... 10
Survivorship & Disability Benefits ........................................................................................................... I. I
DISTRIBUTION OPTIONS ........................................................................................................ 1 1
Guaranteed Lifeme Annuity ........... .. ....................................................................................................... I I
Systematic Puyments ............................................................................................................................... . I I
Combination of Guaranteed and Systematic Withdruwals ........................................................................ I I
IRS Regulations for @ sternatic Withdrawals ........................................................................................... 1 2
CHAPTER 3: APPROACHES TO CONVERSIONS .......................................................................................... 11
Complete Conversion ............................................................................................................................... 13
Freeze the DBplan .............................................................................................................................. I3
New Employes on& Conversion ............................................................................................................ I3
Voluntary Partial P h Conversion ..................................................................................................... I3
' WIN- WIN" APPROACH VOLUNTARY PARTlAL PLAN CONVERSION ............................. 14
A Win- W in Em~ IowBr ened ts. ................................................................................................................. 1 4
A Win- Win Emulowe Benefits .......................................................................................................... I 4
CHAPTER 4: QUANTITATIVE EVALUATION .................................................................................................. 1 3
SUMMARY OF ACTUARIAL PROCEDURES ......................................................................... 1 5
. RESULTS OF STUDY ............................................................................................................ 1 6
NEW EMPLOYEES .................................................................................................................. 1 7
SUMMARY ............................................................................................................................... 18
EXHIBITS ............................................................................................................................... .. 19
CONflDENTlAL PAGE 2 1Wa598
Defined Benefit to Defined Contribubon:
Issues of Conversion
A topic in current discussion in the public sector is conversion from a Defined Benefit (" DB")
plan to a Defined Contribution (" DC") n. The concerns over conversions affect not only
the financial features of both programs, but the fundarnentai d~~ of p h i p h i that
accompany the specific programs.
A Defined Benefit Plan provides a specific benefit at Fetirement age ( typicalty age 60). The
benefit is usually computed based on a variant of years of service and compensation, times
a speck percentage. The benefit is guaranteed for the partidpant's life ( or the pint i i i of
the partidpant and a survivor). Employer CCMWMWareE b ased on certain mathematical
assumptions cailed actuarial assumptions. Contributions are invested through a trust and
investment eamings are used to increase plan assets. DB plans account for benefits as
prospective liability offset against fund assets. Plan assets in excess of proJected benefits
yield an over- funded plan and plan assets less than prowed ' abilities yieM an under-funded
phn.
Defined Contribution Plans are more akin to an investment vehicle or individual account.
Contributions, typically employer and employee, are placed in a trust and invested. The
participant receives either a lump sum equal to the total accumulation in the plan, including
investment eamings, or an annuity equivalent to the lump sum.
A Defined Contn. b uhM. I
plan is a plan under which the employer and the employee make
contributions to individual employee accounts. Each employee ultimately receives elher a
lumpsum or a benefit equal in value to the vested account balance. The value of the
account balance depends on contributions and investment performance. There are no
guarantees of benefit levels.
In a Defined Benefit Plan, factors such as age, final amage pay, and years of service are
the prime determinants of a member's pension. A Defined Contribution Plan, by contrast,
has two fadors for determination: investment retum and contribution level. Unlike the
contractual guarantee of the DB, the DC accumulates according to the contribution level of
the member and employer, and the rate eamed on those contributions.
CONFIDENTIAL PAGE 3 lwWS8
Comparison factors for DB to DC, aside from philosophical distinctions, are usually
based on a benefit to benefit- equivalence basis, present value basis, and a net present
value basis. Each method provides a comparative format from a dirent viewpoint.
Benefit to Benefit Equivalence
In a b e n e M m equivalence comparison, the calculated benefit payment under
the DB plan is compared to the benefit equivalent of the DC plan. The benefit
equ'mlent of the DC is computed by taking the Mure value of accumulated
contributions ( including compensation increase assumptions) and computing a
withdrawal based on similar factors as the DB ( like COLA rider, life expectancy, etc.).
Benefit equivalence is useful to participants acclimated to DB plans, since it relates
similar amounts. The concept of benefit equivakme is tied d ito th e investment
and inflation assumptions used in the projection.
Present Value
The present value method computes the present value of the Defined Benefit plan and
compares it to the Defined Contribution balance at retirement date. The present value
can be computed at a discount mte seleded for comparison w using an
adjusted rate of retum as the discount rate. The time period used is typically the noml
life expectancy of the participant.
Net Present Value
Net present ~ k rme e 5th e present Mlue Of bent? fits, the present Mho f
accumulated contributions, using a hurdle as described above. This method shows the
net afier- contribution value of the pension and is useful where more than one
contribution rate is provided for the participant. An additional, but less reliable method,
is payback, where the net contributions are d i e d into the present value of benefits,
giving a multiple retum. Payback is less effedive than NPV as a comparison technique
but has the advantage of simplicity.
CONFIDENTl4L PAGE 4 l( Y05198
The historical trend of DB as a pension and DC as employee savings has shifted
dramatically. For example, in 1975 there were 103,000 Defined Benefit plans in the prnrate
sedor, out of 31 1,000 total plans. By 1992, the number of DB plans had decreased to
89,000, while the number of total plans in the private sedor had increased to 708,000'.
However, much of the shift to DC in the private sedor is in the aspect of small DB plans
s h i i into the DC sector. Seventy- five percent of the net deaease in Of3 plans in the
pnvate sector from 19851 990 was attributable to very small plans2. Nonetheless, the DC
movement has some fundamental differences in the philosophy and computation that
influence both the puMi and private sedor plans. Shifts from DB to either ' pure" DC or
hybridtype DB/ DC plans is in progress in many states. The DC shift has the following
general aspects:
A shift in society from the " cradbtegrave" employment notion to the acknowledgment of job mobility
and uncertainty, giving rise to a demand for pension portability;
An effort to transfer investment risk and return away from the trust and to the participant;
A desire to create greater plan flexibility thrwgh employee contributions;
An attempt to reduce or eliminate the unfunded past service cost liability of a defined benefit plan.
A consciousness toward cutting administrative costs assodated with a DB program.
' Source: Employee Benefit Research Institute tabulations based on US Department of
Labor, Pension and Welfare Benefts Administration, Frhde Pension 5uW ( VMnter
1 996).
Source: ERBl Notes, June 1996, Worker Decision in an Evolving Retirement Income
System"
Public Policy
A primary consideration in the DBIDC debate in the public sector boits down to a
question of puMi policy or the philosophy underlying the purpose of retirement
programs in general. What is the purpose of a pension system? Is it to provide a base
for retirement income for those who wifl not or cannot prwide for themselves, or a
savings mechanism to allow an efficient means for employers and employees to
accumulate funds for future retirement needs?
Portability
The concept of portability refleds a gmwing asped of job mobility. Where employees
may have achieved the requisle 20 or 30 years of service with an employer in the past,
today's uncertain economic environment, wlh layoffs, privatiiion and merging of
entitii, makes the average employee's tenure significantly less. DB plans generally do
not provide a portabfe benefit with many having requirements of at least 10 years of
service prior to any permanent accrual of benefits. An employee could work for 9 years
at four employers, garnering 36 total years of senrice and have no pension benefit
whatsoever. DC plans provide portability in the account balance which the employee
takes with them to subsequent employers.
Flexibility
A DB program wil usualty only provide a partidpant with a choice concerning benefit
payout ( i. e. in the form of single life annuity, joint and survivor annuity, term certain,
etc.). DC plans can be designed to allow the participants to choose the level of
contribution, the investment vehicle, and the form of payout.
Investment Risk & Return
DB plans assume the investment risk of investment performance. A DB plan is
constructed based on many actuarial assumptions including investment retum,
mortality of pensioners, setback, and entry age.
DC plans usualty shift the investment risk and retum to the participant. Participants
frequently direct their own investments and select a risklretum trade- off appropriate to
their personal situation.
Administrative Costs
A DB program generates additional costs not found in the DC format, including
actuarial services, accounting services, bonding, investment management, and
administration. DC plans are usually less expensive to administer, particularly because
of their bdc of actuarial computation.
CONFlMNTlAL PAGE 6 1WO598
Employees?
Taxpayers?
What is the coned answer? Probably both a Delined Benefit Plan and a Defined
Contribution Plan. Some employees will have a better benefit under the Detined Benefit
Plan, some under the Defined Contribution Plan. The employer should allow employees to
choose the plan that is right for them. By offering a voluntary Defined Benefit to Defined
Contribution conversion, an employer can provide more benel% to more employees for the
same cost. However, most employers actually see cost savings and a financial
strengttrening of their pension trust fund.
DB Vs DC Benefits Compared
I I Years of Service I
40 1 Defined Contribution g Defined Benefit
For Iflusbatrve Pwposes Only
' Not Intended to p 3 c t or popd hdue Mestment results Actual rate of return may be hghw or bwer Figure l
depending on how funds are adually ~ nvested' 4 01' refers to a 401 ( a) defined wntnbubon plan
F i r e I Illusbabes that when in vmrb for a single enpbyer for Wi entie career and hes s w b at normal retirement
c l a t e , ~ 6 0 , t h e y w l d r e c e k a g e a b w b e n e f i t ~ t h q r w l d & u d e r a ~ c o n W l l b b n p t c n . T h e ~ ~ ~
thatenpbyeesccrJeredunderadefinedcontrkrtanpta, widmkageaterbenefrtiftheyMservicepnwtonormalretiement
c a t e , ~ 6 0 , o r i f t h e y m h u d t o ~ d ~ n o r m~ a li ~ 1~ . D ~ ~ , ~ l h e n 2 9 4 6 o f
mplqes stywith cneeqbyerfatheirentiecareer.
CONFIDENTIAL PAGE 7 lor05198
DB Vs DC Benefits Conpared
Effect of Job Change After 15 YOS
Y1
8 fi
Years of Senice
401 Defined Contribution Defined Benefit
DB Benefit with Job Chang Figure II
401& 1~ 11g8%
401 Clmtri- 6%
DB Accxual Rate 2%
NormalRetiranent60
For lllusbative Purposes Only
' Not intended to precbd or ppCt future krveshTlent resulk. Actual rate of retun may be higher or bwer
depending on how funds are actualty iwested. ' 401" refets to a 401 ( a) defned contribution plan.
CONFl DENTIAL PAGE 8 l( Y05/ 99
What is a 401 ( a) Mned Contribubon Plan?
Contributions
Partiints own and direct investments of their own separate accounts. The
maxjmum contribution allowed is the lesser of 25% of compensation or
$ 30,000. Public employees may make contributions, however, any pre- tax
contributions must be mandatory and irrevocable for every employee covered
by the plan. Pretax contributions are allowed under IRC 414( h)( 2). Employee
may make voluntary after- tax contributions but usually choose to make
voluntary pretax contributions to 9E7 plan.
Vesting
Wah a 06 to DC plan conversion, each employee that chooses the DC plan
will become 100% vested immediately regardless of years of service. New
employees, employees hired after completion of the conversion process, may
be subject to a wdhg period. Employees are atways 100% & ed in their
own contributions therefore, vesting schedules only impad the employees
rights to the employers contribution. Unlike Defined Benefit Plans that may
have onerous vesting schedules, a DC plan may nat have a vestii schedule
more resttictii than lied below. The employer can always have a less
restktii vesting schedule but never a more restrictive schedule.
5 Year Clm, 100% vested 3/ 7 Year Graded
af& r 5 YOS 3 YOS 20% vested
4 YOS 40% vested
5 YOS 60% vested
6 YOS 80% vested
7 YOS 1Wh e e d
Portability
Under a Defined Benefit Plan, if an employee leaves service before normal or
early retirement date, a vested employee must wal until normal retirement
before benefits begin. Benefits are tied to Final Average Salary at the time of
leaving service. It may take years before benefits begin. Inflation may
significantly etude the purchase power of the eamed benefit.
A 401( a) Defined Contribution Plan allows employees to change jobs and
bring their assets with them. There is no inflation penalty because assets
- -
CONFIDENTLA1 PAGE 9 1Qn15198
continue to be invested. Fulthemre, an employee may be able to roll their
401 ( a) assets into a new employers 401 plan or an IRA.
Investments
Most employers who put in a 401( a) Defined Contributiin plan allow their
employees to invest contributions among several fund options. This is not
always the case. Some employers make all or some of the investment
decisions on behalf of their employees.
Employer Direded Investment decisions have the potential to expose the
employer to some fiduciary risk If the employer invests to aggressively or
misjudges the market, the benefit the employee realizes at retirement may be
harmed. If the employer invests too conservatively, there may be insufficient
assets to provide an adequate benefi at retirement.
Because of the fiduciary exposure, most employers allow their employees to
make their own investment decisions. The employer makes a broad seledion
of investment optrons available allowing the employee to choose among the
options.
Employers may restrid the number and types of in- options. This
allows the employer to manage the amount of risk and fees their employees
are exposed. Some employers restrid their contributions to a fund of their
choice. The employer restrictions are usually lied when the employee
becomes vested.
AR earnings on in\ lestments acme tax deferred.
Loans
At the employer's discretion, employees may make loans against the assets in
their 401( a) account. Loans cannot exceed the maximum of the lesser of
$ 50,000 or 50% vested assets in the employee's account. The & mum loan
term is 5 years and must be paid back in installments over the term of the
loan. Some plans allow several loans outstanding at one time, however, they
must, combined, adhere to the maxjmurns stated above. If the loan is used to
purchase an employee's primary resident, the term can be exlended beyond
five years. Interest on loans used to purchase a home is not deductible.
Default on a loan constitutes a diribution and is subject to taxation and a
v= penalty tax
There are two types of loans, Collateral and Account Reduction. WRh a
Collateral loan, the employee's 401( a) assets remain in their account The
loan is made by the plan administrator and all interest on that loan is paid to
the plan administrator. tf an employee should default on the loan, the plan
administrator can recover their loss by taking possession of the collateral or
assets in the employee's 401 account. Usually, the plan adminior will
require that assets equal to the loan amount is put in a low yielding stable
value account assuring against loss of principal.
Account Reduction loans ad very differently. When an employee takes an
Account Reduction loan, the employee's 401 ( a)- account balance is reduced
by the loan amount Interest on loans is paid by the employee and is
CONFIDENTIAL PAGE 10 105198
deposited along with principal in the employee's own account. Interest is
generally quoted as a percentage over prime.
Survivorship & Disability Benefits
If an employee becomes disabled or dies, the employee becomes 100%
vested immediately. 100% of both the employer and employee contributions
plus earnings go to the beneficiary. An employee can choose anyone to be
the beneficiary. The beneficiary can choose afl the forms of distribution
availak to the employee.
Under most Defined Benefit plans employees are eligible for a life annuity or,
in many cases, optional f o m of distribution such as Joint and Survivor
Annuity or aduarially equivalent lump sum distributions. These distributions
begin at normal retirement age, usually age 60 or, in some cases, employees
may choose to take a reduced benefit called an early retirement benetit.
Under a 401 ( a) Defined Contribution Plan an employee can retire at any age.
Not only can an employee choose a form of distribution similar to that
provided under most Defined Benefit Plans, but may choose from a wide
seledion of f l e i b i l i distribution options.
Guaranteed Lifetime Annuity
Employees may choose a guaranteed life time annuity. This will provide an
employee with a guaranteed benefit for as long as the employee li. Jo int &
Survivor annuities provide a guaranteed benefit for the employee and a
beneficiary. Anyone can be a beneficiary under a DC plan. DB plans usually
limit the beneficiary to a spouse. Once an annuity is purchased, the employee
may not change the frequency or amount of the payment. In a d d i i , once a
beneficiary is selected, the beneficiary may not be changed.
Systematic Payments
A systematic distribution provides the greatest amount of fleibili. With few
exceptions, employees may choose the amount they wish to withdraw form
their accounts and the frequency of their withdrawals. In - tion, employees
may change the amount of withdrawal, the frequency of withdrawals and even
the beneficiary.
Some of the most attractive features of a systematic withdrawal are the ability
of employees to continue to control their investments and the ability for an
employee to leave an estate. Hawewx, unlike an annuity, the employee is not
guaranteed to receive a benefit for life. There is the risk that the employee
may out live their assets.
Combination of Guaranteed and Systematic Withdrawals
For the maximum in fie> dbility, an employee can choose to use a of the
assets in their 401( a) account to purchase an annuity providing a life
guaranteed benefit while enjoying the tlexibili of systematic withdrawals.
CONflDENTW PAGE 1 1 1( m! BE
IRS Regulations for Systematic Withdrawals
If an employee lea- service before attaining age 55 and begins taking a
distribution before age 59% the employee may be subjed to an early
withdrawal tax of 10% of the distribution. This tax can be avoided if the
employee takes the distribution in equal installments calculated over hislher
lifetime.
If an employee receives a distribution from a quaMied retirement plan after
separation from service and sepamn occurs during or after the calendar
year in which the employee attains age 55, the 10 percent penalty tax will not
apply. Thus, it appears that a 54- year- old employee will not be s u wto the
penalty tax on a distribution made after separation from service as long as the
employee attains age 55 during the calendar year in which separation occurs.
Generally, the 10% additional income tax is imposed on the portion of early
distributions from q u a l i plans that is includible in gross income. However,
under one of the several excewns to that general rule, the tax does not
apply to distributions that are part of a series of substantially equal periodic
payments made not less frequently than annually for the l i ( or l i
expectancy) of the employee, or the joint lives ( or joint life expedancy) of the
employee and his or her beneficiary.
However, if the series of periodic payments is subsequently m o d i within
five years after the date the first payment in the series is made ( or, if later, by
the date an employee reaches age 59112), the exception to the 10%
a d d i a l income tax no bnger applies, and the taxpayer's tax for the year in
which the series of payments has been rnoditied is increased by the amount
that would have been imposed, but for this exception, plus interest.
All employees are required to take a minimum distribution at age 70 %. The
IRS imposes a 50% excise tax on a payment that should have been taken at
70 % but was not
CONFlDENNU. PAGE 12 1Ml5/ 98
Approaches to a Conversion
Complete Conversion
A complete conversion is more commonly known as a fuU plan termination.
Under a full plan termination, annuities are purchased for all ex- employees
who are receiving a benefit and for terminated vested employees who are
owed a future benefit. After purchasing annuities, the remaining pension
assets would be distributed to a d i i employees. When the assets are
distributed to active employees, the employee can do what they want with the
assets. They can rdl them into a new 401( a) plan if allawed by the new plan,
roll them into an IRA or take the money in cash.
If the pension trust is over- funded, the employer may, at their discretion,
recover a portiin of the over- funding. If the trust is under- funded, the assets
remaining after annuities have been purchased is distributed to active
employees on a pro- rata basis. Unlike the private MOpTub, lic employers are
not subject to onerous filings and taxes.
Freeze the DB plan
All benefits are frozen under the DB plan. All new benefits acme under the
DC plan. Employees taking a distribution and terminated vested employees
are unharmed. Their benefits continue as if nothing had changed.
New Employees only Conversion
Most often used when an employer has a severely under- funded pension
system. New employees would be covered by the DC option while current
employees would continue to accrue benefits under the DB plan.
Voluntary Partial Plan Conversion
All new employees go into the 401( a) plan, current employees may choose
which plan they want. This is known as the MlimWin" approach and is the
most common method of conversion in the public sedor.
CONflDENTW PAGE 13 lM15198
No one gets hurt! Employees who expect to receive a greater benefit with the
Defined Benefit Plan may stay in the Defined Benefit Phn. While employees who
expect to receive a greater beneiit from the Defined Contribution plan may choose to
go to the Defined Contribution plan. Employees get to choose which plan best meets
their needs. The employer offers a retirement program that meets the needs of more
employees and in most cases realizes long- term savings.
Generally, new employees are not given a choice. As a condition of employment, they
accrue their retirement benefits under the new Defined Contribution Plan. In some
cases, the employer contribution to new employees is lower then contributions made to
existing employees, further increasing the likelihood of savings for the employer.
A Win- Win Employer Benefits
Predictable fixed funding cost. Unlike a DB plan, funding is fixed as a percentage of
salary. DC plans are pay- as- you- go. Contributions are made to an employee's
account every pay period, eliminating the potential for an unfunded liability. Because
the employer is not carrying the liability of an employee retirement obligation, bond
ratings may improve, reducing the cost to raise capital.
Lower Administrative cost. DC plans do not require services of an actuarial firm,
reducing administrative cost. In most cases, administration and asset management
fees are paid by the employee. Defined Contribution Plans offer s i m p l i plan
administration. There is one source for recordkeeping; investment management;
employer reporting; and participant support and education.
DC Plans are a good recruiting tool. A younger work force is looking for portability.
They want to know, wherever they go, they can take their pension with them. DC
plans can provide that desired portability. DB plans offer little or no portability.
A Win- Win Employee Benefits
Employees always have ownership of contributions and the vested portion of
employer contributions. For those employees who choose to convert from the DB
plan, they are vested immediately, while generally, new employees have a quicker
vesting schedule.
Portability is usually described as one of the most attradive benefit for employees.
Along with portability, employees point to flexibility as an important feature.
Employees have control over investments & distribution decisions. They often see
improved suNivorship and disability benefits and can retire when they want to, at any
age.
Those employees that choose the DC option feel they will realize a greater retirement
benefit wlh the DC plan. This is particularly true for younger employees and
employees who plan to leave service before they would be eligible for a benefit under
the DB plan. This is so because assets continue to be invested after leaving service
and there is no inflationary penalty for delaying distribution.
Accrued benetits are determined on a termination of employment basis using service
and FAC to date. Since FAC is not usually provided, we use current salary as of data
valuation.
Benefit commencement age is the earliest age the member would be eligible to Mire
with full benefits based on projected se~ ce. T herefore, it is assumed that all
employees would receive a beneftt at age 60. This of course is not the case. Some
employees will choose to leave service prior to or following normal retirement date.
However, for purposes of calculating Net Present Value ( NPV) of amed benefit we
must assume that employees will retire when the employee would fkst become eligii
for full retirement Anything less would unfairly penalize the employee.
Unisex mortality is assumed alter benefit commencement age for the purpose of
determining the single sum value at benefit commencement age. This couM be based
on a mortality basis for plan option factors or on the valuation mortality table adjusted
for malelFemale mix In this case, employees are eligible for a lump sum distribution at
retirement based on Unisex 67 Group Annulty Tables with a one year setback and 6%
interest. This table was provided by the employer and used in determining the single
sum value.
This single sum value is discounted to the member's p e n t age using interest only.
The discount rate used is the rate assumed in the last actuarial valuation. A lower
discount rate is allowed and if used, would provide larger single sum distributions. We
calculated the present value of the single sum to current date discounted at 6%.
No further adjustments are made, although potentiilly an adjustment could be needed
to assure sufficiency of plan assets to provide for the probable number of transfers and
leave the defined benefit plan actuarially sound.
CONFIDENTW PAGE 15 l( Yay98
Hypothetical Examples
RetimM ~~ Age 60 with 15 years of semke.
Benefit Formuta: 2% of FAC perpar of servia3 papbk for &.
Memberage 34.5 with 11 pars ofservice: FAC is $ 43,550. Using unisex
morfaiityf able pvided try the empEoyerand 6.0046 mte, ~ M EdMSn
amount of$ 26,4CK).
The expected number of transfers will not jeopardize the actuarial soundness of the DB
plan.
Procedure
AccruFtd benetit = $ 43,550~. U 2 x 11 = $ 9,581 perparpayable at age 60.
Single wm valueatage60 ~$ 9,58x1 12.11 =$ 116,025.91
Trambramount = $ 1 16,025.9741.06) 25- 5 = $ 26,257.62
The use of an adjustment to present values must be reviewed closely. The GASB
funded ratii is not appropriate since it is based on present values calculated using
Mure pay increases. This has been used by some actuaries. The " ABa' FASB
calculation is also not appropriate since it is based on accrued benetit calculated at
retirement ages which may not be consistent with transfer values using the PERS
method.
When calculating termination values, your aduary should keep in mind the effeds of
military buybacks and other form of time buybacks. Buybacks may have a significant
impact on the termination values for those impacted. One last issue concerning
buybacks, at the time of this writing the IRS has not issued an opinion letter on this
subject, any use of buybacks should take into consideration 415 limits.
Your actuary should pay special attention to the impad Qualified Domestic Relation
Orders issued for your employees and adjust termination values to take QDROs into
account. Again, if like buybacks, QDROs are overlooked when calculating termination
values, it create problems during the conversion process.
It is ahuays best NOT TO RELEASE any values io eny, loyees until all values
have been calculated and audited.
You must have an accredited actuary calculate conmion values wing the
aforementioned pnxedtrre. Any numbers provided are for iIIwtdve purposes
ow.
When conducting the analyses, we looked at both the effect on the current employee
population and the comparative effect on new employees. Illustration 1 through 3 show
theeffedsonthewrrentempiOyeepopuhtionuSingmsetofcommonassumptions.
We assumed that employees would receive, on average, a 3.00% annual salary
CONFlDENTLAL PAGE 16 1m5W
increase. We further assumed that the assets in an employee's Defined Contribution
account would eam an average retum of 8.00%.
We understand that most employees at retirement take a lump sum distribution. The
lump sum distribution is determined using an employee's accrued benefit discounted
using 67 GA- 3 215 Unisex mortality tables set to 6%. We used the tables provided by
the Employer when calculating the NPV of employees accrued benefit.
The purpose ofthe first three ibstntbns is to see conbhth rate effed on benefits
under the DC plan when compared to the DB plan. We were looking for what
percentage of your current employees would likely receive a greater benefit from the
DC option and corresponding value of transfer amount from the pension trust.
The pension trust is over- funded. The over- funded position of the plan allows the
employer to look at enhancing the amounts distributed from the pension trust We
a+ ed that by increasing the enhancing d i , the employer could reduce
ongoing contributions to the DC plan. lllustratiin 1 is our base line. We used 100% of
the employees NPV of accrued benefit to calculate each employee's lump sum
distribution. Illustration 2 and 3 used 105% and 110% respectively.
50% ChoctseDC ~ Lowst per head
NO% NPV 14% to 15% $ SO,€#?@ tB%
Xtinpkyees as b? n t42, $ 7.2 rn
105% NPV 13% to 14% $ 61,835 @ 15%
# Employees 104 to 122 141, $ 8.7 million
110% WV 12% t o 13% SQr@ t2@ 17% *- It8 to 146 23, $ 34.9 nriElion
We took the data from Illustrations 1- 3 and sorted them. Our goal was to attempt to
estaMih the most efficient mix of contribution rate, NPV of accrued benefit and asset
roll- out per employee. It is important to establish goals for a DB to DC conversion.
Generally employer's measure the success of a conversion based not onty on the
efficient m'k, but on the number of employees who find the DC optiin more attractive.
We choose a target of 40%. Other employers who have gone through this pmcess
usually see between 40% and 50% of their employees go to the DC option.
By targeting 40% employee roll- out, we have identified the most efficient mix of 100
NPV, 13% contribution rate and a fairly minimum impad on the pension tmst with
expected roll- outs of $ 5.2 million or $ 59,467 per employee.
The Employer can realize even greater savings by requiring new employees to go into
the DC plan. lllustratiins 7- 9 demonstrate based on an 3.00% annual average salary
inaeases, 8% average return on in- in the DC plan, what age and what
contribution rate to target for new employees.
CONflDENTW PAGE 17 1( Y05/ 98
Under all three illustrations an employee who's employment starts at age 20 or
younger and works for the employer until they reach 60, might expect a greater benefit
with the DC plan. Likewise, employees who come to work at age 55 and work until 60
might exped a greater benefit from the DC option. The group of employees who begin
with the employer between age 20 and 55 are affected the most by contribution rate.
As you migM e> cped, when the contribution rate is increased, more employees would
benefit greater from the DC option. This is particularly true for young employees.
Defined Contribution Plans provide a greater retirement benefit for many public
employees. DC plans allow employees to retire when they want to, at any age. DC
Phns a hem ployees to move from one employer to another without being penalbed.
DC plans offer employees the ability to leave an estate.
DB employees are unharmed. Those employees who would expect to receive a
greater benefit from the DB plan can remain in the plan. Those employees who are
term vested or in diibution under the DB plan will not be harmed in anyway. In fad,
most employers who under go a voluntary DB to DC realize an inymvernent in
strength of the pension tnrst.
Employer realies cost savings when the contributiin rate to the DC plan is less then
the DB plans normal cost. Long- term savings are assured when the employer's
contribution rate for new employees is lower then the contribution rate current
employ-.
You can strudure a DC plan that allows for portability while rewarding long service
employees. You want your work force to stay because they want to, not because their
hands are tied by a pension system that penalizes employees for leaving service early.
This generation and mure generations of employees are expected to be more mobile.
This is especially true for skilled and technical employees. A DC Plan will broaden
your pool of recruit. Unless an employee wants to spend their entire career with one
employer, a DC plan will generally provide a greater benefit.
By moving from a Defined Benefit Plan to a Defined Contribution Plan using the Wn-
Win" approach, the employer may provide more benefits for more employees at a
lower cost.
CONR DENTlAL PAGE 18 lWW98
Illustration 1 :
3.00% annual average salary increase
8.00% average annual earnings on assets deposited in a 401 ( a) Defined
Contribution accounts
7W/ o of NPV accrued Benefii discounted at 6% using 67 GA- 3 215 Unisex
I- y ear setback
Contnbution Rate Results on Defined Contribution
Rollover @ 100% NPV Accrued Benefit
200
G 0)
h
o 150 I * E 100 6.
0
L P" 50
E
i -
8. W? 900% 10000h 11. Wh 12. W? 13. Wh 14. W! 15. W? 16. W? 17.000?
Contnbution Rate
eq # Ernpbyees DC # Employees DB
For illustration purposes only
Cdbutimi # Employes # Emplapes M Enydqee~ % Enydayees Roll Amount Rofl Am& Per
DC DR DC DL1 ~ ~ P I w
6 8.0096 31 187 14% 88% 4,529,763.1 1 $ 146,121
9.00% 42 1 76 19% 81% 4,548,487.10 $ 1 08,297
10.00% 52 166 24% 7696 4, W1934.37 $ 88,287
11 .0O0h 61 157 28% 72% 4,648,356.45 $ 76,203
1 2 . m 75 143 34% em 4, tm, n5.73 $ 6~~ 024
13.00% 88 130 40% 60% 5,233,052.1 4 $ 59,467
14. OQ% 105 113 48% 52% 5,754209 ,802
1 5.00% 127 91 58% 42% 6,678,189.01 $ 52,584
16.0046 1 42 76 65% 35% 7,197,563.58 650,687
1 7 .0O0/ o 171 47 78% 22% 9,144,869.02 $ 53,479
CONFIDENTIAL PAGE 19 l( YOY98
Illustration 2:
3.00% annual average salary increase
8.00% average annual earnings on assets deposited in a 401 ( a) Defined
Contribution accounts
105% of NPV accrued Benefrt discounted at 6% using 67 GA- 3 215 Unisex
1 - year setback
Contribution Rate Results on Defined Contribution
Rollover @ 105% NPV Accrued Benefit
Contribution Rate
/ Ed # Employees DC H # Employees DB I
For illustration purposes only
CONFlDENTLAL PAGE 20 1OlDYgs
Illustration 3:
3.00% annual average salary increase
8.00% average annual earnings on assets deposited in a 401 ( a) Defined
Contribution accounts
11PA of NPV accrued Benefit discounted at 6% using 67 GA- 3 215 Unisex
1 - year setback
Contribution Rate Results on Defined Contribution Rollover @ 110%
NPV Accrued Benefit
Contribution Rate
I
Ci3 # Employees DC D# Employees DB
For illustration purposes only
Codiiludinn # EmtpIryes # EmpIqi~ tvs "/ Empi~ yees 96 & plqv! es Roll , h u n t Roll ,4mowtt
DC Dl? DC* DC Per E p i q w
8.00% 37 181 17% 83% 5,799.467.79 $ 156,742 '
9.00% 49 169 22% 78% 5,827,059.21 $ 1 18,920
10.00% 62 156 28% 72% 6,120,971.46 $ 98,725
11.00% 74 1 44 34% 66% 6,667,472.06 $ 90,101
12.0086 ! Q 126 4256 58% 7,296,889.23 $ 79.334
1 3.0O0h 118 100 54% 46% 8,628,482.68 $ 73,123
14.00% 1 46 72 67% 33% 10,764,064.29 $ 73,727
15.00% 1 86 32 85% 15% 13,868,878.31 $ 74,564
16.00% 205 13 94% @% 14J51,! 38tJ. 31 $ 71,981
17.00% 21 3 5 98% 2% 14,891,340.56 $ 69,912
CON Fl DENTAL PAGE 21 lWW! B
Illustration 4: Sorted by Roll per employee
N W Conbibutkn # # % % Ruff Roll
~ m e d E ~ e sEmp kyees Enoplqwm Emyrqve . Amdriuf Amount
&@ SC D3 DC es DB I; PrEnqo.
1 OOO! 16.000r6 142 76 65% 35% 7.197.564 $ 50.687
10096 15.00% ! B% 42% 6; 6? 8; 189 $ 52,584
100% 17.00% 78% 22% 9,144,869 $ 53,479
1009Q 14.00% 105 I13 48% ~ 2% 5,754,209 $ 54,802
1000%~ 130 40% 600' 5,233,052 $ 59,467
105% 77 69% 3596 8f? 18,' 765 $ 61,835
1050/ 0 114 48% ,587,993 $ 63,346
105% 14.00% 122 Q6 56% ,730,742 $ 63,366
100% 12.00% 75 143 34% 66% 4,876,776 $ 65,024
105% 16.00016 184 34 6496 re% t1,97St687 $ 65,085
105% 17.00% 209 9 96% 4% 14,092,861 $ 67,430
110% 17.0046 213 5 98% 2% 14,894,341 $ 69,912
105% 12.00% 81 137 37% 63% 5,743,822 $ 70,911
110% 14. m m 93 ~ 9 6 8% ~ ~ 7, s5o1 $ 71, mt
110% 13.00% 118 100 54% 46% 8,628,483 $ 73,123
110% 14.00% 146 72 6796 33% 1@ 76t, 084 $ 73,727
1100h 15.000' 1 86 32 85% 15% 13,868,878 $ 74,564
100% 11.0001CI 6.1 157 28gg ' 72eg 4,648,356 $ 76203
110% 12.00% 92 1 26 42% 58% 7,296,889 $ 79,314
lW% I t. 0046 67 151 31% 69% 5,497,298 $ 82,049
100% 10.00% 52 166 24% 76% 4,590,934 $ 88,287
110416 13.€ lU% 74 144 34% 66% 6,667,472 $ 90,9& 1
105% 10.00% 58 160 27% 73% 5,331,506 $ 91,923
110% 10.0056 62 156 28% 72% 6+ 120,974 $ W, f25
100% 9.00% 42 176 1 9% 81 % 4,548,487 $ 108,297
105% 9.00% & 173 21% 79% 5,053,422 $ 112298
11W 9. W! 49 169 22% 78% 5,827,059 $ 1 18,920
100414 8.0056 31 687 f 4% 86136 4,529,763 $ 146,221
105% 8.00% 33 185 15% 85% 5,027,084 $ 152,336
11046 8.00% 37 181 17% a, 5,799,468 $ t56,742 ,
For illustration purposes only
CONFlMNTlAL PAGE 22 lW538
Illustration 5: Sorted by total Roll Amount
100% 10.00% 52 la 24% 76% 4,590,934 jiSa31
100% 11.00% 61 157 28% 72% 4,648,356 $ 76,203
100% 12.00% 75 143 34% 66% 4, s7s, 776 $ 65,024
105% 8.00% 33 185 15% 85% 5,027,084 $ 1 52,336
10% 9. m 45 $ 73 21% ' 3996 s, m, AP $ tlZrn
1Wh 13.000h 88 130 40% 60% 5,233,052 $ 59,467
105% 10.00% 58 160 2m - n% 5,% 1,508 % 1,9~~
105% 11.00% 67 151 31 % 69% 5,497,298 $ 82,049
105% 12.00% 81 137 37% . 63% 5,743,822 $ 70,913
100% 14.00% 105 113 48% 52% 5,754,209 $ 54,802
11046 8.00% 37 t8t I?% 83% S1799,468 $ 13,742
110% 9.00% 49 169 22% 78% 5,827,059 $ 1 18,920
110% 10.00% 62 156 28% 7296- 6,12o1Bf1 $ 90,? 25
105% 13.0O0h 104 114 48Oh 52? h 6,587,993 $ 63,346
1? 096 tt. 4AIm6 74 f44 34% 60% 6,$ 67,4? 2 99Q, 101
100% 15.00% 127 91 58% 42% 6,678,189 $ 52,584
1Wh 16.00% $ 42 7ti %% 3596 7,197,564 650,682
110% 12.00% 92 1 26 42% 58% 7,296,889 $ 79,314
105% 14.00% 122 96 58% 44% t,' t3OI712 S&
110% 13.00% 118 100 54% 46% 8,628,483 $ 73,123
705% 15.00% 341 n 85% 35% 8,718.76~ w1, m
1 0O0h 17. Wh 171 47 78% 22% 9,144,869 $ 53,479
110% 14.00016 146 72 6796 3396 20,764,884 $ 73,727
105% 16.00% 1 84 34 84% 16% 11,975,687 $ 65,085
110% 15.00% 186 32 85% 15% $ 3,868,878 $ 74,564
105% 17.00% 209 9 96% 4% 14,092,861 $ 67,430
t10% 16.00% ZC6 t3 94% 6% 34,751,980 $ 71,961
110% 17. Wh 213 5 98% 2% 14,891,341 $ 69,912
For illustration purposes only
CONFIDENTIAL PAGE 23 1iQ5K
Illustration 6: Sorted by Number of the employees choosing DC
r NPf' # # % % Rd A m m Roll
Awrred Chd&& m E+ a En3pqw B~ njdqvees Emplows Amnint
, DC DB W DB Per Emp,
200s16 %. W% 31 181 14% 86% 4,529,763 $ 148,? 2?
105% 8.00% 33 185 15% 85% 5,027,084 $ 1 52,336
110% ~. 00% 37 281 17% 83% 5,799,468 $ 1 56,742
1 Wh 9.0056 42 1 76 19% 81 % 4,548,487 $ 1 08,297
105% 9.0094 45 273 2f % ? Wi 5,053, m Nt2,298
110% 9.00% 78% 5,827,059 $ 1 18,920
100136 10.0056 - 7; 696 4, so. m Ji8828J
105% 10.00% 73% 5,331,506 $ 91,923
10096 ll. M)% tll 157 28% 72% 4,648,356 V6B3
11 0% 10.00% 62 1 56 28% 72% 6,120,971 $ 98,725
' 105% ? f . Om a7 251 31% 69% 5.47- $ B2W9
100% 12.00% 75 143 34% 66% 4,876,776 $ 65,024
11096 1 1 . DO% 74 144 34% 6896- 6,667,472 $ so, dUl
105% 12. Wh 81 137 37% 63% 5,743,822 $ 70,911
lM)% 13~ 00% 88 130 4096.- 8696 ~,= 3, os;! .$ 59,467
110% 12.00% 92 1 26 42% 58% 7,296.889 $ 79,314
10096 14.0096 105 1? 3 40% 5296 5.7509 w, m -
105% 13.00% 104 114 48% 52% 6,587,993 $ 63,346
110% 13.00% 418 f 00 54% 46% 8,628,483 $ 73,123
105% 14.00% 1 ,712 $ 63,366
100% 15.00% f ,189 W. 584
100% 16.00% 1 42 76 65% 35% 7,197,564 $ 50,687
105% I 5.009b 141 77 65% 3596 8318, f65 $ 61,835
110% 1 4.0O0h 1 46 72 67% 33% 10,764,084 $ 73,727
1OOSg 17.0096 $ 71 47 78% 22% QA44,869 $ 53,479
105% 16.00% 184 34 84% 16% 11,975,687 $ 65,085
110% B 5.00% 9156 32 85% t5% 13, W4878 $ 74,564
110% 16.00% 205 13 94% 6% 14.751.980 $ 71 961
1B% 17.00% 209 9 96% 4% t 4 ~ ~ ; 8 6 1 $ 671130
110% 17.00% 21 3 5 98% 2% 14,891,341 $ 69,912
For illustration purposes only
CONFIDENTW PAGE 24 l( Y05/ 98
Illustration 7:
3.00% annual average salary increase
8.00% average annual earnings on assets deposited in a 401 ( a) Defined
Contribution accounts
8.00% contribution to the DC plan
$ 30,000 Starting Salary
Retire at age 60
New Employee Benefits Compared
8% Contribution to DC
20 25 30 35 40 45 50 55
Age Employee Begins
I
For illustration purposes only
Age Lump ,% mD C Pmcent Vested Lsrmp S~ rDnB Percent G7a~ eDd C
nc
i 20 995* 676.00 1We 893,915.00 1W!
25 638,366.00 1000! 674,711.00 1 W!
30 402,755.00 1WX 4! 4W. Or, lW/ o
35 248,2 15.00 1Wh 358,606.00 1WA
40 147,573.00 1000A 247,469.00 1W!
45 82.667.00 1000h 160,102.00 1000A
50 41,375.00 lW! 46,035. W 50%
55 15,612.00 1W/ o 9,927.00 25%
For illustration purposes onb
CONFIDENTIAL PAGE 25 1WWSB
Illustration 8:
3.00% annual average salary increase
8.00% average annual earnings on assets deposited in a 401 ( a) Defined
Contribution accounts
1 O. OOOh contribution to the DC plan
$ 30,000 Starting Salary
Retire at age 60
New Employee Benefits Compared
10Y0 Contribution to DC
Defined Benefi
20 25 30 35 40 45 50 55
Age Emjdoyee Begins
I
For illustration purposes only
Age Lump Sum LJC Pmenf Va- ted Lunp Sunz DB Percenf Vested 3X:
DC
20 1,244,595.00 1 W o 893,915.00 1Wo
25 797,958.00 1 W! 674,711.00 1Wh
30 503,444.00 1Wo 498,867.0 mO?'-/ o
35 3 10,269.00 1Wh 358,606.00 lW!
40 184,466.00 1W/ o 247,469.00 f000h
45 103,334.00 1 W ! 160,102.00 1Wh
50 51,718.00 100% %, Q35.00 50%
55 19,515.00 1W/ o 9,927.00 25%
For illustration purposes only
CONFlDENTlAL PAGE 26 lQIoy98
3.00% annual average salary increase
8.00% average annual earnings on assets deposited in a 401 ( a) Defined
Contribution accounts
1 2.00°/ b contribution to the DC plan
$ 30,000 Starting Salary
Retire at age 60
pp - -
New Employee Benefits Compared
12% Contribution to DC
20 25 30 35 40 45 50 55
Age Ehqioyee Begins
For illustration purposes only
Age Lump Sum DC Percent Vested DC Lump , Ytim DB Percent Vestetf LX
20 1,493,515.00 1W/ o 893,915.00 10%
25 957,549.00 1000/ 0 674,711.00 1W/ o
30 604,133.00 1000%~ 4! 2& 867.00 100? 4.
35 372,323.00 1 W/ o 358,606.00 1 W !
40 221,360.00 1W/ o 243,469.00 1W/ o
45 124,001.00 1 W/ o 160,102.00 1W/ o
51, 62,662.00 1W? 46,03 5.00 W e
55 23,418.00 100% 9.927.00 25%
For illustration purposes only
CONFIDENTIAL PAGE 27 lWEf98
TO:
FROM:
RE:
ARIZONA LEGISLATrVE COUNCIL
MEMO
December 16,1998
Senator George Cunningham
Ken Behringer, General Counsel
Defined Contribution Plans; Effect of Proposition 100
QUESTION
Is a defined contribution plan for public employees allowable under the Arizona Constitution
as amended by Proposition 1 OO?
ANSWER
The Legislature may be prohibited from using a defined contribution plan as part of a public
retirement system.
DISCUSSION
At the 1998 general election, the Arizona voters approved Proposition 100 that added article
XXIX to the Arizona Constitution ( article XXIX) to provide certain protections for public retirement
systems. Article XXTX, section 1, subsection A provides:
Public retirement systems shall be funded with contributions and investment earnings
using actuarid methods and assumptions that are consistent with generally accepted
actuarial standards.
A defined contribution system does not use actuarial methods and assumptions in
determining its fimding levels. The very nature of this system is that contributions are defined and
set, they do not vary based on earnings or liabilities of the retirement fund.
It could be argued that this provision means that, if a defined benefit plan is used, that
generally accepted actuarial standards must be applied. However, the plain language of the
subsection is not limited in this manner. It requires that fbnding be determined using accepted
actuarial methods and assumptions. Since a defined contribution plan does not use these methods
and assumptions, it appears that this type of plan cannot be used for a public retirement system.
In a quick review of other state constitutions, I have not found a similar provision, nor have
I found any court cases looking at any similar issue. I will continue looking and let you know if I
do find anything.
CONCLUSION
Constitution of Arizona article XXIX, as added by Proposition 100, probably prohibits the
Legislature from using a defined contribution plan for a public retirement system.
cc: Debbie Johnston
ARIZONA STATE LEGISLATURE
Forty- third Legislature - Second Regular Session
JOINT LEGISLATIVE STUDY COMMITTEE
ON DEFINED CONTRIBUTION OPTION
Minutes of the Meeting
Friday, November 13,1998
Senate Hearing Room 3
Cochair Bundgaard called the meeting to order at 2: 00 p. m. and roll was taken.
Members Present
Senator Scott Bundgaard, Cochair Representative Michael Gardner, Cochair
Senator George Cunningham Representative David Armstead
Senator Tom Patterson Representative Wes Marsh
Staff
Debbie Johnston, Senate Research Analyst Tami Stowe, House Research Analyst
Speakers Present
Ray Rottas, Chairman, Legislative Committee, ASRS Board
Michael Carter, Actuary, Watson Wyatt
Barry Aarons, Americans for Tax Reform
Scott Baker, Regional Vice President Government Conversion Programs
Jack Cross, Administrator, PSPRS, CORP, EORP
Scott Simmons, Correction Officer, representing Fraternal Order of Police
Tim Hill, Executive Vice President, Professional Firefighters Association
Guest List ( Attachment A)
Senator Bundgaard announced that he would hear Agenda Item # 3 first.
PRESENTATION BY ARIZONA STATE RETIREMENT SYSTEM ( ASRS) BOARD
Ray Rottas, Chairman, Legislative Committee, ASRS Board, thanked the Committee
for the opportunity to speak on this important issue. He said there are 270,000 members
who belong to the ASRS, 55,000 of whom are retired and 45,000 of whom are non- active
or people who have moved on but left their money in the system and who will collect a
portion when they retire at age 65. Mr. Rottas said he hopes to supply information to the
Committee on which it could base its decision. He noted the Committee is dealing with a
large number of people, and cautioned it to " tread softly through this issue" as many
retirees are concerned about their future and react quickly. Mr. Rottas stated that Michael
Joint Legislative Study Committee on
Defined Contribution Option
Carter will cover the report the Committee had received yesterday ( Copy was not
distributed to the staff and is not attached.)
Michael Carter, Actuary, Watson Wyatt, stated his pleasure at the opportunity to present
the report to the Committee, which he noted is an imposing document. Mr. Carter noted
that currently there is no alternative plan to the State's defined benefit plan. He said
Watson Wyatt has studied three alternative defined contribution plans and the impact of
each on the defined benefit plan, the State and the employees.
Mr. Carter called the Committee's attention to page 23 of the report and described the
contribution pattern that will be followed throughout the discussion. He explained that
Scenario 2 - an Alternative Defined Contribution Plan is structured to have an employer
contribution rate of 4%, and the employee rate will be employer rate plus what the
employer would be putting into the continuation of a health supplement plan. Arizona's
defined benefit plans have supplemental health plans that help pay for the retiree's medical
care as well as a long- term disability plan that is separate from the defined benefits plan
but also administered by ASRS. Mr. Carter stated that the assumption is that the retirees
will not be precluded from having a health supplement, therefore that amount is included
in the defined contribution proposal, and it is also assumed that they will still be covered
by a long- term disability plan. He noted that the current cost for the long- term disability is
.49% of pay from employees and employers. The cost of the health plan is 1.25% for the
employer.
Mr. Carter stated Scenario 3, which is modeled on page 24, assumes that the total cost for
the employer would be no greater than it is in FY1999. The State is currently contributing
3.34% of pay to the retirement plan and the long- term disability plan. In the example Mr
Carter described, 1.60% of pay is paid for retirement, 1.25% for the health supplement and
.49% for the long- term disability.
Mr. Carter described Scenario 3 as a low- cost option, Scenario 2 as a mid- cost option and
Scenario 4 as a high- cost option. Referring to page 25, Mr. Carter explained that Scenario
4 includes only a few employees in higher education and the " grandfathered system" for
which the obligation is a total of 7% of pay.
Mr. Carter said the purpose of the analysis was to determine the impact under any of these
plans which are assumed to be an alternative to the defined benefit plan, and the
employees will have a choice to remain with the defined benefit plan or go to the defined
contribution plan. Mr. Carter discussed the election rates between various age groups
noting it is assumed that the older employees would stay in the defined benefits plan, and
the younger new hires would go into the defined contribution plan.
Mr. Carter explained the only concern is if there is a reduction in the influx of new members
into the defined benefit plans that would have a detrimental effect on the defined
contribution plan. He directed the attention of the Committee to page 94 and explained the
Joint Legislative Study Committee on
Defined Contribution Option
basis for the analysis focuses on asset allocation and how that could be affected. The
costs of the defined benefit plans have been going down, and currently the State is
contributing 2.85% to the defined plan along with the 1.25% for the supplemental health
care plan and the .49% for long- term disability. To measure the detrimental effect on asset
allocation the difference between the contribution or net external cash flow and the benefits
paid out is calculated. As contribution rates decline, the dollar amount also declines, while
benefits increase and a negative external cash flow results. Mr Carter suggested that as
long as the negative cash flow is not above 5% of assets there is not an asset allocation
problem. The retirement system can generate interest and dividends.
Senator Bundgaard asked if Mr. Carter was referring to asset allocation as an investment
strategy. He wondered if the retirement system would be able to pay all the benefits if
everyone suddenly demanded their money. Mr. Carter clarified that if the difference
between the contribution inflow and the benefit outflow exceeded 5% of the assets, the
retirement system might need to change the assets from equities into fixed income interest-bearing
securities that would be available to the net cash flow requirements.
Mr. Carter said that Scenario 1 is the existing defined benefits plan, and over the next 25
years he does not see a problem with cash allocation. If Scenario 2 is chosen, there will
be fewer dollars flowing into the defined benefit plan.
Senator Bundgaard asked why Mr. Carter assumed that new employees would not join the
defined benefit plan. Mr. Carter said the defined contribution plan builds value to an
employee much faster than a defined benefit plan, and if an employee does not see
himself as a long- term employee, he will likely choose the defined contribution plan. Mr.
Carter gave examples of possible new employees and which program they might consider.
Representative Gardner asked what ratio was used for models 1, 2, 3 and 4 in the
presentation. Mr. Carter referred the Committee to page 26 and said that if existing
employees were within five years of being able to retire, and have fifteen years of service,
they would keep the defined benefit plan. Under age 40, Mr. Carter felt that 95% of the
employees would choose the defined contribution plan under Scenario 2. He stated that
under Scenario 3 it was assumed that more employees would elect to stay since it has a
lower contribution rate. Scenario 4 has a higher contribution rate and more employees
would enter the contribution plan.
Representative Gardner asked for the overall assumption from which the percentages on
page 94 were obtained. Mr. Carter said that the 1997 data was available for the model and
they entered the number of retirements and deaths based on current actuarial assumptions
taken from the actual experience of the State. It was assumed the total workforce would
grow at the average rate of 1% per year over 25 years. The percentages of new people
coming into the system were then fed into the computer and a model was obtained. Those
percentages are indicated on pages 26, 27 and 28.
Joint Legislative Study Committee on
Defined Contribution Option
Representative Gardner said there are an extraordinary amount of assumptions built into
that model. Mr. Carter explained the assumptions, and stated that one in particular should
be noted. The assumption is that there would be no aging of the group of new hires, but
that demographics show that there will be fewer employees age 25 to 35 in the work force
in ten years. If the election rates are geared to age and the group is older, they will be
more likely to go into the defined benefit plan. He said he believed the analysis to be a
conservative one.
Representative Gardner said he saw it the opposite way, and that there would be older
people coming into the work force and the defined benefit plan would be stronger than
reflected in the analysis.
Senator Patterson stated he had a problem with the issue of asset allocation, and said it
makes no sense to say that a portfolio that is25% to 35% invested in fixed securities which
experiences a rise from 5% to 8% in the amount of payout, would then experience an
inadequate cash flow, and stated that Mr. Carter is presenting an extreme situation.
Mr. Carter said that cash influx items are coupons or interest payments on fixed income
and dividends on stock and allocations to cash, i. e., 30 day bills. He said in an extreme
situation one could sell securities. He said that if the system must generate more cash to
meet benefit payments there is a limited amount of dividend income, which leaves selling
securities, using fixed income interest or changing the allocation to cash. For the proper
management of the plan, cash holdings or fixed income holdings should be increased. The
system may have to move from 35% fixed income to 40% or more fixed income. Over the
long- term, the fund will have a higher expected return with a higher allocation to equity- type
investments.
Senator Patterson said he did not believe that the system managers would not maintain
the system and the ratios of securities within the account. He took issue with Mr. Carter's
answer about why a 30- year old would choose a defined contribution plan and said he
believed that the long- term arrangement with its multiples of rate- of- return would have a
greater payout upon retirement and that even a 30- year old would consider that.
Mr. Carter responded that, when talking about a stand- alone defined contribution plan
versus a defined benefit plan, if the defined contribution plan averaged 15% over the years,
it would be true that the defined benefit plan would have also earned that much, and
probably would have earned more because of the management fees for a defined
contribution plan. Mr. Carter said that has happened with the current retirement plan and
the cost is only 2.8%. When the 1998 valuation is presented, a further decline will be seen,
and in the last asset liability model the cost is zero for this plan. The Legislature has a
choice to increase benefits, or enjoy the good fortunes of a zero contribution rate.
Joint Legislative Study Committee on
Defined Contribution Option
Senator Patterson said that his point is that the 30- year old would be better off choosing
the defined contribution plan throughout his life and that the quick turn- around on profit is
not the only reason he would choose that plan.
Representative Armstead stated the 30- year old segment will most likely be turning over
faster than the 40- year old segment. He said employment statistics agree with what Mr.
Carter said and that many employers deal with that daily.
Mr. Carter stated that the defined benefit plan will need to have more assets going to cash
flow under the option of having both defined benefit and defined contributions plans. The
actual return will diminish and when the difference is severe enough, an asset allocation
change will have to be considered.
Senator Bundgaard asked if there is something which shows the effect that a lesser return
on assets will have on a defined benefits plan. Mr. Carter replied there is not because it
will not have an effect. Senator Bundgaard referred to page 4, indicating a possibility of
not having cash on hand to pay employees who withdraw their retirement benefits, and
queried if that would not effect retirement. Mr. Carter confirmed that it only effected the
cost of the defined benefit plan.
Senator Cunningham asked who bears the cost in that instance. Mr. Carter responded
that under the current structure both employees and employers will bear the cost. If there
is a decline in investment returns then the cost to the employer and employee over the
years will increase, but the benefit will remain untouched. Senator Cunningham clarified
that by cost Mr. Carter meant the amount of contribution on both the employer's and
employee's part.
Mr. Carter referred to page 95 of the report and stated if an alternative program is created,
the cost of the defined benefit plan will drop, and the benefit plan will lose more liabilities
than it will transfer assets. The employees transferring to the contribution plan will take
their assets but will not take the percentage by which the benefit plan is overfunded.
Mr. Carter said that if and when a dual system is created, the existing employees will have
an option to stay in the benefit plan or move to the contribution plan during the first year.
When they move to the contribution plan, the retirement benefit value is transferred with
them. The liabilities that will be moved will be greater than the assets that will be moved.
Senator Patterson said that should be a decision of the Legislature when they create the
plan. Mr. Carter agreed, and stated that one bill in the 1998 Legislature anticipated an
election by the current employees with a movement of assets from those employees.
Representative Gardner clarified that the liability is greater than the asset. Mr. Carter said
initially it is, and the contribution rate for the defined benefit plan will be lower than the
current status quo rate. Eventually, if the allocation rate becomes enough of an issue, the
Joint Legislative Study Committee on
Defined Contribution Option
ability of the fund to return the assumption rate is impaired, and will go down 1%. Mr.
Carter explained that once that begins happening, the contribution rate to the plan will
increase as shown. The contribution rates between the current plan and Scenario 4 are
almost identical and it is not until the later years that there will be a greater cost. In terms
of money, the amount is going to be less because you have fewer people in the system.
He asked the Committee to turn to page 99 and stated that the defined benefit plan costs
would gravitate upward and level out at 5% to 5.6%. Mr. Carter stated that in Scenarios
2 and 4, there would be a higher cost to the employer while Scenario 3 would cost less.
Senator Cunningham referred to page 98 and asked if the figures were the sums of the
costs of the defined benefit and defined contribution plans to the employer. Mr. Carter
verified they are and also include the long- term disability benefit and the health
supplement. Senator Cunningham clarified that Scenario 3 is the least costly to the
employer.
Representative Gardner stated that the difference between Scenario 1 and Scenario 3 is
$ 100 million, and asked if the reinvestment of that money is included in the model. Mr.
Carter said it is presumed the money would be budgeted somewhere else within the
employer's budget.
Mr. Carter said the next step was the implication for the employee. Four hypothetical ages
for hire were considered with 3 employees within each age category. He said the average
age of State employment in Arizona is 35. He added that three levels of employee
performance had been modeled. The lower performers were given an assumed raise of
2% throughout their career, the average performers averaged 4% and the high performers
would average 6% increases. Mr. Carter explained the chart on page 55, and stated the
low performers demonstrated on the chart would be better off in a defined contribution
plan. He called attention to the fact that in the early years of employment the defined
contribution plan options exceed the value of the early years of the defined benefit plan.
Senator Patterson asked how to translate the benefit into a lump sum. Mr. Carter replied
a 2Oh multiplier is used times the salary growth times the years of service for a benefit to
be paid at retirement. He said an actuarial figure is applied to the current age. He said the
idea is similar to a single premium deferred annuity insurance policy.
Mr. Carter referred the Committee to page 62, and said for the average performer the long-term
benefit is greater under the defined benefit plan. For the high performer, Mr. Carter
said that a traditional defined benefit plan will pay out better over the long- term.
Tape 1, Side B
Mr. Carter explained the connection between the long- term disability program and the
retirement system, noting that ASRS pays disability until the person retires.
Joint Legislative Study Committee on
Defined Contribution Option
Mr. Carter stated that currently in a defined contribution plan a retiring employee would
take either a lump sum or a roll over, and he suggested that the Committee draft legislation
for a supplemental health plan if the person is taking a lump sum or roll over. He also said
that if the contribution rates are closely related, he would suggest putting a floor on a
defined contribution rate from both the employer and employee. He reiterated that
Scenarios 2 and 4 would cost the employer money. He said the Committee should assess
what level of benefit it wants to provide. Mr. Carter mentioned the excess- earning cost- of-living
adjustment ( COLA) and said that would be harder to maintain if the numbers are
reduced entering the defined benefit plan. If there is a concern for portability, a cash
balance overlay can be built into the plan.
Mr. Carter mentioned page 90, and said the public sector has a disadvantage in that it
cannot set up a new 401 K like the private sector can. Therefore, if the plan is to be tax-sheltered,
a choice cannot be given to the employee as to the rate he contributes. The
employee must be locked into a rate when he comes into the plan. Responding to Senator
Bundgaard, he said the tax code says the rate must be specified and they must contribute
it in order to be tax- sheltered. He thought the Legislature could develop a choice which
would be an irrevocable selection.
He added that some defined contribution plan options could end up costing the employer
more in the long run.
Representative Armstead thanked Mr. Carter for his presentation and said Mr. Carter had
clarified the subject matter for the Committee.
PUBLIC COMMENTS
Scott Baker, Vice President for Regional Benefit Plan Conversions, Great West
Benefits Corporation, said he will address the procedural issues, the first of which is the
pre- tax contributions made by employees. If the Legislature chooses to have the
contributory pension system, any contribution made by an employee with pre- tax treatment
must be mandatory and irrevocable for every employee under that plan. The employees
cannot discriminate and can have only one pick- up contribution. He suggested there
could be a formula similar to that which currently exists.
Mr. Baker said he believes in defined contribution plans, although they are not right for
every employee and employees should be given the choice. He claimed that defined
benefit plans could " hurt" an employee far more than a defined contribution plan. He said
most employers feel they can supply more benefits at lower costs. Mr. Baker attested the
Legislature's challenge is to construct a plan which will supply more benefits at a lower
cost.
Mr. Baker said the mean tenure of a local government worker is 9.3 years, for a man it is
5.1 years and for a women3 is 3.8 years. Most government plans have a 10 year vesting,
Joint Legislative Study Committee on
Defined Contribution Option
which means that most government employees never receive benefits from a defined
benefit plan because they do not stay long enough to vest. Mr. Baker claimed that fewer
than 25% of the employees reach 20 years of service. He noted that more than 75% of
the employees receive less than 40% of their compensation according to national statistics.
Mr. Baker also commented that during their lifetime, most people will change jobs seven
times and do not benefit when a defined benefit plan is the only option.
Mr. Baker distributed " Defined Benefit vs Defined Contribution- Considering Your Options"
( Attachment B) and referred to the graph on page 7 which illustrates the assumptions for
the comparison in a defined contribution plan as explained below that chart. Mr. Baker said
any employee who leaves service prior to his normal retirement date is penalized by the
defined benefit plan. Older, long- term employees that work beyond their retirement date
will also benefit from a contribution plan. He claimed that 75% of employees get a reduced
benefit under the defined benefits plan, and only 25% of employees receive an adequate
retirement. He referred to the chart on page 8, and stated the lower white area represents
an employee that left service once in his carrier after 15 years and illustrates that a defined
contribution plan would be the better benefit.
Mr. Baker cautioned that the Legislature must consider portability if a defined contribution
plan is offered. He stressed that portability is an important consideration. He also noted
the risk of investment and the responsibility for the investment shifts to the employee. Mr.
Baker said he advocated a voluntary change from a defined benefit to a defined
contribution plan, and that the State must provide adequate information and time for the
employees to make the decision. The risk lies in the fact that they may make the wrong
decision.
Senator Patterson stated the Committee was working from two different models since it did
not have a specific option to discuss. He said Mr. Baker's comments are the opposite of
most plans to which he had been introduced, and that a beneficiary packet of information
was given to the employees with certain options for qualified investments worthy of a
pension plan as well as instructions on how to choose the options. Senator Patterson said
most companies do not necessarily rely on the educational process.
Mr. Scott replied the education is not about specific investment options. If the employee
is supplied that, he will not understand the benefits as compared to a defined benefit plan.
He said the employees must be educated as to what the plans are in order to make an
intelligent decision.
Representative Armstead stated his experience has been with medical insurance plans,
but said Mr. Scott's point was well- taken. A change in carriers had been made at
Representative Armstead's place of employment; the company had taken the time and
spent the money to educate the employees on the benefits. He said the results were that
people understood what their benefits were and used them more effectively.
Joint Legislative Study Committee on
Defined Contribution Option
Mr. Scott stated that if employees were allowed to make voluntary decisions and the
employer expected a certain percentage to move to the new plan, but the employees were
not provided with adequate information, the company would not reach the expected
percentage. He used the State of Michigan as an example where 10% of employees
elected to go into a defined contribution plan while 25% had been expected to change. He
noted several reasons for that, but the main reason was inadequate communication about
the prospects of the plan. He said it is a real challenge to provide proper information.
Mr. Scott said he felt that the defined contribution plan is still the best way to go, and that
it provides a win- win situation because of predictable fixed funding costs. There are also
lower actuarial costs, as one is not needed for a contribution plan, and if an employee has
questions, he calls the plan administrator. Mr. Scott said there is also less record keeping
because the State's costs cease when the employee leaves. It further eliminates the
potential of an under- funded plan. He noted the contribution rate is locked in, and there
is one source for record keeping, investment management, and employee aid. Mr. Scott
said it is good for the employee because he has control over his investments, and there
is immediate vesting. He noted that portability was the major benefit, but there are also
better survivor benefits; the employee can leave at any age, and the assets continue to
grow after he leaves service. He mentioned that in some cases there is loan capability.
Senator Cunningham referred to Mr. Carter's presentation, and said that Mr. Scott's
underlying premise of more benefits with less cost contradicted Mr. Carter. He said he felt
that the Legislature would require more education before offering such a plan to its
employees. He said there is disagreement between the two presentations over policy and
the projections. Senator Cunningham said the differences between the two must be
reconciled and that the Committee should approach the situation slowly.
Senator Patterson said he did not feel there was contradiction between the two
presentations. Mr. Carter's Scenario 2 would cost only marginally more than the current
plan and in the course of seven years, would actually cost less. He felt that each had
presented a plan which would be more beneficial than the current defined benefit plan. He
said the defined contribution plans out- perform the defined benefit plan overall. Senator
Patterson thought that for the same amount of money there would be better benefits even
with Mr. Carter's possibility of the allocation rate becoming an issue in the benefit plan.
Senator Cunningham said his perception was that it is not uniformly beneficial to members.
When high performers are hired at age 40 or better, the defined benefit plan may be
preferable, especially in the later years. He stated that proves the point that one cannot
make the uniformly applicable statement that the defined contribution plans are going to
provide more benefits across the board. Senator Cunningham said it is important the
Committee knows what it is offering and what the implications are before it is presented to
the employees.
Joint Legislative Study Committee on
Defined Contribution Option
Jack Cross, Administrator, Public Safety Personnel Retirement System ( PSPRS),
Correction Officials Retirement Plan ( CORP), Elected Officials Retirement Plan
( EORP), commented on the discussion of the cost savings of a defined contribution plan.
Mr. Cross said it depends on whether the most savings are in administrative costs, what
the investment cost savings are and how the plan is managed. If employees were to
choose a mutual fund, the costs would rise for the employee, but go down for the
employer. Mr. Cross noted that in the PSPRS all of the administrative plan costs total 3
basis points. He said for the existing deferred compensation plan, depending on the
mutual fund chosen, the costs can be between 140 and 282 basis points. Mr. Cross said
the State's investment performance is better than 90% of the funds offered by the deferred
compensation program. He said the statement by Mr. Baker that the employer costs would
drop is true, but it is shifted to the employee.
Mr. Cross said that portability is a problem. In the PSPRS he said there is not much of an
issue with portability, as those people stay in their chosen career for life. In an effort to
reduce turnover, portability and vesting are definite considerations, especially in light of the
money spent to train people.
Senator Bundgaard asked what shortening the vesting periods would do to the returns on
the funds. Mr. Cross said if the vesting period is shortened and money is paid to people
that have not previously been paid, the contribution rates would rise.
Senator Patterson asked why a fund manager would charge three basis points for a
defined benefit plan and up to 282 points for a defined contribution plan. He said he
thought if the plans were the same size, it would not matter where the money came from.
Mr. Cross replied the difference is that he is the fund manager for the three funds and does
not receive the salary a Wall Street Manager does. He commented that they are often paid
$ 1 million per year, and that marketing costs, operating costs and profit are factored into
the cost of administering the plan.
Senator Patterson said that Mr. Cross is assuming that there will be some changes in the
fund management, and that is not necessarily the case. Mr. Cross agreed that if the
change is made to a plan similar to the deferred compensation program where the
employee chooses the mutual fund, then there would be an increase in cost. If the plan
is administered as it currently is, there would be no increase.
Mr. Cross noted the other concern was that of liability. He stated that the three plans he
manages have been able to do better than predicted every year. He added that the
managers are very conservative about investments and how they do the funding, and also
all the earnings are not recognized every year. If the earnings were recognized in the
actuarial valuations the plans would be up to 150% funded.
Joint Legislative Study Committee on
Defined Contribution Option
To assuage concern about what happens during " bad times," Mr. Cross said the plans are
all well- managed, the managers are very conservative about where the money is placed
and should be encouraged to be more conservative, and he agreed that perhaps a floor
should be put on the contribution rate for the members and employers. He commented
that if all the assets were recognized, the CORP and EORP rates would be at zero now.
Scott Simmons, Correction Officer, Pima County, representing the Fraternal Order
of Police ( FOP), stated the view of the FOP is that it is against employees of the courts
and public safety going into a defined contribution plan. He stated the members can see
the benefits for other groups such as the elected officials because of the term limits. He
stated the members feel it would pull too much out of the system, and with the aging
population there would be fewer members coming in to contribute to the system.
PRESENTATION ON DEFINED CONTRIBUTION OPTION - AMERICANS FOR TAX
REFORM
Barry Aarons, representing Americans for Tax Reform, said he had heard very
qualified presentations from both Mr. Carter and Mr. Baker, and he would not go into
actuarial assumptions. He said there will be a future time for discussing those
assumptions. Mr. Aarons reminded the Committee that the Americans for Tax Reform had
brought Peter Ferrara to testitj about defined contributions before the Senate Finance
Committee, and he wanted to bring out a few points from that testimony. Mr. Aarons stated
there is a weakness in the defined benefits system regarding portability, which is a
nationwide problem. He said a particular Arizona problem is the term limits of elected
officials where a group of legislators are forced to retire and they will have little to show for
their time in office. The EORP is a good place to begin a defined contributions system.
Mr. Aarons said the benefit may not apply to judges, who once appointed stay in office.
He said he thought the issue of portability is very important due to the mobility of workers
in society today. He mentioned that in the 1950' s and 1960' s people changed jobs only
three to four times in a lifetime, but today the rate of career change is 7.5 times. Therefore,
many employees will reach retirement age and not have a lot to show for it. If an employee
chooses a defined contribution plan and can roll over into another defined contribution plan
or another type of federally approved plan, then he can change jobs many times without
losing his retirement benefits.
Using himself as an example, Mr. Aarons related his recent work history, and said that had
he not been able to contribute to a defined contribution plan, he would have saved very
little for his retirement. While the balance in his plan was not as much as it would have
been under a defined benefit plan, he still maintained a significant balance toward his
retirement.
Mr. Aarons stated that recent statistics show that 70% of all California state workers would
get only 40% of their benefits, and that is also true in some other states. He related some
experiences that had occurred in the state of Michigan when it turned to a defined
Joint Legislative Study Committee on
Defined Contribution Option
contribution system. He noted 42% of government workers in Oakland County, Michigan,
chose to go into the new plan and took less than 37% of the assets from the defined
benefit plan, which also continued to grow throughout the conversion. In Palm Beach,
Florida, 63% of workers took a defined contribution plan and took only 14% of the assets
of the defined benefit plan with them. He said when the Committee arrives at a set of
numbers reflecting those who will move from a defined benefit plan to a defined
contribution plan, it should make any move that it finds " appropriate and comfortable"
toward a defined contribution option.
PUBLIC COMMENT
Tim Hill, Executive Vice President, Professional Firefighters, stated that the members
of PSPRP are concerned with any move toward a defined contribution plan. He stated a
lot of members, when making career decisions, look at the public safety and compare it
with the long years as well as the good benefits that currently exist in the defined benefit
program. They realize that when they reach a certain age, or if they become disabled,
there are benefits for their families. This is an attractive recruiting tool for the firefighters
to keep people in the profession. He said for the firefighters it was as much a safety issue
as a benefit because of the money that is spent in training firefighters. There is an
additional cost if that firefighter is trained an a paramedic.
Mr. Hill said the members are enjoying low contribution rates and the employers are able
to benefit from low costs. Mr. Hill stated that the PSPRP members are assured a benefit
for their families if they are disabled or killed in the line of duty. Under a defined
contribution plan, the family will get only the amount that has been paid in plus the interest
paid to that point. There is no long- term disability program. Mr. Hill said the firefighters
were in support of the portability concept, although those in that line of duty did not move
around as much as those in other occupations. He also said that a defined contribution
was fine for someone who started young and worked till retirement. However, the
firefighters do not want someone fighting a fire along side them at the age of 65 because
it affects both the firefighters' and the public's safety. He mentioned smaller departments,
i. e., Bisbee, would be extremely harmed if an employee left service and took his defined
contribution payment with him and that department had to invest more money in training
a new firefighter.
Senator Patterson questioned whether Mr. Hill thought more rapid vesting is a good idea.
He stated that Mr. Hill had presented a lot of arguments against a defined contribution plan
for public safety personnel. He did not understand the harm in offering them an option.
Senator Patterson said no options will be taken away from, but more will be offered.
Mr. Hill stated that he is not anti- defined contribution plans, but is trying to express
concerns which should be considered regarding adoption of such a plan.
Tape 2, Side A
Joint Legislative Study Committee on
Defined Contribution Option
Mr. Hill said as long as the education about the plans was thorough and complete on both
sides, i. e., the benefits of a defined benefit plan versus the benefits of a defined
contribution plan, and the ramifications of both, then he would agree to offering the options.
He said that young people are not interested in building a home or having a family, and are
often tempted to take the money from the plan and spend it unwisely. Also the earnings
on something such as a 457 plan are limited by the federal government, so one does not
reach his goal as well under a defined contribution plan.
Senator Bundgaard asked for clarification on the disability system offered the firefighters.
Mr. Hill said if the firefighter is totally disabled in the line of duty, he receives a disability
pension which is approximately that of retiring with 25 years of service and receiving a full
pension. If he is killed, the family receives a full survivor's pension. In the defined
contribution plan, there is no such provision and the family receives only the amount that
has been put into the plan and the interest gained to that point. Under the defined benefit
plan, there is a clause which tells the family exactly what it will receive, while under the
defined contribution plan there is nothing to let them know what they will receive.
Senator Bundgaard said it seemed to him that a defined contribution plan, such as in
Scenario 4, would have been better in both the short- term and long- term. Mr. Hill
responded that the assumptions were based on a 7% contribution, and that no employer
is paying 7%. He asked Mr. Cross to clarify the matter.
Mr. Cross said the answer is that if the firefighter were killed with only three years of
service he might have only $ 10,000 in his account, but under the current defined benefit
plan, the family would receive half of his pay for the rest of their lives. The analysis does
not look at the public safety program.
Senator Patterson said that is the reason for life insurance being purchased in defined
contribution plans.
There being no further business the meeting was adjourned at 4: 30 p. m.
Respectfully submitted,
~ ar'enN euberg 1
Committee Secretary
\
( Attachments and tape on file in the Secretary of the Senate's Office)
Joint Legislative Study Committee on
Defined Contribution Option
Hearing Room No. - L -
Date: , I y.' / ' C C 3
Time: - . .. - 2 -
MEETING OF COMMITTEE ON
ARIZONA STATE LEGISLATURE
Forty- third Legislature - Second Regular Session
JOINT LEGISLATIVE STUDY COMMITTEE
ON DEFINED CONTRIBUTION OPTION
Minutes of the Meeting
Wednesday, December 16,1998
Senate Hearing Room 2
Cochair Bundgaard called the meeting to order at 2: 16 p. m. and roll was taken.
Members Present
Senator Scott Bundgaard, Cochair Representative Michael Gardner, Cochair
Senator George Cunningham Representative David Armstead
Senator Tom Patterson Representative Wes Marsh
Staff
Debbie Johnston, Senate Research Analyst Tami Stowe, House Research Analyst
Speakers Present
Leroy Gilbertson, Director, Arizona State Retirement System
Discussion and Recommendations
Senator Bundgaard said the Committee has considered some recommendations for
Legislation next year, which will be discussed and voted on.
Senator Cunningham stated he asked Legislative Council what the effect of Proposition
100 is, assuming the passage of Proposition 100 and a defined contribution option is
enabled. He said the conclusion of Ken Behringer, General Counsel, Legislative Council,
( Attachment A) is that a defined contribution plan is not allowed with the language in the
Constitution regarding Proposition 100 because of the provisions relating to actuarial
standards. Senator Cunningham said he wondered if the Committee wants to seek further
clarification from the Attorney General.
Senator Bundgaard said he was just made aware of the problem regarding the proposed
bill and how it relates to Proposition 100. He agreed that once a bill is compiled a legal
opinion may be worthwhile. However, he stated he would prefer to continue with a defined
contribution option plan, and if necessary, allow it to be tested in the courts.
Senator Cunningham requested that the Legislative Council's opinion be included in the
Committee's report.
Joint Legislative Study Committee on
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1211 6/ 98
Senator Patterson stated he thought characterizing this as a Legislative Committee being
in defiance of the Constitution is somewhat extreme. He said Legislative Council is
" hooded in its approach and only points out problems. He said the intent of the provision
is that generally accepted actuarial standards should be used, not other standards, and
not that the program should be restricted to plans that have investment earnings based on
actuarial standards. Senator Patterson said the Committee is not in defiance of the
Constitution and is certainly not bound by an opinion of the Legislative Council.
Representative Annstead said he had just read the proposal entertained by the Committee
in reference to a bill. He asked if the Committee has been able to determine the effect on
the existing plan. He said he thought that had not been discussed in its entirety at the last
meeting. He asked if the causeleffect relationship is a part of the bill the Committee will
recommend. He suggested that should be submitted to the Legislature~ imultaneously.
" /"--- +- -
Representative Gardner stated the proposal has a long way to go and the purpose of
today's meeting is to make recommendations and stated thatxthinks this type of plan has
merit within certain parameters. Representative Gardner felt a lot of those challenges will
have been worked out before the Legislature votes on the legislation. He said he thought
the Committee had investigated the causeleffect relationship thoroughly, and that the plan
has opportunities for the employees from which they should not be deprived.
Representative Armstead said he thought the Committee should come up with a defined
contribution option package which includes all the relevant data. He reminded the
Committee that there will probably be only one committee hearing during session on the
subject. He said it is a very complex issue and would bring questions such as Senator
Cunningham has raised. Representative Armstead suggested study sessions for the
legislators. The package should be provided to each and every legislator so that
information will be in front of him when the bill is heard. He mentioned an acquaintance
had made nothing on his defined contribution plan the prior year. Representative
Armstead asked that person about the counseling or informational programs offered
through his company, and was told there were none. He stated the Committee should use
that as a warning signal and make sure the information is in place for everyone to assess.
Senator Bundgaard stated he felt the presentation by Watson Wyatt at the last meeting
had given an accurate picture of the system with several " worst case scenarios." He said
the object of this Committee is give employees the choice of which type of system they
want to belong to. He noted that there is greater benefit for some employees to stay in a
defined benefit program, but for others there is benefit in the defined contribution. He said
he would like to investigate Proposition 100 further, but felt the memo from Legislative
Council only pointed out a possible problem. He said he wanted to continue deliberations
on the defined contribution option and begin drafting a bill.
Senator Cunningham reminded the Committee that high performing employees will benefit
most from the defined benefit plan, while low performing employees will benefit most from
Joint Legislative Study Committee on
Defined Contribution Option
1211 6/ 98
the defined contribution plan. He said he did not know if that was the way the State
wanted to go, and wondered if a choice should be offered.
Representative Armstead said that is an important point. He said if something is to be
done for employees it must be equal to all employees. He stated there is always a
question of legal vulnerability to discrimination. The program may not be designed for the
lower achieving employees. He suggested that left room for lawsuits.
Senator Bundgaard said he could not foresee lawsuits because the State offered a choice
to employees. He said people make choices as to where to shop and where to send their
children to school, and were trusted with those choices as adults.
Senator Patterson said he is concerned about those remarks being entered into the
record. He said he thought that all employees could benefit from a well- designed plan.
He attested that every plan previously discussed offers guidance and restricts choices to
' worthy choices tFat are a grade of investments that would go into a retirement plan and "-
said he did not feel it is a problem. He said the Committee had heard one speaker say the
, plan would favor low performing employees, while the next speaker said it would favor high
performing employees. Senator Patterson said no one knew the exact wording of the plan
but obviously those who earned more would invest more and thereby be rewarded for
being high performing employees. He said he hoped that the Legislature would have
some more definite scenarios to discuss, and not have to continuously deal with possible
problems. He said he thought it should be approached with an open mind, and that
employees had the potential to retire with two to three times as much as they might in
another plan.
Representative Armstead said the State does not have the ability to identify high
performing employees.
Senator Cunningham said the testimony by Watson Wyatt was well researched, and the
company had made it clear there would be some winners and some losers. He felt that
those who are disabled would be worse off under a defined contribution plan. Senator
Bundgaard asked for justification of that remark.
Leroy Gilbertson, Director, Arizona State Retirement System, said that unless provided
in a separate plan there is no long term disability plan, which is provided in the current
defined benefit plan. He said that if a defined contribution plan is provided, a longterm
disability plan would have to be included.
Senator Bundgaard stated that the Committee should review the recommendations, as that
is one of the recommendations for legislation.
Joint Legislative Study Committee on
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1 2/ 16/ 98
Senator Cunningham said the other category of " losers" could be those who stay in the
defined benefit plan. He said there would not be as much excess earnings generated, and
they will not received cost of living allowances that they might otherwise receive. He said
he believed the subject should be examined more closely. He said he sensed a
presumption on the part of the Committee that it would move forward with a defined
contribution plan in spite of the testimony received. Senator Cunningham said that a
characterization of his postion as " less than open- minded" could be shared as a
characterization of others on this Committee.
Senator Cunningham said that he came from an organization that had both types of plans,
that the experience of one person is often anecdotal, and the Committee should not resort
to anecdotal policy making and should review the trends and patterns. He assured the
Committee that there will be a minority report setting forth some of his concerns stated
here, as well as his concerns about the constitutionality.
Senator Bundgaard thanked Senator Cunningham for his remarks. He asked that the
recommendations be discussed.
Senator Patterson moved the recommendation that the Arizona State
Retirement System ( ASRS), the Corrections Officers Retirement Plan ( CORP),
the Elected Officials Retirement Plan ( EORP), and the Public Safety Personnel
Retirement System ( PSPRS) employers be required to offer an optional
defined contribution plan by July 31, 2000. The motion CARRIED by voice
vote.
Representative Gardner moved the recommendation that the new defined
contribution plan shall offer ancillary benefits similar to those offered by the
existing defined benefit plans, i. e., survivor and health benefits and long- term
care disability. The motion CARRIED by voice vote.
Representative Gardner moved the recommendation that the Department of
Administration to administer the new defined contribution plan through a
procurement contract with a single provider. The motion CARRIED by a voice
vote.
Representative Gardner moved the recommendation that the Department of
Adminstration recommend to the Legislature employer and employee
contribution rates. The motion CARRIED by voice vote.
Representative Gardner moved the recommendation that members of the new
defined contribution plan will be vested after one year. The motion CARRIED
by voice vote.
Joint Legislative Study Committee on
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1211 6/ 98
Representative Gardner moved the recommendation to require the existing
defined benefit plans to transfer to the new defined contribution plan the
present value of " accounts" for members switching to the new defined
contribution plan, including the principal, interest and the growth. The motion
CARRIED by voice vote.
Representative Armstead said he had a recommendation he would like to move.
Representative Armstead moved that a complete fiscal analysis upon the
current plans be conducted, and a complete analysis of the fiscal effect of
what has been moved under the defined contribution plan be done to
determine the effect on the Department of Administration.
Senator Bundgaard asked if the Watson Wyatt study would provide any of that information.
Debbie Johnston, Senate Research Analyst, stated that the Watson Wyatt report may
possibly address the ASRS portion of the effect on DOA but not the other retirement
systems, nor would it address the costs incurred by DOA.
The motion CARRIED by voice vote.
Senator Patterson commented that he had been concerned about Proposition 100 during
the last election and whether it would affect the ability of the Legislature to pass an option
such as the defined contribution plan for the employees. Upon investigation of that
possibility, he was assured that was not the intention or effect of Proposition 100. He said
he hopes that those people will continue to hold that position.
There being no further business, the meeting was adjourned at 2: 45 p. m.
Respectfully submitted,
Karen Neuberg
Committee Secretary
( Tapes and attachments on file in the Secretary of the Senate's office.)
Joint Legislative Study Committee on
Defined Contribution Option
12/ 16/ 98
MINORITY REPORT
FOR THE JOINT LEGISLATIVE STUDY COMMITTEE ON
DEFINED CONTRIBUTION PROGRAMS
FINDINGS
The testimony at the committee meetings indicated the following:
If all new employees were forced to go to a defined contribution plan, the lower investment
return would cause the contribution rate of the current defined benefit plan to increase
dramatically. Therefore, optional defined contribution plans were modeled.
Of the three alternatives modeled, only one ( Scenario 3) would result in a cost savings to the
state. That scenario, however, results in significantly lower employee pensions than under the
current defined benefit plan.
High performing employees will benefit most from the current defined benefit plan.
Employees who become disabled will be worse off under the defined contribution plan. For
example, an employee who becomes disabled and survives until retirement age will not be
provided with adequate benefits when the long- term disability benefits cease. This occurs
because the DC plan does not receive accruals during the disability, other than interest. The
defined benefit plan permits service credit to accrue during the disability, increasing the
employee's retirement benefit.
The defined benefit plan continues to be a bargain for Arizona taxpayers and plan participants
because favorable investment returns have driven its costs down. ** FYs 99 and 00 it has a rate
of only 2.1 7%.
The defined contribution options, other than the high option, may save employers money but
benefit levels more than likely will be reduced for many employee classifications.
Initially, the creation of an alternative defined contribution plan is beneficial to the funded
status and contribution rate of the defined benefit plan, but may lead to funding and negative
cash flow problems and higher contribution rates.
Public employees have not advocated for the adoption of a defined contribution plan. If the
current plan is changed, this will have a tremendous impact on public employees. It is these
individuals that should decide which plan they consider to be most beneficial to them.
POTENTIAL EFFECT IF EMPLOYEES GIVEN CHOICE OF PLANS
Employees who stay in the current defined benefit plan will probably not receive cost- of- living
adjustments, because it will be difficult to generate excess earnings.
Employees hired at a later age are much better off under the current defined benefit plan.
b The defined contribution plan alternatives reward the shorter- service employee over the longer-term
employee.
Under the defined contribution plan, the average performing employees will be better off in
the early years of their career, but worse off in the latter years.
If the objective is to increase portability and to increase short- term benefits with no decrease
in long- term benefits, the defined benefit plan can be amended to include a cash balance
overlay feature for a modest increase in cost. A defined contribution alternative only provides
portability to defined contribution program members.
If defined contribution plans cost more to the state and give fewer benefits to the employees
that the state would most like to attract, i. e., long- term, high performing employees, then the
only reason to adopt a defined contribution plan is because it is portable. There are, however,
cash balance overlay options that could be added to the current defined benefit plan to
increase its portability.
CONSTITUTIONALITY
At the last meeting of the committee, the question was raised regarding the ability of the
Legislature to adopt a defined contribution plan in light of the passage of Proposition 100 in
the General Election held November 3, 1998.
Proposition 100 was designed to provide certain protections for public retirement systems by
requiring the funding of these systems with contributions and investment earnings using
actuarial methods and assumptions.
In a memorandum written by the general counsel of the Arizona Legislative Council, it was
stated that a defined contribution system does not use actuarial methods and assumptions.
Therefore, it was concluded that the " Constitution of Arizona, Article XXIX, as added by
Proposition 100, probably prohibits the Legislature from using a defined contribution plan for
a pub1 ic retirement system." ( Memorandum attached)
For these reasons, we feel the committee should not recommend to the Legislature the adoption of the
defined contribution plan, but instead direct the Arizona State Retirement System to research and
recommend at least three cash balance overlay options for the Legislature to consider during the
upcomih session. 7
December 22, 1998