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Ocean City

ELECTION DEBATE: which pension plan is best?

Answer depends on age, investment market, philosophy and which think tank you ask

ZACK HOOPES ¦ Staff Writer

(Oct. 26 2012) Reading this paper’s multitude of interviews with City Council candidates – both this week and in weeks past – may cause one to wonder what exactly it is about the city’s retirement plan than makes it such rich fodder for political debate, or why exactly it seems that neither side of the city’s political aisle can agree on exactly what fiscal conservatism is when it comes to long-term funding.

The devil is in the details – details that likely tie Ocean City closer to the national debate than does any other issue.

Over the next 20 years, Ocean City will be going through an admittedly difficult period, as it transitions from a defined-benefit (DB) retirement plan to a defined contribution (DC) system.

Under a DB system – the traditional pension – employees contribute a certain amount of their paycheck each week to a group retirement investment fund. The city also matches this with its own contribution. Upon retirement, employees are then paid a pre-defined fraction of their salary until death, in order to support them after they stop working.

Since 1991, the city’s public safety employees have had a separate fund from the city’s general employees, due to the different retirement norms for public safety work. General employees pay five percent of their salary each week into the pension fund, with an identical match from the city. After 30 years of service, they become fully vested, meaning they will receive the maximum post-retirement benefit of 50 percent of their salary. Retiring earlier provides a somewhat lower payout.

For public safety employees, the vesting term is 25 years, and the benefit is 60 percent of salary, but they must contribute 8 percent of their pay while they work.

Following a series of heated City Council debates from late 2010 through the spring of 2011, the pension fund was closed to new hires. While employees currently enrolled in the DB system will stay in the plan, all new hires after April of 2011 have a DC system of individualized 401(a) accounts.

For both the public safety and general worker sectors, employees must contribute five percent of each paycheck to the fund. They may also contribute up to an additional two percent. Any contribution will be matched by the city. When an employee leaves, he or she can take all of the money in the account that they have contributed, and a portion of the city’s contribution depending on how long they were employed. The portion increases 20 percent each year, until fully vested at five years.

The transition comes with a certain monetary cost, because DB plans are designed to be self-perpetuating. New, young employees will be paying into the pension fund, but will likely not be taking anything out of it for decades. Thus, their contributions are used to fund those employees currently retired. The fund is also invested, creating a return that can be continually reinvested to grow the fund as retired employees use up assets.

If no new employees are paying into the fund, however, the city must contribute additional funds to close the gap – such differential payments are known as amortizations. With a closed plan, actuarial payments to the DB system are projected to be higher, to the tune of $900,000 by 2030, according to city Human Resources Director Wayne Evans.

The end benefit, however, will be that the city will be completely devoid of longterm liability, once the plan is closed and all of its participants are deceased. At that time, all employees will be responsible for their own 401(a) retirement accounts. The sustainability of these assets is not the problem of the city, but the responsibility of the employee.

“In terms of how the costs look over time, both plans work,” said city Finance Administrator Martha Bennett. “The difference is that [in a DB plan] the risk goes to the employer, versus the risk being on the employee [in DC].”

How much the city will actually be on the line for in the next 20 years is a hot topic. Since closing the plan, the city has changed from basing its amortization from a level percentage of its retiree payroll to an even dollar amount.

“We made it an equal amount every year, like a mortgage … in the early years, you’re putting in more than you would otherwise,” Bennett said.

“The change in methodology resulted in a change of $353,000 more than what the old methodology would.”

Amortizations also fluctuate depending on relative gains or losses in the plan’s assets, or in its projected liabilities. The city has already, on many occasions, committed to benefit changes that have forced an amortization increase, such as in 2004 when the general employees plan was changed so that employees would contribute 5 percent of their pay, but receive 50 percent on retirement. Previously, the plan had been entirely city-funded, but gave out only 35 percent.

“That meant our funding ratio [of assets to future liability] immediately went down, but we immediately started funding it at a higher level,” Bennett said.

The actuary’s reports issued to the city in the spring of 2011 by the Mercer Group outlined similar projected costs and savings for the transition from DB to DC – the seriousness of which lies at the core of the current electoral debate. But the crux of the matter is that the predictions are not set in stone.

Mercer notes that a “smoothing” has been done to the DB plan’s projected investment gains and losses to its assets for valuation purposes.

“Due to the asset smoothing method used, the actuarial value of assets (AVA) used to determine the employer contribution rate in the 2010 valuations exceeds the market value of assets (MVA),” the report states. “Absent future gains to offset the investment losses being smoothed, future employer contributions would increase as past investment losses become recognized.”

Additionally, the level of return on investment over time may vary. Mercer provides two separate scenarios, one in which the return is seven percent and one in which it is four. The latter “will require much higher contributions than the Town currently makes.”

Given that a sizable portion of the town’s workforce is close to retirement, and the slow economic recovery, it is likely that the city will be funding a large number of liabilities with assets maturing at the lower rate, at least in the short term.

Also in flux is the forfeiture level – how many employees leave unanticipated money behind when they retire before full vestment – which the Mercer report admittedly ignores, although it states that “the value of the nonvested benefit for a participant leaving the employer remains in the plan assets, the reducing contribution requirements.”

This is compounded by the fact that the DC plan now has a variable contribution level of five to seven percent. According to Evans, the city’s 401(a) service has 58 par- ticipants, of which only 16 contribute more than the five percent minimum.

These uncertainties also mirror a national debate between economic policymakers who have also weighed the considerable public risk of DB pension systems against the considerable advantage inherent in such a large funding pool.

Right-leaning institutions, such as the American Enterprise Institute, have typically come out strongly in favor of major accounting reform for public sector pensions, and, in some cases, their complete elimination.

“GASB [Government Accounting Standards Board] rules cause U.S. public pensions both to vastly understate their true liabilities and to take excessive investment risk, putting in danger both government budgets and the economy as a whole,” writes AEI’s Andrew Biggs.

“Since riskier investments have higher expected returns, shifting to a riskier portfolio allows public pensions to use a higher discount rate, instantly improving their funding status.”

But more left-leaning groups say these risks are not exclusive to publicly ensured plans, and may become worse in the hands of individually invested plans such 401 accounts.

“Wide fluctuations in asset prices and returns make it hard for even wellinformed savers to select an affordable saving rate and an investment strategy guaranteed to produce a decent income in old age,” writes Gary Burtless of the Brookings Institution.

“Public pension systems partly insulate workers against economic and financial market risks by sharing these risks across workers, retirees, and taxpayers in multiple generations.”

What does it all mean? The Mercer report says that the variables in outcome mean that the choice between DB and DC boils down to principle.

“Neither design is necessarily better or worse,” the report states. “Instead, the appropriate model will depend on the employer’s philosophy and objectives for the retirement program.”

In a number of different scenarios for employees entering the workforce at different ages at different levels of return, Mercer outlines the resulting shift in employment patterns.

For an employee joining the town at age 25, with a starting salary of $25,000, a three-percent raise each year, and assuming a five percent contribution and a seven percent investment return, the DC plan is more advantageous if the employee either moves on early or retires late. The value of a DB plan in the same assumptions is greater only between ages 55 and 61.

But if the starting age of the employee is increased, or if the return on investment is lowered, the result is amplified. The DC plan is more valuable for a shorter period at the beginning, and become more valuable again even later in the employee’s life.

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