State and local government retirement benefits are dictated by statute in some instances, but local governments and some state universities are free to offer whatever retirement benefits they choose. Separate laws mandate the main retirement benefits offered to public school employees (including community college and some public university employees), state police, state employees, judges and legislators. There are additional state rules for the retirement benefits offered to certain local police and fire employees. The state constitution also prevents the mitigation of earned pensions and requires governments to set money aside to pay for benefits as they are earned.
With 241,629 members in just the school employee and state employee retirement systems alone, the majority of government employees in Michigan are in state-managed retirement plans.
There was a state-run municipal retirement system, but it became an independent nonprofit in 1996. Even prior to this, not every local government was a member of that system and local government units — cities, villages, townships and counties and whatever subsequent authorities and agencies they create — are free to offer whatever retirement benefits they choose, subject to collective bargaining when employees are unionized.
Regardless of whether or not a retirement system is managed locally or by the state, the majority of them are defined-benefit pension systems, where employees receive annuities paid upon retirement based on a formula. These formulas typically involve factors such as the number of years employed, average salary (over a certain period) and a prescribed multiplier.
Michigan’s constitution requires that all government employers set aside money necessary to cover the costs of the retirement benefits earned by employees. Government employers accomplish this by pre-funding retirement benefits. They hire actuarial firms to estimate the amount of money necessary to cover the annual retirement benefit earned. This money is set aside and invested in the market and the investment funds provide a return. These savings and returns are used to pay for the costs of pension payments to retirees.
Most government entities in Michigan have not saved enough to cover all the costs of the retirement benefits earned by their employees and retirees. In order to cover this shortfall (called an unfunded liability), government employers need to make an additional payment to their retirement systems. The total expense of a pension system, then, are the costs required to cover the retirement benefits earned in a year — the normal costs — plus the costs to catch up on any unfunded liabilities. Unfunded liabilities do not have to be immediately paid off as they develop — they can be amortized and repaid over an extended period of time, typically up to 30 years.[*]
Amortization payments on unfunded liabilities are a major and volatile expense of government pension plans. For example, the Michigan Public School Employees’ Retirement System, the largest state-run pension system, currently carries $24.3 billion in unfunded liabilities, and the amortization payments amount to 18.64 percent of contributing employers’ payroll. As market returns rise and fall, the actuarial value of pension fund investments correspondingly rise and fall as well, changing the amortization payments. Graphic 2 shows MPSERS’ unfunded liabilities over time.
Graphic 2: Unfunded Liabilities in MPSERS, 1988-2012
Source: 1996-2012 MPSERS Comprehensive Annual Financial Reports, MPSERS 2012 Annual Actuarial Valuation Report.
The state government employee pension plan, the Michigan State Employees’ Retirement System, cost the state $23,512 per active member in fiscal 2012.[†] This covered the normal and amortization payments divided by the number of working employees in the system. The plan is only 60 percent funded so the costs to catch up are substantial.
The costs of the MSERS pension plan per active member tend to be higher than other pension systems. For instance, MPSERS costs only $7,371 per active member to prefund pension benefits and make amortization payments. This plan is 65 percent funded. The Municipal Employees’ Retirement System of Michigan, which offers a variety of pension benefit options, costs an average $7,957 per active member, though there is substantial volatility in the required contributions as a percent of payroll for each employer.
New state government employees are offered participation in a defined-contribution pension system instead of a defined-benefit one. All employees hired on or after March 31, 1997 are offered retirement benefits where the state automatically puts in 4 percent of employees’ salaries and matches employee contributions up to an additional 3 percent of their salaries. As of 2012, the state had 32,749 participants in its defined-contribution plan and there were 17,860 active members in its closed-out, defined-benefit retirement system.
Retirement benefits in the private sector are different from those commonly found in Michigan’s public sector. A 2010 survey of major Michigan private sector employers found that only 25 percent offer participation in a defined-benefit pension plan and none offered a plan based on final average compensation, which is typically used in public sector pension formulas. Moreover, the 25 percent that did offer defined-benefit pension plans were “cash-balance” plans, which do not base pensions on an employee’s final compensation — which tends to be more generous — but on contributions made on behalf of that employee over time.
The majority of private sector retirement benefits are offered through defined-contribution retirement plans. In these types of plans both employees and employers make contributions to an individual, tax-favored account. These funds are generally managed by employees, and employees accumulate the benefits of investing these funds. Employees can then use these funds upon their retirement.
All of the Michigan companies surveyed in 2010 offered defined-contribution plans to new employees. While these plans can be designed to be as expensive as employers wish — subject to limitations of tax preferences — they also put the risk for investment return onto the employee, who becomes responsible for selecting plans that meet his or her individual risk preference.[‡]
In 2012, only 19 percent of private sector workers nationally had access to defined-benefit pension systems and 59 percent of workers had access to a defined-contribution retirement system. In the same year, 83 percent of state and local government employees had access to defined-benefit retirement system, while 31 percent had access to a defined-contribution system.[§]
In addition to differing in the types of retirement benefits they offer, the private and public sectors differ in the portion of employees to whom they offer such benefits and in the portion of their employees who make use of them. In 2013, 64 percent of private sector employees nationally were offered retirement benefits, and 49 percent participated. For state and local government employees, 89 percent were offered access to retirement benefits, with 85 percent participating.
Much, but not all, of the access disparity can be explained through the use of part-time employment, considering that part-time employees are less likely to have access to retirement benefits.[¶] Private sector employers make greater use of part-time employment, with about 19 percent of jobs defined as less than 35 hours of work per week. This same figure is only 14 percent for state and local government jobs. In many defined-benefit pension systems, all employees participate regardless of whether they work full time or part time.[**]
[*] For instance, Michigan’s largest pension system is paying off its unfunded liabilities over the next 25 years. "Michigan Public School Employees' Retirement System: Comprehensive Annual Financial Report for the Fiscal Year Ended September 30, 2012," (Michigan Office of Retirement Services, 2013), 37, http://goo.gl/NwCb6 (accessed Sept. 23, 2013).
[†] Author’s calculations based on data from "Michigan State Employees' Retirement System: Comprehensive Annual Financial Report for the Fiscal Year Ended September 30, 2012," (Michigan Office of Retirement Services, 2013), 45, http://goo.gl/7qUqY (accessed Oct. 1, 2013). This estimation may be high because the state’s actuaries believe that the normal cost is about $95 million while the amortization payment required is $417 million. This is also high relative to the normal costs because the plan was closed in 1997 and active members have been gradually decreasing, meaning that larger payments are necessary to defray the costs of retirement benefits that they are accruing. For more information, see: "Michigan State Employees' Retirement System: Annual Actuarial Valuation Report, September 30, 2012," (Gabriel Roeder Smith & Company, 2013), D-1.
[‡] Defined-benefit plans are not entirely risk free from an employee’s perspective; they contain inherent political risk, for example. If government managers do not properly fund pension systems, there may not be enough assets to pay the benefits that employees have earned. Bankrupt cities have defaulted on pension payments and bankruptcy judges have lowered pension benefits. Whether pension benefits in Detroit will be mitigated is subject to a bankruptcy judge’s ruling. For more on this, see: Cate Long, "The real history of public pensions in bankruptcy," (Reuters, 2013), http://goo.gl/7U6HIB (accessed Oct. 2, 2013).
[§] The figures can add up to more than 100 percent if employees are offered optional participation in both defined-benefit and defined-contribution plans. "National Compensation Survey Custom Data Report," (U.S. Bureau of Labor Statistics), www.bls.gov/ncs (accessed Apr. 16, 2013).
[¶] Nationally, 37 percent of part-time employees have access to retirement benefits, while 78 percent of full-time employees are offered these benefits. "Employee Benefits in the United States - March 2013," (U.S. Bureau of Labor Statistics, 2013), 6, http://goo.gl/YNrFM (accessed Oct. 3, 2013).
[**] While all employees are participants, part-time employees earn only a portion of a year’s service. For instance, a full-year service credit in MPSERS requires 1,020 hours worked in a year — less than half of the standard 2,080 hour full-time work year. If the employee worked less than 1,020 hours in a year, their service credit is pro-rated for that period. "How You Earn Service Credit," (Michigan Office of Retirement Services), http://goo.gl/OaxCBj (accessed Sept. 6, 2013).