Sharing defined benefit pension costs: A survey of public sector practices

Defined benefit pension plans have long been a primary method by which state and local governments provide retirement security for public employees. Under these pension plans, retired public workers receive a predetermined monthly benefit based on their years of service and salary history. This analysis explores how public-sector employers share and allocate defined benefit pension costs between employers —taxpayers— and employees, compares these practices with those in the private sector, and advises policymakers on creating cost-sharing policies to balance the burden of retirement benefits between the employer and employee.

Background 

The cost of a defined benefit pension plan is usually divided into two main categories: normal costs and unfunded liabilities.

Normal costs refer to the ongoing expenses of funding pension benefits earned by employees in a given year, determined by actuarial valuations.

Unfunded liabilities arise when a pension plan’s liabilities exceed its assets, often due to investment returns below expectations, insufficient contributions, or changes in actuarial assumptions. 

The pros and cons of defined benefit cost-sharing

Having employees help pay for some portion of defined benefit (DB) pension costs has advantages and disadvantages, which can vary depending on the context and specific arrangements.

Advantages

• Financial sustainability: Cost-sharing can help ensure the financial sustainability of pension plans by distributing the funding burden between employers and employees.
• Risk mitigation: Cost-sharing can mitigate the financial risk for employers (taxpayers), reducing the likelihood of severe budgetary impacts.
• Equity: Cost-sharing can promote a sense of fairness, as both employers and employees contribute to the funding of retirement benefits.
• Incentives for fiscal responsibility: When employees share the cost of their pensions, they may be more invested in the pension plan’s financial health and supportive of prudent management practices.

Disadvantages

• Affordability for employees: Increased employee contributions can strain household budgets, particularly for lower-income workers.
• Fairness and equity concerns: Defined benefit plans are supposed to fund each year’s accruing benefits as they are earned through normal cost contributions. While cost-sharing for normal costs is a fair proposition, cost-sharing for unfunded liabilities is for benefits earned in the past. So, asking employees (particularly new hires) to pay for a portion of unfunded liability costs might be perceived as unfair because it means they might be paying for someone else’s accrued liabilities.
• Complexity in negotiations: Cost-sharing agreements can complicate labor negotiations, potentially leading to labor disputes or employee dissatisfaction.
• Negative retention impacts: Some cost-sharing arrangements may be perceived as a reduction in pay and may lower employee retention rates. Again, this would particularly occur if employees share in the cost of any unfunded pension liabilities.

Defined benefit cost-sharing practices in the private sector

The private sector has seen a significant shift from DB plans to defined contribution (DC) plans. However, some private sector employers still offer DB plans, and their cost-sharing arrangements differ from those in the public sector.

In the private sector, normal costs and any unfunded liability costs are typically 100% funded by the employer. In the case of collectively bargained employees, the pension costs are set within the collective bargaining agreement. Even for these arrangements, the employer technically is paying 100% of the cost of the pension plan via a negotiated trade-off between taxable pay and benefits.

Private sector employers also avoid having employees share in the funding of pension plans because employee contributions would generally be on an after-tax basis (the 401(k) cash or deferred plan rules cannot be used to make employee contributions on a pre-tax basis). After-tax employee contributions for pensions complicate plan administration and compliance with federal laws governing the funding of private-sector pension plans, such as ERISA. To avoid legal and financial complications, private-sector employers have preferred not to adopt employee cost-sharing practices for pension benefits.

DB cost-sharing practices in the public sector

Public sector defined benefit cost-sharing practices are quite different from those in the private sector. The vast majority of plans require both employer (taxpayer) and employee contributions, with only a few being “non-contributory,” requiring no employee contributions. 

Using 2023 data from the Public Plans Database (PPD), we examined the cost-sharing practices of roughly 230 state and local pension plans in the U.S. The PPD had normal cost data for 194 of these pension plans and total cost data (with unfunded liability costs) for 192. 

We first look at how much of the public pension plans’ normal costs are being paid by employees. Figure 1 shows a distribution of employee shares for the 194 pension plans as a percentage of the total normal cost. Among these plans, the average share of normal cost paid by employees is 51%. The median level is 49%. But the range of cost-sharing of the normal cost is extremely broad, ranging from 0% to 100% (or above 100% in some cases).

Figure 1 

Source: Reason analysis of contribution data from PPD.

It’s also valuable to see how much of the public pension plans’ total pension cost (normal cost plus any unfunded liability cost) is being paid by employees. Figure 2 shows a distribution of the 192 plans as a percentage of total pension cost. Among these plans, the average share of the total pension cost paid by employees is 25%, with the median at 23%. The sharing of total costs ranges from 0% to 72%.

Figure 2

Source: Reason analysis of contribution data from PPD.

Differentiating between normal costs and unfunded liabilities

It is essential to distinguish between normal costs and unfunded liabilities when determining any cost-sharing structure for DB pension costs. Normal cost-sharing is more straightforward to manage and share, as it is based on current employment and actuarial projections. Fixed contribution rates for both employers and employees can provide stability and predictability in funding.

Unfunded liability cost-sharing poses a more significant challenge, as it represents historical deficits that require additional funding. Sharing these costs with employees can be more contentious. This often involves increasing contributions or reducing future benefits to address the shortfall.

Policymakers must carefully consider the fairness concerns of newer employees who may not have any relationship with those past liabilities, and how such measures may impact employee morale, retention, and retirement security.

Figure 1 shows that some public plans have employees pay more than 100% of the plan’s normal cost. This means that employees are helping pay part of the unfunded liability that, in many cases, was accrued before they were hired. 

IRC Section 414(h) “pick-up” arrangements can muddy the water

Public policymakers need to factor in how Internal Revenue Code (IRC) section 414(h) “pick-up” arrangements may impact the desired pension cost-sharing structures. Under this code section, employee contributions are paid by the employer, treating them as pre-tax employer contributions for tax purposes. While this arrangement can provide tax benefits for employees, it complicates the crafting of appropriate pension cost-sharing models, depending on whether the “pick-up” is using a salary reduction method or an offset against future pay increase approach. If all or part of the employee contribution is paid by the employer as an offset against future pay increases, it can obscure the actual cost of pension funding to the employer, making it difficult to assess the balance between employer and employee contributions. This complexity is absent in the private sector, where such pick-up arrangements are not available. 

For example, assume a pension plan has a normal cost contribution rate of 10% of pay with a cost-sharing policy that splits the cost evenly between the employer and employee. The employer contribution rate would be 5%, and the employee contribution rate would be 5%. A salary reduction “pick-up” would not change this split. It would make the employee’s 5% share pre-tax instead of after-tax. In contrast, if an offset against salary increase “pick-up” is used, this effectively results in the employer paying the full 10% amount, notwithstanding the plan nominally adopting an evenly split cost-sharing policy.   

Public policymakers need to consider how the different pick-up arrangements can affect employer contribution rates.

Recommendations for public sector policymakers

Public sector policymakers should design pension cost-sharing policies that support a pension plan’s funding policies and objectives.  

• Periodic reexamination of cost-sharing policies: Cost–sharing structures that may have worked in the past may not remain optimal as the plan’s funding requirements change over time. Pension reform efforts should include cost-sharing policy discussions. 
• Transparency and communication: Both participating employers and employees must clearly understand the pension plan’s financial status, funding requirements, and cost-sharing arrangements. Transparent communication can build trust and support for necessary changes. 
• Balance contributions and benefits: Strive to balance the need for sustainable funding with the affordability of contributions and the adequacy of benefits. This may involve setting contribution rates that are fair and manageable for both parties while also ensuring that benefits provide sufficient retirement security.
• Address unfunded liabilities separately from normal costs: Develop strategies to address unfunded liabilities without placing an undue burden on employees, particularly new generations of employees. This may necessitate looking at new benefit structures, benefit adjustments, or seeking additional funding sources. 
• Consider hybrid plan designs: Explore hybrid pension program designs that combine elements of defined benefit and defined contribution plans. Such designs can provide a balance between predictable retirement income and shared funding responsibility.
• Consider the impact of any IRC Section 414(h) pick-up arrangement: It is important to know whether the employer is already paying part of the employee contribution rate via an offset against future pay increases. 

Conclusion

The sharing of public sector defined benefit pension costs between employers and employees is a complex but essential aspect of ensuring the financial and benefit sustainability of pension plans. Public sector practices often involve fixed employee rates for normal costs and varying approaches to addressing unfunded liabilities.

By considering the pros and cons of cost-sharing and differentiating between normal costs and unfunded liabilities, policymakers can design public pension plans that balance financial sustainability with retirement security. Transparent communication, proactive strategies, and employee engagement are key to successfully balancing interests and successful pension plan management in the public sector.

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Source: https://reason.org/commentary/sharing-defined-benefit-pension-costs-a-survey-of-public-sector-practices/