Defined benefit or defined contribution: That is the question facing the city of Knoxville in providing a new retirement plan for city employees in the wake of the debacle that has saddled the city with $135 million in what is tantamount to debt arising from its existing pension plans.
The city is on the hook for the $135 million because under state law (actually a State Supreme Court decision), nothing can be done to reduce the lucrative defined benefits that current city employees and retirees have been promised under the existing plans. Their cost, coupled with pension fund investment returns far lower than projected, have left the city in this hole for the amount by which its pension-fund liabilities exceed its assets. And the painful prospect of having to pay it off has produced a hue and cry for eliminating the risk of defined benefits for new city employees and offering them instead a risk-free (to the city) defined contribution plan under which the city would match their contributions and be liable for no more.
In her first major initiative as mayor, Madeline Rogero has recommended what’s being called a hybrid plan that represents a combination of the two. Under her proposal, new employees would be entitled to a more limited set of defined benefits based on the first $40,000 of their compensation. But a required contribution of 6 percent of their total earnings would be matched by the city in a way that, in the latest iteration, would entitle them to the greater of their defined benefit or payments based on the value of their defined contribution account at the time of their retirement.
That value would depend on the investment performance of their account during their years of service, and particularly for higher-paid employees could yield benefits well in excess of the defined ones. The defined benefit would remain a guaranteed floor for all, but the investment return on pension funds needed to fully cover it would be substantially reduced from the 8 percent return assumption that long governed the existing plans and put them so far under when the stock market tanked during the recent Great Recession.
Rogero’s plan would reduce the defined benefit in several ways. Among them: It would increase the employee vesting period and raise the retirement age (differently for fire and police, on the one hand, and civil service workers, on the other). In addition, it would reduce the benefit to two times an employee’s salary per year of service from a 2.5 multiplier presently. And very importantly, it would reduce the annual cost of living adjustment (COLA) from a minimum of 3 percent to an amount tied to the consumer price index with a 3 percent cap.
City Council has wrestled with the proposal through a series of protracted workshops during which the entire defined benefit (DB) vs. defined contribution (DC) issue was very much in doubt. For a time, the pendulum appeared to be swinging in favor of a pure DC plan on grounds that the city shouldn’t be assuming more risk at a time when most of the private-sector has been eschewing it by going to 401(k) plans. But at last week’s crucial meeting, Councilman George Wallace had a seeming epiphany and spoke eloquently in favor of the DB component of a hybrid plan.
“It’s my belief that a city employee works for everybody in the city at all hours of the day and night. That type of employee sets itself apart from the private sector... and I believe it’s reasonable for the city to guarantee them a pension plan,” Wallace declared.
Guided also by Vice Mayor Nick Pavlis, Council ended up casting a non-binding 6-3 vote in favor of the hybrid plan. That majority is still dependent on working out what Wallace termed the “nuts and bolts” of the plan. And he is commendably in the forefront of efforts to minimize the city’s risk exposure by maximizing its ability to subsequently modify the plan if circumstances warrant. He suggested, for example, that any COLA could be made contingent on a set of exposure parameters and that the $40,000 base might itself be “tweaked.” Lower-risk investment strategies are also contemplated.
The city’s actuarial consultant, Alan Pennington, also made what were to me telling points in favor of a DB plan. For one, he brought out that for workers who don’t stay with the city until retirement age, employer contributions (8 percent in the case of civil service, 10 percent in the case of fire and police) would remain in the pension fund, whereas in a DC plan the worker would be entitled to them. Moreover, he invoked what he termed the rule of shared morbidity, which in essence means that contributions of retirees who die younger in a DB plan help support those who live longer, whereas in a DC plan the long-lived might exhaust their retirement funds.
Beyond all that, I believe it is crucial to avoid rebuffing Mayor Rogero on her first major initiative. She has worked mightily to gain acceptance for her hybrid plan from the city’s sometimes fractious employee organizations. And a failure to deliver on it could impair her standing and ability to lead.
Because the pension plan is embedded in the city charter, any changes will require a charter amendment that must be approved by the voters in a referendum. Building voter understanding and acceptance of the complexities involved will be anything but easy, but the consequences of a failure to approve a new plan will mean at least two more years of subjection to the extremely flawed old one.