Too generous, too incompetent, too corrupt? Today, city and state public pension funds’ administrators are under fire, and although nobody has been convicted of any wrongdoing, ongoing scandals have drawn attention to a widespread problem – the widening deficit of defined benefit (DB) plans in the public system. The issue has given more fuel to the proposal for transforming DB public plans into defined contribution (DC) individual retirement schemes, like the 401(k)s prevalent in the private sector, or the new Roth 401(k)s, available from 1 January 2006.
Since spring, the governor of California Arnold Schwarzenegger has been trying to offer a 401(k)-style system only to new state employees. He has not succeeded so far, but he has not given up either, with San Diego’s “pension-fund debacle” - as the Wall Street Journal headlined it - helping his cause. For almost two years San Diego, has been struggling with a $1.4bn (e1.2bn) deficit in its municipal pension fund: subsequently, the mayor Richard Murphy has lost his job and several authorities, like the Securities & Exchange Commission, the FBI, and the US Attorney’s office are investigating allegations of securities fraud and public corruption in connection with the fund.
In addition, the San Diego District Attorney has charged six former and current pension fund trustees on conflict-of-interest charges; they were city employees whose benefits increased $386-$2,530 a month as a result of the city’s deal with the pension fund.
In 2002, the trustees accepted the city’s offer to raise employees’ benefits and annual contributions to the pension fund instead of paying $500m to fill the fund’s deficit gap, which was created by a mix of previous generous labour deals and bad stock market returns. The problem with pension funds like San Diego’s is that their boards are controlled by unionsz which, according to Steven Erie, a professor of political science at the University of California, San Diego, is “a very serious financial problem”.
Colorado’s Public Employees Retirement Association (PERA), is also suffering from an incompetent board loaded with politicians, and is facing a projected $12bn shortfall. A state-appointed commission found out that “the overriding cause of PERA’s financial deterioration stems primarily from the failure of PERA management and its governance structure to act as responsible stewards”. Among the board’s irresponsible decisions from 1999 onwards, there was the permission for state employees to retire earlier and get better benefits with a fixed, 3.5% cost of living adjustment. The panel recommended replacing the board members, raising the employee contribution rate, lowering the cost of living adjustment and increasing the retirement age. Commission member, University of Colorado economics professor Barry Poulson, stresses that the only solution is changing PERA into a DC plan.
Illinois’ public pension fund is also in trouble. Governor Rod Blagojevich is accused of hatching a covert “fund-raising strategy”; investment firms and consultants were allegedly considered for pension business in exchange for campaign contributions, a claim the administration strongly denies but prosecutors continue to investigate. With such big interests are at stake in the public pension fund system, privatisation and transformation into a 401(k)-style scheme in unlikely soon.
Meanwhile, private sector employees will have a new option at the beginning of 2006 – the Roth 401(k). The new plan is similar to the Roth Individual Retirement Account (IRA) – named after the late senator William Roth, co-sponsor of the related legislation. IRAs are DC individual plans for self-employed workers. Roth 401(k)s will differ from 401(k)s because the employee contribution will be in after-tax dollars; and they will differ from Roth IRAs because they will allow for contributions of $16,000 a year for employees under the age of 50. The earnings on the Roth deferrals will be tax free if the contributions remain in the plan for at least five years and if the participant does not take withdrawals before attaining age 59.
A traditional 401(k) contribution is tax deferred at the time of contribution and both the deferral and the earnings on the deferral are taxable when distributed. Some consultants stress that employees will be able to accumulate more money in a Roth 401(k) than a traditional 401(k) because they’ll have already paid taxes on their Roth 401(k) contributions.
Father of 401(k) plans Ted Benna, points out that if an individual’s tax rate remains the same, the Roth and the regular 401(k) both result in the same amount of tax savings; but an employee can benefit from a Roth 401(k) if he is in a higher tax bracket when he retires and starts withdrawing the money.