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The Governor’s Pension Reform Proposal Should Become Law

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It is imperative that in the current session the General Assembly pass Governor McDonnell’s Virginia Retirement System (VRS) reform package or something similar. Two factors create the urgency in this matter.

First, the Governor and General Assembly leaders made clear for several years their intention to make changes to increase the long-term sustainability of the current defined benefits (DB) system. Rumors and proposals abound, leaving employees in a state of uncertainty about future retirement benefits and contribution rates. There is anecdotal evidence that senior, experienced employees are retiring earlier than they planned in order to lock in current pensions before any changes can be made. A brain drain of key employees is likely to occur if the General Assembly closes the session without settling the issue.

Second, bond credit rating firms are issuing warnings about the Commonwealth or putting it on a watch list for a potential downgrade. Their concern is an expected reduction in federal government spending. Because Virginia benefits significantly from federal spending, there’s an anticipation that lower federal spending will harm Virginia’s economy and reduce its tax revenues. Reducing the cost of the retirement system and shrinking its projected unfunded pension liability could help retain the Commonwealth’s AAA rating.

The Governor’s proposal, released January 12, strikes a fair balance between protecting the reasonable expectations for financial security of employees and reducing the cost of the retirement program to taxpayers. The Commonwealth would increase its contributions to a plan it traditionally has underfunded, and employees would contribute a higher portion of their salaries and have some benefits reduced.

  • Newly-hired employees (other than judges and public safety employees) would have their benefit multiplier modestly reduced from 1.7 to 1.6, which means they’ll receive a slightly lower pension benefit for the same salary and years of service as those who retire today.
  • Similarly, the average final compensation on which the pension is based would be calculated over 60 months instead of 36 months for employees hired before July 1, 2010. Those hired after that date already have this formula. Again, this would modestly reduce benefits.
  • The cost of living allowance on pension annuities would be capped at 3% for current employees, newly-hired employees, and deferred members. In addition, the COLA formula would be changed so the COLA fully matches the first two percentage points of increase in the CPI and matches up to the next two percentage points at a rate of one-half to one until reaching the 3% annual limit. Also, for all employees the COLA wouldn’t be available until an employee reaches the age for unreduced retirement benefits. Members within five years of their unreduced retirement date as of Jan 1, 2013, wouldn’t be affected. A COLA is a very expensive feature of a DB plan, so reform here provides meaningful savings for the plan.
  • A 5% employee contribution rate was established in the 2011 General Assembly session. The employee contribution would be increased to 6% for those newly hired or re-employed after June 30, 2012 under the Governor’s plan. That increase would be phased in for current employees at the rate of 0.5% per year. The 5% increase was offset by a matching salary increase, and the proposed increase would be more than offset by a salary increased proposed by the Governor. Judges, teachers, and other local employees would be excluded from the contribution increase, but the state’s example might make it easier for localities to require their employees to pay more for their benefits.
  • The Governor proposes a new optional hybrid plan for new hires and existing employees. The hybrid would include a defined benefit plan with a 1.0 multiplier and a 4% employee contribution and a defined contribution plan with a mandatory employee contribution of 2% of salary (matched with a 1% contribution from the state) and optional employee contributions of up to 4% of salary (matched by up to 2.5% from the state). The hybrid would not be available to local employees or to several classes of employees who already have an Optional Retirement Plan.

The employer’s contribution to the DB portion of the hybrid plan would be determined actuarially as set out in the state code. This would be an important change from the current DB plan for which the General Assembly traditionally has decided how much it wants to put in the plan each year, putting in less than the actuarially-determined amount 17 out of the last 20 years.

The current DB plan would be the default plan for both existing employees and new hires. Current employees would have 120 days as of Jan. 1, 2014, to choose the hybrid or stay with the DB plan. The option would be one-time and irrevocable.

The Governor’s proposal is a good compromise between the competing interests and the many variables inherent in defined benefit pension plan reform.

The proposal re-establishes the principle that employees should contribute meaningfully to their DB plan benefits, but it does this without inflicting pain on the employees. They have to begin making contributions, but they receive pay increases in the initial years to offset the new contributions. This essentially is done at little or no net cost to the government, because the contributions would have been needed by the government if the employees weren’t making them.

Once the concept of pension plan reform is accepted, it would be easy to get lost in a debate over the specifics. Why not reduce the multiplier by more? Why not make the hybrid plan mandatory or at least the default option for new hires? Why not reduce the COLA further? Why not make the hybrid option available to local employees?

Arguments can made in support of these and other issues. But the Governor has worked with key constituencies to reach a compromise that is estimated to improve VRS’s financial position by $5.8 billion over 21 years through a combination of higher contributions and lower costs. The General Assembly should pass it or something similar, and it must take action this session.

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