State public retirement systems can better manage economic uncertainty by adopting cost-sharing and benefit design features intended to compensate for lower-than-expected returns on investments or other assumptions that fall short. These mechanisms distribute costs among employers, employees, and retirees by following predefined rules that automatically adjust benefit levels and contribution rates based on actual investment performance or demographic changes.
Cost-sharing features often include cost-of-living adjustments (COLAs) that vary depending on a plan’s funded level, as well as variable contribution rates that split costs between employers and employees, or alternative plan designs that reduce risk exposure for government employers.
In its research, The Pew Charitable Trusts identified 17 states that incorporate formal cost-sharing features in their traditional defined benefit (DB) or pension plans and 23 that have implemented alternative plan designs, including hybrid, cash balance, or defined contribution (DC) plans. Of those, 17 set the alternative plan as the default for at least some employees, typically new state workers or teachers.
Our research finds that states with the most robust cost-sharing features tend to be among the best funded—and they use a range of plan designs. For example, Wisconsin and Tennessee are two of the best-funded plans in the country. Although the plans differ in many respects, both employ strong cost-sharing mechanisms.
On Aug. 5, Pew joined Bob Conlin, secretary of Wisconsin’s Department of Employee Trust Funds, and Erica Nale, assistant director of the Tennessee Consolidated Retirement System, at the National Conference of State Legislatures Legislative Summit in Nashville, Tennessee, to explore how other states can use such features to plan for economic volatility.
The Wisconsin Retirement System provides a traditional pension plan to nearly all state, university, school, and local government employees. The plan incorporates several cost-sharing features to ensure full funding and stable contribution rates while providing retirement security for plan members. Conlin said the system’s key features include employee and employer contributions that rise and fall equally in response to market conditions, and adjustments to post-retirement benefits based primarily on investment performance.
The Wisconsin Retirement System’s benefit calculation policy is designed with retirement security in mind. The plan calculates retiree benefits two ways: first, based on the traditional pension formula, and second, using a money purchase formula, which calculates an annuity based on total employee and employer contributions plus interest. Retirees receive the greater benefit. The traditional DB calculation ensures that workers who have spent their careers in public service achieve security in retirement, while the money purchase calculation tends to help shorter-term workers, as well as those with longer-than-average tenures.
In Tennessee, lawmakers adopted a risk-managed hybrid plan in 2013 for state workers and teachers who started on or after July 1, 2014. Nale said the new plan reduced the pension benefits offered by the closed legacy plan but added a 401(k) account with a 5 percent employer contribution.
The new approach has features designed to keep employer costs stable, including changes to employee contribution rates and benefits. Under the plan, the employer contribution for the DB component is set at 4 percent, a rate currently higher than needed to meet expected costs. The plan deposits the additional funding above the actuarially determined contribution into a stabilization reserve that provides a cushion for when the funded level falls below 100 percent.
If those funds do not improve Tennessee’s funded status, Nale said, the plan design automatically triggers five policy changes, including a reduction or suspension of the retiree COLA and a 1 percent increase in employee contributions. The changes remain in place until the plan is back on track to full funding, an approach that keeps the employer contribution stable even during a downturn.
South Dakota, Nebraska, and Utah also stand out as states with well-funded retirement systems that use different plan designs and cost-sharing features to manage risk. South Dakota has a DB plan with fixed employer and employee costs. To maintain these contribution rates, the plan automatically adjusts benefits as needed, including use of a variable COLA. That helps ensure that the set contribution rate is adequate to pay for benefits and that the plan remains fully funded.
Nebraska, meanwhile, has a cash balance plan for state and local workers that has kept employer costs stable over the last decade. And in 2011 Utah adopted a hybrid plan with a fixed employer contribution of 10 percent, split between the DB and DC elements. Employees must make up the difference if costs for the DB component exceed 10 percent of payroll.
These high-performing states highlight how cost-sharing features, especially when combined with funding discipline, can play a key role in helping retirement plans achieve financial stability. Moreover, they underscore the reality that there is no single strategy for designing effective mechanisms.
Greg Mennis is a director and Aleena Oberthur is a manager with The Pew Charitable Trusts’ public sector retirement systems project.