S L P P N N r ON STATE AND LOCAL WORKERS By Alicia H Munnell JeanPierre Aubry Joshua Hurwitz and Laura Quinby Alicia H Munnell is director ID: 212496
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S L P P N , N \r THE IMPACT OF LONG VESTING PERIODS ON STATE AND LOCAL WORKERS By Alicia H. Munnell, Jean-Pierre Aubry, Joshua Hurwitz, and Laura Quinby* *Alicia H. Munnell is director of the Center for Retirement Research at Boston College (CRR) and the Peter F. Drucker Professor of Management Sciences at Boston College’s Carroll School of Management. Jean-Pierre Aubry is the assistant direc - a research associate at the CRR, and Laura Quinby is a former research associate at the CRR. This brief is based on Munnell et al. (2012). I Stories abound regarding the generous pension ben - e ts provided to state and local government workers, but two aspects of plan design leave many of these workers with little or no accrued bene ts. First, state/ local plans are based on nal earnings, under which those who leave early receive little. Second, employee vesting – the period of service needed to qualify for any pension bene t – takes ve or ten years. In most cases, participants who leave before vesting receive only their own contributions plus some low rate of earnings plan are trivial for many years. This ar - rangement raises a basic question of fairness, since it is not possible to identify early leavers and compen - sate them with higher wages. Fairness is a particu - larly important issue in states like California, Con - necticut, Massachusetts, Illinois, Louisiana, and Ohio, where one or more of the large retirement systems do not participate in Social Security. With no Social Se - curity and long vesting periods, short-service workers can leave with no bene ts of any kind for their time spent in public employment. This brief explores how back-loaded bene ts structure on state/local workers. The discussion proceeds as follows. The rst section describes the typical state and local plan and documents the extent of back-loading and vesting provisions. The second section explains the construc - tion of the data used in the analysis, which reveal that nearly half of workers leaving state and local employ - ment depart without any promise of future bene ts. The third section presents an equation that relates the probability of vesting to the length of the vesting period. The nal section concludes that back-loaded LEARN MORE crr.bc.edu Center for Retirement Research * Includes Libraries, Housing, Community Development, Environment, Recreation, and All Other. Source: U.S. Census Bureau, Annual Public Employment Survey , . bene ts and long vesting periods deprive short-term workers of retirement protection. The nding sug - gests that the recent trend towards the introduction of a de ned contribution component in state/local systems provides for a more equitable distribution of bene ts between short-term and career employees. T\f D \n P S D \n B \n P Public de ned bene t plans vary enormously across states and between states and localities, because these plans cover three di erent sets of workers – general government employees, teachers, and public safety personnel – each of whom have di erent career paths (see Table ). T . S L F- E\r\f E \n\t \n F, \b, M\t Nevertheless, the de ned bene t plans share a basic structure. In almost all cases, they calculate the initial bene t at the full retirement age as the prod - uct of three elements: ) the plan’s bene t factor, ) the number of years of employee service, and ) the employee’s average earnings, which are generally based on the three to ve years of highest earnings (see Figure ). As a result, a worker in a plan with a -percent bene t factor retiring after years with a $ , nal salary would receive a pension bene t of $ , . Activity State Local Total Education . . . Elementary and secondary . . . Higher education . . \b. Protective services . . \b. Health . . . Community development* . . . Transportation . . . Administration .\b . . Public welfare .\b . . Public utilities and waste management . . . Total . \b.\b . F . D\t S L P\t, \n Y\t A\f P, \b Source: Public Plans Database ( ). 6.3% 65.9% 7.9% 19.8% 0% 20% 40% 60% 80% 1-2 3 4 5 A simple model based on typical public plan characteristics can illustrate the extent to which nal pay provisions produce back-loaded bene ts. The measure used to calibrate the degree of back-loading is the change (relative to the gross salary) in the present value of the promised pension bene t less the pension contribution at each age. This measure increases markedly throughout a worker’s career and particularly at older ages (see Figure ). F \b. I\t L P\t B \t P A E\t Source: Authors’ calculations. 0% 20% 40% 60% 35 40 45 50 55 60 65 Start at 25 Start at 35 Start at 45 Age Issue in Brief As a result, an employee starting at with a - year career will earn more than percent of lifetime pension bene ts in the last ve years of employment; those leaving with years of service receive about percent of the possible lifetime bene ts (see Figure ). Thus, participants face minimal bene ts if they leave early and a very strong incentive to keep work - ing until full bene ts are available. The valuations provide “decrement tables” that contain the rate at which plan members of a given age and tenure are expected to terminate or retire within the next year. € One minus these decrement rates is approximately the probability of an individual plan member of a given age and service remaining one additional year. The probabilities of an individual remaining one additional year can be used to generate the probability of an individual staying in the plan for multiple years. For example, as shown in Table , an individual with a starting age of and zero years of service has an F . P L P\t B\t E \f E \n’\t -\n C, S A Source: Authors’ calculations from the Public Plans Data - base ( ). 6% 14% 27% 44% 68% 100% 0% 25% 50% 100% 40 45 50 55 60 65 In addition to back-loaded bene ts, public plans have very long vesting periods (see Figure ). Nearly a quarter of plans require years of work for full vest - ing. In contrast, in the private sector, the Employee Retirement Income Security Act (ERISA) requires either graduated vesting beginning after years of service or cli vesting after years for de ned bene t plans. In the public sector, those who leave before they are vested generally receive back only their own contributions plus some low rate of interest. The question is whether delayed vesting increases the likelihood that people leave with nothing or whether they remain with the plan until vested. T\f D To assess the impact of vesting on public employees, it would be lovely to have data on each individual in each plan in the Public Plans Database (PPD). Unfor - tunately, such data are not readily available. But it is possible, using each system’s actuarial valuation, to engineer a representative population of plan partici - pants and estimate the percentage of those who vest. F . D\t S L P\t, \n Y\t V\t P, \b Source: Public Plans Database ( ). 7.9% 58.7% 8.7% 24.6% 0% 10% 20% 30% 40% 50% 60% 70% 0-4 5 6-9 10+ T \b. P\n R ‚ P \n S A Y\t S\f Starting age Years of service \b \b . . \b. . . .\b \b . . . . . .\b . \b . . . . .\b . . \b . . . . . . . \b . . . . . . .\b . \b. . . .\b . . * Numbers in italics represent cumulative probabilities. Source : Authors’ calculations from actuarial valuation reports. * * * * * Center for Retirement Research ƒ -percent chance of staying for one year. In addi - tion, the table shows that a year from now when that individual is € with one year of service, he has an ƒƒ percent chance of staying one more year. These -year probabilities can be multiplied to calculate the cumulative probability of the -year-old staying mul - tiple years. That is, he has an ƒ . percent probability of remaining for one year, a „ . percent probability of remaining for two years, a €„.„ percent probability of remaining for three years and so on. This process is replicated for each age (roughly ) and length of tenure (roughly ) and for each plan in the PPD (roughly ), producing about €,€ probabilities. Applying the probabilities to a representative population of plan members generates a distribu - tion of leavers by age and tenure. Figure shows the projected distribution, by tenure and bene t status, of participants leaving the plan. The important point for this analysis is that, of those who leave state and local pension plans, „ percent depart without any promise of future bene ts (see Figure €). „ The probability data were then used to estimate how the length of the vest - ing period a ects the likelihood of becoming vested. T\f I\t \n V The analysis on the probability of staying with the plan long enough to vest involves estimating an equa - tion of the following form: P i ( v | a )= ß + ß SS i + ß V i + ß DC i + ß W i + ß X + where the probability of staying in the plan long enough to vest, for a member at a given starting age, is related to whether the plan has Social Security cov - erage, SS i , the number of years required for vesting, V i , and participation in a de ned contribution plan, DC i . ƒ An additional variable is the ratio of average annual salaries in the plan divided by the average an - nual private sector salary in the state, W i . Finally, a vector of eight dichotomous variables, X , captures the member’s age at hire, broken into ve-year brackets, from to . The coe…cient of interest is that for the vest - ing period. The intuition here is that the longer the plan’s vesting period, the less likely the participant is to vest. The impact of Social Security coverage could have either a positive or negative e ect on tenure, while the presence of a de ned contribution plan should reduce the incentive to stay until vesting since participants have something to take with them should they leave. Higher wages should encourage people to stay, as should age. F . D\t L\f\t P P D, \n T B S\t, \b Source: Authors’ estimates from various actuarial reports. Years of service Retirees Deferred vested Non-vested F . P L\f\t P P D, \n B S\t, \b Source: Authors’ estimates from various actuarial reports. Non-vested, €.„% Deferred vested, ƒ.€% Retirees, .ƒ% Issue in Brief The results are shown in Figure „. (Full regres - sions and summary statistics appear in the Ap - pendix.) As expected, the probability of vesting is negatively related to the vesting period, and has a statistically signi cant coe…cient. A one-standard- deviation increase in the vesting period ( . years) reduces the probability of an employee remaining until vested by „. percentage points. This result implies that a vesting period of years instead of ve reduces the probability of staying until vested by about € percentage points. The results also show that a higher average wage in the plan relative to wages in the private sector is associated with staying and the later the age at which people are hired, the more likely they are to remain until vesting. Neither Social Security nor participation in a de ned contri - bution plan has a statistically signi cant e ect. The main message from the vesting equation is that long vesting periods are likely to lead to participants leav - ing with no accrued bene ts. C Sole reliance on nal earnings de ned bene t plans raises human resource and equity issues. Final earn - ings plans produce strongly back-loaded bene ts and, when combined with delayed vesting, deprive short- term employees of retirement protection, especially for those systems that do not participate in Social Security. Therefore, some mixture of de ned bene t and de ned contribution plans will produce a better balance between the bene ts provided to short- and long-tenure workers. F . I S F\t P\n V\t, E† P F P\t, \b Notes: Solid bars indicate signi cance at the -percent level or better. The bars represent a change from zero to one for dichotomous variables, and a one-standard-deviation change for continuous variables. Sources : Authors’ estimates from the U.S. Department of Labor, Current Population Survey ( ) and the Public Plans Data - base ( ). 11.1 Social Security coverage Public to private wage ratio Vesting period Has DC plan Hiring age - Hiring age - Hiring age - Hiring age - Hiring age - Hiring age - Constant Statistically signi cant Not statistically signi cant 41.5 10.1 11.1 10.1 7.9 5.1 2.5 -3.3 -7.4 3.8 1.6 -10 0 10 20 30 40 50 Center for Retirement Research € Nebraska is an exception to this generalization since it has a cash balance plan for general state em - ployees. Nebraska still provides a traditional pension bene t for its public school teachers and state police. The Texas Municipal Retirement System, Texas County and District Retirement System, and Califor - nia State Teachers’ Retirement System (for part-time employees of community colleges) also provide a cash balance plan. This exercise, based on Diamond et al. ( ), uses a plan with a constant -percent bene t factor, a three-year averaging period, a full retirement age of €, actuarially fair adjustments for early retirement, and a COLA that compensates for . percent in‡a - tion after the start of bene ts, the average COLA in the Public Plans Database (PPD). The calculation also assumes . percent nominal earnings growth (faster at young ages and then slowing) and percent in‡a - tion. Employees may claim a pension as early as , provided they have accumulated at least years of service. Those who leave prior to age and have ac - cumulated at least years of service are assumed to claim a pension at the full retirement age. No cap is imposed on the replacement rate. Employee pension contributions are . percent of salary, the most typi - cal rate found among our PPD sample of plans. Present values are computed using a real interest rate of percent, similar to the . percent rate used in the Social Security Trustees Report. Mortal - ity rates are formed as a - gender mix of the RP- combined healthy tables, projected to using Scale AA. The calculation is pre-tax; it ignores the role of both income and payroll taxes, as well as promised Social Security bene ts, in determining the level of compensation. If the plan caps the replacement rate, the strong incentive to continue working stops when the cap is reached. For (k) plans, the predominant retirement plan o ering for private sector workers, ERISA requires either graduated vesting beginning after two years of service or cli vesting after three years. € Within a given plan, bene t generosity and plan design often vary by occupation and date of hire, cre - ating “tiers.” Whenever possible, demographic tables were collected by plan tier and gender, and the rel - evant decrement rates applied to each group. When detailed demographic information was not available, the rates of the largest demographic subgroup were applied to the whole population; for example, female rates were often applied to the entire membership of teachers’ plans. The rates presented in the decre - ment tables are based on the plan’s actual experience over some length of time and are typically updated by the plan’s actuaries every ve years, when the plan performs an experience study. „ This pattern is similar to that found by the State of Maine Uni ed Retirement Plan Task Force ( ). ƒ Social Security coverage is a dichotomous variable equal to one if a majority of plan members are cov - ered by Social Security, and zero otherwise. The average plan wage was obtained by dividing total payroll in the PPD by the number of active mem - bers in the PPD. The average private sector wage was produced by the March Supplement of the Current Population Survey . The private sample was limited to non-military workers between the ages of € and „ who earn more than $ , per year. E Issue in Brief „ R \n Diamond, Peter A., Alicia H. Munnell, Gregory Lei - serson, and Jean-Pierre Aubry. . “Problems with State-Local Final Pay Plans and Options for Reform.” State and Local Pension Plans Issue Brief . Chestnut Hill, MA: Center for Retirement Research at Boston College. Munnell, Alicia H., Jean-Pierre Aubry, Joshua Hur - witz, and Laura Quinby. . “Public Plans and Short-Term Employees.” NBER Working Paper ƒƒ. Cambridge, MA: National Bureau of Eco - nomic Research. Public Plans Database . - . Center for Retire - ment Research at Boston College and Center for State and Local Government Excellence. State of Maine Uni ed Retirement Plan Task Force. . Task Force Study and Report: Maine State Employee and Teacher Uni\red Retirement Plan . Augusta, ME. U.S. Census Bureau. Annual Public Employment Sur - vey , . Washington, DC. U.S. Department of Labor. Current Population Survey , - . Washington, DC. U.S. Social Security Administration. . The Annual Report of the Board of Trustees of the Federal Old- Age and Survivors Insurance and Federal Disability Insurance Trust Funds . Washington, DC: U.S. Government Printing O…ce. APPENDIX Center for Retirement Research Notes: Robust standard errors are in parentheses. Coe… - cients are signi cant at the -percent (*), -percent (**), or -percent (***) levels. Sources : Authors’ estimates from the Current Population Survey ( ) and the Public Plans Database ( ). T A. R\t\t R\t\t P\n V\t, E† P F P\t, \b Variable Coe…cient Social Security coverage . (.\b) Public to private wage ratio . *** (.) Vesting period -.\b\b *** (.\b) Has DC plan -.\b (.\b) Hiring age \b-\b \b.\b *** (.) Hiring age - . *** (.) Hiring age - . *** (.) Hiring age - .\b *** (.\b) Hiring age - .\b *** (.) Hiring age - . *** (.) Constant . *** (.) R-Squared .\b Number of observations , Issue in Brief Sources : Authors’ calculations from the Current Population Survey ( ) and the Public Plans Database ( ). T A\b. S\n S\t\t R\t\t P\n V\t, E† P F P\t, \b Variable Mean Standard deviation Probability of vesting . . .\b . Social Security coverage .\b . Public to private wage ratio .\b .\b . . Vesting period . \b.\b Has DC plan . . Hiring age \b-\b . . Hiring age - . . Hiring age - . . Hiring age - . . Hiring age - . . Hiring age - . . Minimum Maximum A \f C The Center for Retirement Research at Boston Col - lege was established in ƒ through a grant from the Social Security Administration. The Center’s mission is to produce rst-class research and educational tools and forge a strong link between the academic com - munity and decision-makers in the public and private sectors around an issue of critical importance to the nation’s future. 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