Savings Plus Program: An Optional Retirement Benefit for State Employees

Savings Plus Program: An Optional Retirement Benefit for State Employees MAC TAYLOR • L E G I S L A T I V E A N A L Y S T • MARCH 14, 2017 AN LAO REPORT 2 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT EXECUTIVE SUMMARY In addition to retirement benefits that are at least partially paid by the state—including pension, retiree health, Social Security, and Medicare benefits—the Savings Plus Program (SPP) provides state employees a low-cost investment vehicle to save money on their own for their retirement. This report reviews SPP and is organized into three broad sections. Background on the SPP Program and Employee Participation. We find that although nearly three-fifths of eligible state employees have an SPP account, only about one-third of state employees regularly make contributions to their SPP account and that most regular contributions are low. In addition, we find that certain factors affect employees’ contributions—including age (younger employees are less likely to participate), income (higher-paid employees are more likely to participate and to save a higher percentage of their pay), and economic conditions (employees reduced their contributions during recent difficult economic periods). As a result of low participation and low regular contributions, the typical account balance is low, with most account balances being lower than $50,000. Role That State Retirement Benefits—Including SPP—Play in Retirement Security. Although everyone can benefit from saving money for their retirement during their career, we conclude that long-term state employees likely could retire without relying heavily on savings because of the financial security provided by state-funded benefits. However, we identify three groups of employees who could benefit most from putting aside money: shorter-term employees, who work less than a full career with the state; lower-paid employees, who might need money in addition to their pension to cover essential costs in retirement; and future employees, who will earn less generous retiree health and pension benefits. In addition, we discuss the benefit of investing over long periods of time to use the power of compounding interest—something younger employees can benefit from most. Comments About SPP and Options for the Legislature to Consider. We think that SPP is an important benefit the state offers employees as part of its employee compensation package. That being said, many employees who would benefit from using the program are not participating or are not contributing a meaningful amount of money to their accounts. When reviewing ways to improve participation, we recommend that the Legislature review policies other employers have adopted to improve participation in their retirement savings plans—including auto-enrollment, auto-escalation, and employer matches. We recommend that the Legislature take its time to consider its options and understand the possible effects of making changes to the current benefit. www.lao.ca.gov Legislative Analyst’s Office 3 AN LAO REPORT 4 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT INTRODUCTION This report examines the state’s optional state retirement benefits—including SPP—play deferred compensation program available to in providing retirement security to retired state state employees—known as the Savings Plus employees. Third, we provide overall comments Program (SPP). The report is organized into three on the program and discuss legislative options to broad sections. First, we provide background improve participation in the program. Throughout on SPP—including the program design and the report, we discuss a variety of topics intended options available to employees—and present to help the reader understand the program’s role our findings related to employee participation in state employee compensation and retirement in the program. Second, we discuss the role that planning. SAVINGS PLUS PROGRAM Optional Employee-Funded Retirement In addition to the optional deferred Savings Benefit. Most state employees earn compensation program available to most state retirement benefits that are at least partially funded employees, SPP also administers two deferred by the state, including a pension, retiree healthcare compensation programs designed for specific types benefits, Social Security, and Medicare. In addition, of employees—the Alternate Retirement Program an optional deferred compensation program— (ARP) and the Part-Time, Seasonal, and Temporary known today as the Savings Plus Plan—has existed (PST) Employees Retirement Program. The ARP is since 1974 in order to encourage retirement a program that provided new employees who were savings and increase savings options available hired between August 2004 and June 2013 up to to state employees. The program is managed by two years of retirement savings in lieu of traditional the California Department of Human Resources pension benefits. Employees who are not covered and allows most state employees—about 250,000 by Social Security and are excluded from earning employees, generally all state employees except state pension benefits are enrolled automatically in those who work for the University of California—to the PST retirement savings plan—SPP reports there set aside money they earn during their state career are more than 14,000 active participants in PST. to save for retirement. The SPP is a self-funded The ARP and PST are not included in this report’s program supported by administrative fees and analysis of SPP. operating expenses charged to participants’ Four Account Types Available to Participating accounts. The state currently does not contribute Employees. The types of retirement savings plans money to employees’ SPP accounts—either in the available to state employees through SPP include form of a match or otherwise. Employees who 401(k) and 457(b) retirement savings plans. The choose to participate in the program determine names of these plans refer to the section of federal (1) how much money to save, (2) how to invest the tax law that authorizes each plan. The law treats money they have saved, and (3) how to use these these plans differently in some respects, including funds in retirement. the amount of money employees may contribute later in life above the normal contribution limits www.lao.ca.gov Legislative Analyst’s Office 5 AN LAO REPORT established under federal law (referred to as than actively managed funds, resulting in “catch up” contributions) and the circumstances lower operating expenses and fees. under which a participant may withdraw money • Target Date Funds. With the two types of before retirement. Beginning in 2013, state fund options discussed above, participants employees have two account options within each must implement and monitor their plan—“traditional” or “Roth”—that affect when investment strategy over time. Participants they pay taxes on the money that is invested in who want to “set and forget” their either their 401(k) or 457(b) plans. investment strategy can choose to invest Variety of Investment Options. People choose their money in a target date fund. Target how to invest their retirement savings based on date funds offered by SPP are constructed personal investment goals, the amount of time using the core investment funds discussed before they expect to draw down savings, how above. Participants select a target date fund involved they want to be in managing their based on the year in which they expect to investments, the level of risk that they want to take, begin drawing money from the account. and their willingness to pay fees. The investment Over time, fund managers change the mix funds SPP offers range from conservative (with of these funds so that investments in the virtually no risk that investors lose money on target date fund are exposed to lower levels their investment) to aggressive (with much higher of risk as the target date approaches. probability of losing money in any given year). A fund with higher risk is expected to achieve higher Optional Self-Directed Brokerage Account. returns on the investment over time (conversely, Although participants have choices among the investments in lower-risk funds are expected to three types of funds described above, they do not have lower average returns). A common retirement have discretion as to what investment decisions saving strategy directs investors to adjust their are made within each fund. Participants who investments over time so that they expose their want a more direct role in selecting specific stocks assets to lower levels of risk as they approach or mutual funds included in their investment retirement. Participants can choose to have their portfolio may choose to manage their savings in asset allocation professionally managed or to make SPP through a self-directed brokerage account— these decisions themselves by investing their money currently provided by Charles Schwab. in any mix of the funds offered by SPP, including: Annuity Products Not Available. Despite the fact that current law requires SPP to offer an • Managed Funds. Managed funds are annuity product, SPP has not included this type “actively managed funds,” meaning fund of product among its investment options for more managers make informed decisions to trade than three years. In a nearby box, we discuss the with the goal of earning higher investment challenges SPP has identified in offering annuity returns than the market average. products and why the Legislature should consider • Index Funds. Index funds are “passively removing the requirement in current law. managed.” Fund managers make trade Low Administrative and Investment Fees. decisions with the intent of matching the Participants pay two types of ongoing fees to invest average performance of a group of stocks. their money with SPP: (1) administrative fees and Index funds typically have less overhead (2) operating expenses of investment funds. The 6 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT SPP monthly charges a flat dollar administrative fee from 0.13 percent and 0.77 percent (0.05 percent of $1.50 to participants of each plan in order to pay of these expenses go towards SPP administration for staff and other operating expenses of the state costs). It is difficult to compare fees charged by program. Investment fund operating expenses are retirement savings plans offered by different charged by the investment manager as a percent employers; however, it appears that SPP fees are low of the fund’s balance, reducing any gains from the compared with national averages. fund. The operating expenses vary by the type of Fees can have a significant effect on the growth investment chosen by the participant and range of funds over a period of time. To illustrate how Annuity Products and Savings Plus Program (SPP) Current Law Requires SPP Provide Annuity Product. An annuity is an insurance product that commonly is used to provide an income stream in retirement. While there are different types of annuities, the basic structure of an annuity is that a person invests money with an insurance provider in exchange for regular payments from the provider in the future. State law—Section 19993.05 of the Government Code and Section 599.942 of the California Code of Regulations—requires SPP to offer an annuity product among its menu of investment options available to participants. Should Legislature Consider Removing Requirement? SPP has found it challenging to offer an annuity product among its investment options. For more than three years now, no vendor has submitted bids to SPP’s Request For Proposal for an annuity product. As a result, SPP currently does not offer an annuity product as an investment option to participants. SPP staff have identified two fundamental challenges with offering this type of product among the program’s investment options: • Incongruous Contract Periods. Annuity products provide participants income streams over long periods of time, requiring them to have relationships with the same annuity provider over many years. This arrangement is awkward for SPP as it contracts with providers typically for periods of only five or seven years. When a contract expires, SPP is required to seek competitive bids from the vendor community—the most competitive bid might not be from the old provider. • Fiduciary Role to Minimize Costs. SPP serves a fiduciary role over the money participants invest in the program. SPP interprets this role to mean that it must provide participants investment options that will help participants reach their investment goals at the lowest possible cost. Compared with investment options with similar returns, annuity products tend to have relatively high fees and other costs. Given the challenges SPP has identified in offering an annuity product, we think it is reasonable for the Legislature to hear from SPP and annuity providers to determine whether or not state law should continue to require SPP to offer an annuity product. Regardless of whether or not SPP provides an annuity option, participants can—upon separating from state service—use their assets in SPP to purchase an annuity in the private market. www.lao.ca.gov Legislative Analyst’s Office 7 different expense ratios can affect a person’s savings, can significantly reduce their account’s growth Figure 1 illustrates the effect of $10,000 invested to potential and, ultimately, the amount of money earn an average return of 5 percent each year over available to them in retirement. 25 years with (1) an annual operating expense of Employee Participation 1 percent compared with (2) an annual operating expense of 0.5 percent. At the end of the 25-year Nearly Three-Fifths of Employees Have SPP period, the perhaps seemingly small difference of Account, but Few Make Regular Contributions. Of 0.5 percent in operating expenses results in the the nearly 250,000 employees eligible to participate account with higher fees being more than 10 percent in SPP, the program reports that—as of May 2016— ($3,000) less than the account with lower fees. about 144,000 employees have an account with SPP. Accessing Money Before Retirement. Before This means that fewer than 60 percent of eligible retiring, eligible participants can access the funds state employees are saving for retirement using SPP. they have invested with SPP through either a This level of participation is lower than the national withdrawal or a loan. Money that is withdrawn— average of 70 percent of people eligible to participate permanently taken out of their account—before in a 401(k) through their employer. There are a retirement may be subject to income and penalty number of reasons why participation might be lower taxes. In the case of a loan, participants borrow among state employees. For example, employees money from their account and pay the money might (1) not see a need to save because of the back—with interest—over time. (We discuss state-funded retirement benefits provided in the loans in greater detail later in this report.) While state’s compensation package, (2) find it financially accessing this money before retirement can help difficult to participate because of other competing participants address immediate cash needs, it also priorities in their personal budgets, (3) choose to invest retirement savings in Figure 1 another type of account, or Annual Fees Significantly Affect (4) not be aware of SPP. In Long-Term Account Balances 2014-15, 93,600 employees Comparing Effect of Two Different Fees on $10,000 Investment Over 25 Years made contributions to their SPP accounts—about $35,000 two-thirds of employees with 30,000 an SPP account. This low level 0.5 Percent Fee of regular participation in 25,000 the program seems relatively 20,000 1 Percent Fee consistent over the past 15,000 15 years. (Participation among California State University 10,000 employees appears to be 5,000 particularly low, with only about 10 percent regularly 5 10 15 20 25 participating in SPP.) ecnalaB tnuoccA AN LAO REPORT Year of Investment Note: Assumes a 5 percent annual return on investment. 8 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT Some Types of Employees More Likely to Relatively Few Employees Have Both 401(k) Participate. Some employees are more likely to and 457(b) Plans. Depending on a person’s use an SPP account than others. These employees financial goals, it can make sense to invest money include: in both plans offered by the state under SPP. The largest benefit of investing in both plans is • Higher-Paid Employees. There is that it allows participants to contribute up to significant variation in participation the maximum amount of money authorized for across the state’s 21 bargaining units. each plan. (A person can contribute to both plans Historically—as shown in Figure 2— without contributing the maximum amount to bargaining units that are paid more have either plan.) About 20 percent of the participants had higher participation rates. Higher-paid making regular contributions to SPP in 2014-15— managers and supervisors also are more more than 18,350 participants—regularly likely to make regular contributions. contributed money to accounts in both plans. • Managers and Supervisors. About half of Bargaining units with higher-paid members tend managers and supervisors make regular to have a higher share of employees who contribute contributions to SPP accounts. As Figure 3 money to both accounts. shows (see next page), managerial or Employee Contributions supervisorial professional engineers, physicians, highway patrol officers, Contributions Limited by Minimum and attorneys, correctional officers, and Maximum Requirements. Participating employees professional scientists all have participation choose whether they want to regularly contribute rates exceeding 50 percent. Managers and money to their SPP accounts and how much money supervisors typically are long-term state Figure 2 Higher-Paid Rank-and-File Employees More Likely to employees who have Participate in Savings Plus Program (SPP) worked with the state for more than 15 years. Average Annual Pay of Bargaining Unit Members • Older Employees. A $250,000 disproportionate share of older employees 200,000 participate in SPP. As 150,000 Figure 4 shows (see page 11), employees 100,000 who are older than 55 years represent 50,000 about one-quarter of state employees but 10 20 30 40 50 60 70% represent more than 35 percent of SPP Share of Bargaining Unit Members Regularly Contributing Money to SPP participants. Note: Each point corresponds with one of state’s 21 bargaining units. www.lao.ca.gov Legislative Analyst’s Office 9 AN LAO REPORT they contribute. However, these contributions are Regular Contributions Are Low. Some limited by state and federal policy. Specifically, employees contribute significant amounts of money (1) SPP requires a minimum regular contribution to their SPP accounts. (For example, in 2011, of $50 per month and (2) federal tax law establishes more than 300 state employees contributed more the maximum amount of money that participants than $30,000 to their SPP accounts.) However, may contribute each year towards their 401(k) and many of these large contributions are not regular 457(b) plans. In most cases, the limit for each plan contributions, but rather are one-time contributions in 2017 is $18,000. made at the end of a person’s career (discussed in Figure 3 Over Past 15 Years, Managers More Likely to Participate in Savings Plus Program (SPP) Than Rank-and-File Employees Bargaining Units 1—Administrative, Financial, and Staff Services 2—Attorneys and Hearing Officers 3—Professional Educators and Librarians 4—Office and Allied 5—Highway Patrol 6—Corrections 7—Protective Services and Public Safety 8—Firefighter 9—Professional Engineers 10—Professional Scientists 11—Engineering and Scientific Technicians 12—Craft and Maintenance 13—Stationary Engineers 14—Printing and Allied Trades 15—Allied Services 16—Physicians, Dentists, and Podiatrists 17—Registered Nurses Managers and Supervisors 18—Psychiatric Technicians Rank-and-File 19—Health and Social Services 20—Medical and Social Services 21—Educational Consultants and Library 10 20 30 40 50 60 70 80 90% Share of Unit Participating in SPP 10 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT greater detail below). Regular Figure 4 ongoing contributions to SPP Older Workers Disproportionally appear to be low. In particular, Likely to Have Savings Plus Account in 2011, (1) more than one-half of participants contributed 40% less than $2,000 in the year Share of Savings Plus Participants 35 Share of State Workforce and (2) nearly 30 percent of participants contributed 30 less than $1,000 in the year. 25 Considering the minimum regular contribution requires 20 participants to contribute 15 at least $600 each year, it seems that many participants 10 contribute about the minimum 5 amount. Leave Cash Outs Under 35 36-45 46-55 55 and Older Result in Large One-Time Contributions Upon their age. Participating employees who are the Retirement. Employees who farthest away from retiring contribute the smallest are retiring often have significant balances of portion of their pay to SPP while employees closest unused leave. Employees can receive payment for to retirement contribute the largest portion of their certain types of unused leave when they separate pay. The larger contributions from older employees from state service as (1) income subject to income likely are due to a combination of large one-time taxes or (2) a pre- or post-tax deposit to SPP. Many leave cash outs upon retirement and catch-up employees choose to deposit a large portion of contributions. this payment into their SPP account. As a result, Employees Reduced Contributions During there are large spikes in contributions to SPP in Periods of Economic Stress. Parts of the past years when more people retire with large leave 15 years have been difficult economic times. Many balances. (Within a given year, there often are Californians—including state employees—were spikes in contributions in months with high rates faced with personal financial challenges as a result of retirement.) of the end of the housing bubble in the mid-2000s Higher-Paid Employees Regularly Contribute and the recession that followed. In particular, Larger Share of Pay. Not only are higher-paid state employees saw significant cuts in their pay— employees more likely to participate in SPP, but between about 5 percent and 14 percent—during up those who participate in the program regularly to 49 months of furloughs between 2009 and 2013 tend to contribute a higher percentage of their pay (see our March 2013 report, After Furloughs: State than participating lower-paid employees. Workers’ Leave Balances, for more information on Older Employees Contribute Larger Share the furlough program). Employees participating of Pay. The percentage of pay that participating in SPP seem to have reduced how much money employees contribute to SPP depends greatly on www.lao.ca.gov Legislative Analyst’s Office 11 AN LAO REPORT they contributed to their SPP accounts in response Retirement Research (CRR) at Boston College, to these economic challenges. As Figure 5 shows, the median 401(k) balance for employees aged the average contribution to SPP—as a percent of between 55 years and 64 years who earn between pay—over the past 15 years peaked in 2005-06 $61,000 and $90,999—the pay range in which the at nearly 10 percent of pay and declined during average state employee falls—was about $100,000 years of furloughs. The figure includes money in 2013. Although some SPP participants have large participants contributed after cashing out leave account balances—1,300 participants have account upon retirement and captures a period of time of balances exceeding $500,000—the vast majority increased retirements after 2009-10. As a result, of participants have very low account balances. participating state employees likely reduced their More than 70 percent of SPP participants have regular contributions during furloughs by more account balances of less than $50,000. The median than what is reflected in the figure. 401(k) account balance of SPP participants between the ages of 56 years and 65 years is $25,000— Account Balances one-quarter of the amount reported nationally. Low Account Balances. We would expect state (The median 457[b] account balance for this same employees to need less savings than employees cohort of participants is slightly higher at $28,000.) in the private sector. That being said, account Loans balances in SPP are much lower than national averages. According to January 26, 2016 testimony As mentioned earlier, participants can borrow to a U.S. Senate committee by the Center for money from their retirement savings in SPP. Specifically, participants can Figure 5 have up to two open loans Participants Reduced Contributions to from each plan—401(k) and Savings Plus During Recent Economic Challenges 457(b)—at any one time. The Average Annual Contribution as Percent of Pay minimum amount of money Great Recession that participants can borrow 12% for each loan is $2,500 and the maximum amount is $50,000. There are two types of loans 10 available to participants: (1) general purpose loans that 8 can be used for any purpose and (2) primary residence 6 loans that can be used to Furloughs Beginning of California help employees purchase a 4 Housing Collapse primary residence. For each type of loan, the interest 2 charged to the principal—as of September 2016—is 4.5 percent. (Under current 2000-01 2002-03 2004-05 2006-07 2008-09 2010-11 2012-13 2014-15 policy, the interest rate is 12 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT determined as 1 percentage point higher than the easier for state employees to access cash during the prime interest rate reported by The Wall Street state’s furlough program. When comparing data Journal in the quarter during which the loan is from the years between 2006 and 2009 (the period initiated.) Participants who take out a loan must immediately before furloughs and before the lower repay the loan back to their own accounts within threshold was established) with the years between (1) five years in the case of a general purpose loan 2010 and 2015 (the period during and immediately and (2) 15 years in the case of a primary residence after furloughs), the number of general purpose loan. loans doubled. However, the value of the average Policy Change and Furloughs Increased general purpose loan decreased from about Borrowing From Retirement Savings. In order $12,900 to about $10,400. This suggests that more to initiate a loan, SPP requires participants to state employees took smaller loans against their have a minimum account balance of $5,000. This retirement savings in order to deal with personal threshold was established in June 2009 when SPP financial difficulties arising from the pay cuts reduced the minimum account balance from during furloughs. $10,000. This policy change was intended to make it STATE EMPLOYEE RETIREMENT SECURITY A person’s financial security depends largely known as the income replacement ratio. This ratio on their income and the costs they incur to attempts to determine how much annual income a maintain a certain standard of living. It is difficult person needs to sustain a certain standard of living to generalize how much money a person needs in retirement. This ratio is a person’s expected at any stage in life because a person’s financial retirement income expressed as a percentage of the security depends on a number of personal choices, income the person earned before retirement. If a circumstances, and assumptions regarding the person’s replacement ratio exceeds a given target, future. This is particularly true regarding a person’s he or she is more likely to have enough income retirement security. That is, how do you determine to maintain his or her preretirement standard of whether a person will have enough money in the living. There is no one-size-fits-all replacement future to pay all expenses incurred from the date ratio. A 2005 CRR publication found: “Overall, he or she exits the workforce until he or she dies? the range of studies that have examined [the] In this section, we discuss the retirement security issue consistently finds that middle class people provided by state-funded retirement income and need between 65 percent and 75 percent of their healthcare benefits and how the level of security preretirement earnings to maintain their lifestyle provided by these benefits will change for retired when they stop working.” Similar to the 2005 study, future employees. a 2010 U.S. Census Bureau paper found that the replacement ratio for the median individual—as Retirement Income of 2004—was between 66 percent and 75 percent Measuring Retirement Security. One common of preretirement income. In general, lower- metric among financial planners and economists income workers may need a higher replacement for assessing a person’s retirement security is ratio because they are expected to spend a www.lao.ca.gov Legislative Analyst’s Office 13 AN LAO REPORT higher proportion of their income on housing, they are when they begin receiving Social Security transportation, food, healthcare, clothing, and benefits and how much money they earned during other essentials. their career (up to the wage limit mentioned above). A “Three-Legged Stool.” During the 20th California Public Employees’ Retirement System Century, retirement security in the United States (CalPERS) estimates that Social Security replaces evolved into what is referred to as the three-legged between 15 percent and 30 percent of a typical stool of retirement security whereby a typical eligible retired state employee’s final salary. Any retired worker is expected to receive income in changes in federal policy that affects Social Security retirement from a combination of three sources: could affect state and state employee costs to fund Social Security, employer-sponsored retirement the benefit and could reduce the retirement security plans, and personal financial assets. The retirement provided by the benefit. benefits offered to state employees largely are Defined Benefit Pension. The vast majority based on the structure of the three-legged stool of full-time state employees earn a defined benefit of retirement security. Specifically, most state pension as part of their compensation. When employees participate in Social Security, receive an employee retires, he or she receives a lifetime a pension from the state, and have the option to pension that is determined using a mathematical deduct money from their pay to save money on formula that takes into account the number of their own for retirement in SPP. As we discuss years of service credited to the employee multiplied below, the level of retirement security these benefits by a rate of accrual (determined by the employee’s provide retired state employees depends a great job, date of hire, and age at the time of retirement) deal on how long the employee worked for the state, and multiplied by the employee’s final salary when the employee was hired by the state, and the level. Retirees typically receive a cost-of-living level of pay the employee earned during his or her adjustment of up to 2 percent each year to at least career with the state. Our discussion below looks partially offset erosions in purchasing power only at the level of retirement security provided by resulting from inflation in the broader economy. In state-funded benefits. We cannot generalize state the event that inflation exceeds 2 percent, the state employees’ overall retirement security as we do not guarantees that a retiree’s pension will maintain at know employees’ or retirees’ alternate sources of least 75 percent of its original purchasing power. income or personal assets held outside of SPP. The state’s pension benefits are funded through Social Security. Most state employees three main sources of funding: investment returns, participate in Social Security. The largest groups state contributions, and employee contributions. of state employees who are excluded from Social CalPERS reports that about two-thirds of every Security are peace officers (like correctional dollar paid to its retirees is paid from investment officers) and firefighters. During the career of returns. Revenues from investment returns vary employees in Social Security, both the employer significantly year-to-year depending on market and employee pay taxes on earnings. In 2017, both performance. CalPERS makes assumptions about the employee and the state pay 6.2 percent of the investment returns when determining how much employee’s pay. Payroll taxes are not applied to money must be contributed each year to fund the earnings above a wage limit—$127,200 in 2017. system. The state’s contributions towards these When a worker retires, he or she receives monthly benefits are greatly affected by the extent to which Social Security benefit payments based on how old investment returns vary from these actuarial 14 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT assumptions. CalPERS staff expect investment for each year of service. Accordingly, the returns over the next ten years to be lower than pension benefit increases with every year of past average returns and lower than current service. assumptions. At its December 2016 meeting, the • Age at Retirement. The percentage of final CalPERS board voted to reduce its assumed rate salary received by state employees for each of return over the next few years to reflect these year of service depends on an employee’s lower expected returns. This assumption change age at retirement. Generally, employees will increase the amount of money that must be receive a larger pension if they retire later contributed to the system each year. This will result in life. in the state paying more to fund pension benefits for all employees. In addition, employees will need State employees who were hired after to contribute a larger percentage of pay in order to 2013—“PEPRA employees”—will need to work maintain the standard established under the Public longer to receive a pension that replaces the same Employees’ Pension Reform Act of 2013 (PEPRA) portion of their working salary compared with that employees pay one-half of “normal costs” employees earning pension benefits established of pension benefits. To the extent that the state before the state reduced pension benefits—often shifts higher pension costs onto state employees, referred to as “classic employees.” In addition, employees likely will save less money in SPP. high earning employees subject to PEPRA receive Certain Factors Affect Employee Retirement no benefit for earnings above a certain threshold, Security Provided by Pension. A number of meaning that the state pension benefit replaces factors affect how much of final salary is replaced a somewhat smaller portion of these employees’ by the state’s defined benefit pension to retired salary. state employees. Specifically, this replacement ratio Substantial Share of Salary Replaced for depends on employees’: Long-Term Employees. In total, pension and Social Security benefits (after eligible retired • Type of State Job. Peace officers and state employees choose to begin receiving Social firefighters who do not participate in Social Security payments) replace between 70 percent Security receive pensions that are designed and 90 percent of a typical long-tenured state to replace a larger share of their salary at employee’s salary in retirement. Assuming they younger ages than other state employees. work a few extra years, this level of financial • Date of Hire. Periodically, the state has security also is available to long-serving PEPRA modified the pension benefits received employees. by future state employees. Most recently, Healthcare employees hired after January 1, 2013— when PEPRA went into effect—are subject Healthcare costs are largely nondiscretionary. to a somewhat less generous benefit than For most retired Americans, healthcare is one of employees hired before that date. the highest costs incurred in retirement—especially as the retiree ages. For the past two decades, health • Length of Service. Pension benefits are premiums across the country have consistently designed so that employees receive a increased at rates faster than inflation in the specified percentage of their final salary broader economy. Health premiums are expected www.lao.ca.gov Legislative Analyst’s Office 15 AN LAO REPORT to continue growing faster than the economy for benefits are based on the salary employees earned the foreseeable future. To the extent that healthcare during their career, these increased costs will costs consume a growing share of a retired person’s disproportionately affect lower-paid state employees income, his or her financial security can be in retirement. Future employees who work fewer significantly weakened. than 15 years with the state will receive no money Low Retiree Healthcare Costs for Long-Term from the state to pay for these costs. Employees. Employees with long careers with the Employee Contributions to Prefund Benefit state receive substantial state contributions to pay Discourage Savings . . . The standard established for their health premium costs. We describe this by the state’s current plan to prefund retiree benefit for current employees and its interaction health benefits is that the state and employees with Medicare in the box on page 17. The state’s each will agree to pay one-half of normal costs retiree health benefit largely has shielded retired to prefund the benefit. In the agreements ratified state employees from rising premium costs by by the Legislature to date, these contributions paying most—if not all—retiree health premium are established as a percentage of pay. The state costs. With the state paying a substantial portion and employee contributions to prefund the of healthcare costs for state employees who retire benefit likely will need to be revisited in future after working a long career with the state, retired rounds of collective bargaining. To the extent that state employees can use larger portions of their employees are required to pay larger shares of retirement income on other costs. their pay to prefund retiree health benefits in the Benefit Changing for Future Employees. As future, employees probably will save less for their part of his 2015-16 budget proposal, the Governor retirement. proposed significant changes to the state’s health . . . Especially for Some Lower-Paid Employees. benefits provided to retired state employees and Unlike pension benefits, the state’s retiree health how the state pays for these benefits. This policy is benefit is not based on a person’s income either being implemented for most of the state workforce during his or her career or in retirement. The through either collective bargaining or state law. state’s retiree health benefit is the same for an We describe the major elements of this policy in employee earning $30,000 as it is for an employee the box on page 18. For a more detailed discussion earning $100,000. The agreements with the nine of the plan, please refer to our March 2015 report, bargaining units represented by Service Employees The 2015-16 Budget: Health Benefits for Retired State International Union Local 1000 share the total Employees, or our analyses of recently proposed cost to prefund retiree health benefits across the labor agreements. units so that all affected employees pay the same Higher Health Costs for Future Employees percentage of pay. For other units, labor agreements When They Retire. Future retired state employees implementing the state’s shared cost prefunding will experience significantly higher health costs standard require employees in lower-paid than current state retirees by paying a larger bargaining units to pay a higher percentage of pay portion of CalPERS Medicare plan premiums and than employees in higher-paid bargaining units. the full Medicare Part B premium. Future retired For example, the agreement with Bargaining Unit 2 state employees’ health costs likely will rise faster (Attorneys)—a unit with an average base pay of than the cost-of-living adjustment provided for more than $100,000—requires employees to pay their pension. Because pension and Social Security 2 percent of pay each year to prefund the benefit, 16 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT Interaction of Medicare and CalPERS Health Benefits for Current Retirees Four Parts to Medicare. Medicare is the federal program that provides health care coverage to people over the age of 65 years. The program is funded by a combination of payroll taxes levied on active employees and their employers, premiums paid by people enrolled in Medicare, and money from the federal budget. The four parts of Medicare are discussed below. People participating in Medicare must be enrolled in Part A and Part B—referred to as “Original Medicare”—but can choose whether or not they want to participate in Part C or Part D. • Part A (Hospital Insurance). People who paid Medicare payroll taxes for at least ten years do not pay a monthly premium for this coverage in retirement. • Part B (Medical Insurance). To receive this benefit, people pay a monthly premium that is determined based on their income. The standard premium in 2017 paid by an individual making less than $85,000 each year is $134 each month ($1,608 for the year). • Part C (Medicare Advantage Plans). Federal law allows people to purchase health insurance offered by a private company that contracts with Medicare to provide benefits covered by Part A and Part B. People enrolled in a Medicare Advantage Plan pay the monthly Part B premium in addition to whatever premium is established for the Medicare Advantage Plan. • Part D (Outpatient Prescription Drug Insurance). People in either Original Medicare or a Medicare Advantage Plan can choose to pay an additional monthly premium to purchase Medicare-approved prescription drug insurance under Part D. State Contributions for Most Retired State Employees Cover Medicare Costs. Retired state employees receive money from the state to pay for health care costs. The amount of money the state pays is based on a weighted average of the premiums for the four health plans with the highest enrollment of state employees. Since 1978, the maximum contribution available to retired state employees has been what is referred to as the “100/90” formula, whereby the state pays an amount up to 100 percent of the average premium cost for the retiree and 90 percent of the average additional costs for his or her dependents. Retired state employees generally are eligible to receive this full contribution after 20 years of state service. (Retired employees with ten years of state service receive 50 percent of this amount, increasing 5 percent annually until the 100 percent level is earned.) Most state retirees are eligible to receive the full 100/90 contribution from the state. Before being eligible for Medicare, retired state employees are enrolled in the same health plans available to active state employees. Once eligible for Medicare, retired state employees enroll in a Medicare Advantage Plan (Medicare Part C) administered by the California Public Employees’ Retirement System (CalPERS). The CalPERS Medicare plans include the coverage and costs for prescription drug coverage under Medicare Part D. Because Medicare is supported by money employees pay through payroll taxes and federal funding, the remaining premium costs for these CalPERS Medicare plans are much lower than the premiums for the health plans available to active state employees. In 2017, the premiums for these CalPERS Medicare plans range from $325 to $464 per month for single coverage—much lower than the state’s maximum 100/90 contribution to retirees of $707. State law allows the remainder of the available 100/90 contribution to reimburse retirees for their costs to pay premiums for Medicare Part B. In most cases, the state’s contribution fully offsets the retiree’s costs towards premiums. www.lao.ca.gov Legislative Analyst’s Office 17 AN LAO REPORT whereas the agreement with Bargaining Unit 12 . . . And Shorter-Term Employees. Under the (Craft and Maintenance)—a unit with an average state’s plan, new employees are eligible to receive base pay of less than $50,000—requires employees retiree health benefits from the state only if they have to pay 4.6 percent of their pay to prefund the same worked with the state for at least 15 years. However, benefit. As a result, lower-paid employees are less the plan requires all employees to contribute money likely to save for retirement on their own under the to prefund the benefit. Under no circumstance would state’s retiree health prefunding policy. an employee who leaves state service before reaching Major Changes to Retiree Health Benefit The state is implementing the Governor’s plan to reduce the state’s costs to provide health benefits to retired state employees. We summarize the major provisions of the changes being implemented below. Significantly Lower Maximum State Contribution for Future Employees. Unlike the benefit received by current retirees, retired future employees will receive a significantly smaller amount of money from the state to pay for health premiums. Specifically, (1) the maximum benefit available to employees not eligible for Medicare will be up to 80 percent of the weighted average premium cost of CalPERS health plans available to active employees and (2) the maximum benefit available to employees eligible for Medicare will be up to 80 percent of the weighted average premium cost of CalPERS Medicare plans and retirees will be responsible for paying the full Medicare Part B premium. Benefit Prefunded With Equal State and Employee Contributions. The state and employees each contribute the same percent of pay to prefund the state retiree health care benefit. These contributions will be deposited into a trust fund that is invested. At some point in the future, the benefit will be paid with a combination of money from the state, the employee (paid during the course of his or her career), and investment gains. No Benefit for Future Employees Who Work Fewer Than 15 years. Future state employees must work with the state for 15 years to receive 50 percent of the maximum contribution. Retired state employees with fewer than 15 years of service will receive no benefit. In order to receive 100 percent of the maximum contribution, future employees must work with the state for 25 years. Current and Future Employees Pay Same Contribution as Percent of Pay. The retiree health benefits earned by future employees provide significantly less money towards their health care in retirement compared with the benefit earned by current employees. Labor agreements implementing the Governor’s plan require all employees in a bargaining unit to contribute the same percentage of pay—between 2 percent and more than 4 percent of pay—regardless of (1) what benefit they are eligible to receive in retirement or (2) their pay level relative to other employees in the bargaining unit. No Refund of Employee Contributions. An employee who separates from state service with fewer than 15 years of service will receive no retiree health benefit. In addition, these employees have no rights to the money they contributed to the retiree health trust fund over the course of their state career—potentially tens of thousands of dollars—or any of the earnings gained on these contributions. 18 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT the 15-year mark—or his or her beneficiary—be • Lower-Paid Employees. People who might eligible to receive a refund of the contributions he need money in addition to their pension to or she has made to prefund the benefit. In the case cover essential costs in retirement. of the Unit 12 agreement, a future employee who • Future Employees. People who will earn separates with 14 years of service will receive no less generous retiree health and pension benefit in retirement even though the employee benefits. will have contributed nearly 5 percent of his or her pay to a state trust fund each year. Under the plan, As we discuss below, SPP provides these the employee’s contributions over the course of the employees with an important opportunity to save 14 years—on average totaling more than $30,000 money for their retirement and improve their for a Unit 12 employee—will do nothing to improve financial security in retirement. However, data the employee’s retirement security but will reduce suggest that these employees may be less likely to the cost to prefund retiree health benefits earned save money in SPP. by other employees who work longer than 15 years. Shorter-Term Employees. The average retired If, instead of prefunding coworkers’ retiree health state employee retires after working more than benefits, the future shorter-term employee had 20 years. However, many people do not work this been able to deposit these contributions into an SPP long with the state. Employees who work fewer account and invest the money into a conservative than a couple of decades with the state or who fund consisting of bonds and earning an average do not retire immediately after their state career annual return of only 4 percent, the employee could receive far less financial security in retirement have more than $50,000 in an SPP account at the than long-term employees who retire from state end of the 14-year period. Even a modest account service. This is especially true in the case of future balance of $50,000 could substantially improve the employees (1) whose pensions are based on PEPRA retirement security of this employee. formulas that require them to work additional years to receive a benefit comparable to the benefit Saving Improves Financial Security received by classic employees and (2) who must Most for Certain Employees work with the state for at least 15 years to receive Although everyone can benefit from saving any state retiree health benefit. Similarly, employees money for their retirement during their career, with large gaps between the date they last worked retired long-term state employees likely could for the state (or another government employer) retire without relying heavily on savings because and the date they begin collecting a pension from of the level of financial security provided by state- CalPERS can improve their retirement security funded benefits. However, there are many state through a retirement savings account. This is employees who could significantly improve their because CalPERS pension benefits are calculated financial security in retirement by saving more based on an employee’s final compensation with no money on their own during their working career. adjustment to the final compensation to account In particular, we think the employees who could for any inflation in the economy that may have benefit most from putting aside money include: occurred since the date the final compensation was received. • Shorter-Term Employees. People who work Lower-Paid Employees. Many expenses in less than a full career with the state. retirement are not discretionary. These basic costs www.lao.ca.gov Legislative Analyst’s Office 19 AN LAO REPORT of living include housing, transportation, food, ratio from their state pension than lower-paid healthcare, and clothing. According to the U.S. employees. Bureau of Labor Statistics, the average person aged Saving Creates Great Opportunity for between 65 years and 74 years spent about $38,000 Younger Employees on these categories of expenditures in 2014. A retired state employee who worked a long career Members of the Millennial Generation—people with the state likely would have somewhat lower born between the early 1980s and the early basic costs of living as the state’s contributions 2000s—are expected to become a majority of the would pay for a large portion of the retiree’s state workforce within the next ten years as state healthcare. Although the state’s pension benefit employees who were born before the mid-1960s replaces a significant portion of a person’s final (currently about 40 percent of the state workforce) salary, there are many state classifications that are exit the workforce. At least in the beginning of paid a low enough salary that employees retiring their careers, these younger people are more likely from these classifications with long careers could to be in the three groups discussed above whose be at risk of not being able to pay for basic costs retirement security can benefit most from saving in of living. Without other sources of income in SPP. Regardless of whether these future employees retirement, retired lower-paid state employees are are lower-paid or shorter-term employees, younger (1) more likely to take Social Security payments employees have the greatest opportunity to earlier in life, resulting in a smaller benefit and maximize returns on their investment through the (2) at a greater risk of receiving government-funded power of compounding interest. benefits for lower-income individuals. Although Maximize Power of Compounding Interest. lower-paid employees would benefit from having One of the most powerful factors that affect assets in a retirement savings account, it likely is retirement savings is time. Long-term investors financially difficult for many of these employees to gain returns on both their initial investment and contribute money to an account during their career. past returns on that investment—a phenomenon Future Employees. All retired future state referred to as compounding interest. The result employees will face higher healthcare costs than of compounding interest is that the growth of the current retirees under the state’s planned changes retirement savings account accelerates over time, to retiree health benefits. This especially is true allowing investors to reach long-term savings goals for retired future employees who work fewer with a smaller principal investment. For example, than 15 years with the state and receive no state $10,000 invested with an average annual return contribution towards their healthcare. Retired of 5 percent will grow to (1) about $16,300 after future state employees would benefit from the 10 years but (2) more than $43,000 after 30 years. ability to use assets in a retirement savings account Although older people can take advantage of to pay for these higher and rapidly growing costs in compounding interest by delaying when they begin retirement. In addition, because PEPRA pensions to drawdown funds from their retirement savings, are calculated based on an employee’s salary up younger people benefit the most. Having a long to a limit established in statute ($117,020 in 2016), time horizon also allows younger people to invest higher-paid PEPRA state employees have a great their money in portfolios of stocks and bonds with incentive to use a retirement savings account. This higher expected average returns for longer periods is because they will receive a lower replacement of time. 20 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT LAO COMMENTS SPP Benefits Employees and the State. The for these employees to participate in the program SPP program is an important benefit the state offers during their state careers. employees as part of its employee compensation Legislative Options to Improve Participation package. Compared with deferred compensation programs offered by other employers, the state’s Changing a retirement benefit is a significant program offers participants low fees and the ability policy decision that can have very long-term effects to contribute up to the maximum contribution on the state’s finances, the financial security of to two retirement savings plans. The relatively state employees, and the state’s ability to recruit high regular participation among higher-paid and retain employees. Accordingly, changes state employees indicates that SPP currently in retirement benefits should involve careful is an attractive investment vehicle for them. legislative deliberation and input to the Legislature An important benefit of the program is that it from employees, the administration, experts inside assists lower-paid state employees by providing and outside of state government, and the public. supplemental income in retirement. This additional Review Policies Other Employers Have income can significantly improve a retired Adopted to Improve Participation. Many employee’s financial security—especially in the employers who sponsor deferred compensation years between retiring from the state and collecting plans have adopted policies aimed at increasing Social Security. Improving the retirement security participation among their employees. (Soliciting of lower-paid state employees also benefits the state input from public and private employers with these by reducing the risk that the state will incur future policies could be valuable.) These policies seem costs to provide these people benefits via programs to have improved participation nationally. That that assist low-income Californians. being said, there still are many people who are Key Groups of Employees Not Participating eligible to participate in a deferred compensation in Program. While participation among some plan who choose not to participate. The Legislature groups—notably older and more highly paid state could consider adopting similar policies to employees—is encouraging, groups that could improve participation in SPP. The most common benefit most from using the program are much policies that employers have adopted to improve less likely to participate. Employees who receive participation include: less retirement security from the state-funded • Auto-Enrollment and Auto-Escalation. retirement benefits—shorter-term, lower-paid, Through auto-enrollment, an employer and future employees—could see the greatest automatically enrolls new employees into improvement in their retirement security by the deferred compensation plan with a participating in the program. In addition, SPP default contribution amount and investment provides younger employees—who are more likely option. Through auto-escalation, the to be one of these three groups and who have a long employer automatically increases the time before they will retire—the opportunity to contributions that employees make to the improve their retirement security with a smaller plan over a period of time. Employees can initial investment than would otherwise be choose to (1) make contributions or choose required. The state currently creates little incentive www.lao.ca.gov Legislative Analyst’s Office 21 AN LAO REPORT investment options other than the default the Legislature could consider the following options or (2) opt out of the plan entirely. questions: Auto-enrollment and auto-escalation • What Is the Purpose of SPP in a features can boost overall participation in Compensation Package That Includes savings programs and have become more Pension Benefits? The state is known for common in recent years. If implemented offering a generous pension to employees without an employer match, these policies who work with the state for many years. would have no direct cost for the state. That being said, SPP can greatly improve the retirement security of many state • Employer Match. Employer matches come employees—especially employees who in different forms but the basic concept work fewer than 15 years with the state, is that the employer makes contributions have many years before retirement, or to the plan if the employee makes could benefit from supplementing their contributions. This creates an incentive for pension benefits with other sources of employees to make sufficient contributions income. to at least receive the full employer match so they are not “leaving compensation on • How Could Changes to SPP Affect Other the table.” Offering an employer match for Elements of Compensation? As the employee contributions to SPP would not recent labor agreements implementing necessarily cost the state more money. It the Governor’s retiree health prefunding is possible for the Legislature to create an plan have demonstrated—changes in option to offer an employer match that is retirement benefits can have significant cost-neutral relative to current policy—for effects on other elements of compensation. example, by moderating growth of other It is possible that some approaches to types of compensation. One thing to improving participation in SPP could consider before offering a match is that create pressure to make changes elsewhere some employees are more likely than others in employee compensation at the to participate. For example, based on past bargaining table. experience, higher-paid state workers may be more likely to contribute to a plan and • How Could Changes to SPP Affect thus benefit from an employer match. Employee Recruitment or Retention? Consequently, some employees will receive There always exists a tension between higher levels of compensation than others providing valuable benefits that attract and based on their decisions of whether or not to retain qualified employees and minimizing participate. costs to the state. Changing SPP could involve additional state costs. But what Take Time to Understand Effects of Policy benefit would the state see in terms of Changes. If the Legislature wants to change SPP recruiting and retaining quality employees? to improve participation, it should hold hearings Opinions might vary and the Legislature to determine what action—if any—is necessary would want to solicit feedback on this issue and take its time to develop the right path forward. before making changes to SPP. Among the topics discussed during these hearings, 22 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT • Is the State Willing to Incur Cost to or creating stricter requirements for Increase Participation? The state already is participants to initiate loans could paying significant sums of money to fund significantly increase the amount of the current structure of state employee money participants have in their accounts retirement benefits. Under current policy upon retirement. (It is our understanding and assumptions, these costs will grow that SPP plans to implement stricter for the foreseeable future. Any discussion requirements for participants to initiate of offering an employer match should be loans effective April 1, 2017.) The program considered in the broader context of the would need to weigh the benefit of state budget. increasing regular contributions against the potential cost of a higher minimum • Can SPP Improve Account Balances contribution discouraging employees from Without Legislative Action? SPP could participating. In addition, the Legislature take a number of actions to improve could consider whether the existing law account balances without any formal requiring SPP to offer an annuity product legislative action. In particular, increasing (discussed in the box on page 7) could be minimum contribution requirements changed to make that goal more realistic. to a meaningful contribution amount CONCLUSION Employee compensation policies are complex the program to save money for their retirement. and have long-term effects on the state’s finances Recent changes that reduce other retirement and the wellbeing of state employees. The SPP benefits in the state’s compensation package create program is one facet of the state’s employee an opportunity for the state to consider SPP’s compensation package. SPP offers employees a role in recruiting and retaining employees and low-cost retirement savings option; however, many enhancing retirement security for state employees. state employees whose retirement security would That being said, any change to the program should benefit most from the program do not regularly use not be made without careful deliberation. www.lao.ca.gov Legislative Analyst’s Office 23 AN LAO REPORT LAO Publications This report was prepared by Nick Schroeder and reviewed by Jason Sisney. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This report and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. 24 Legislative Analyst’s Office www.lao.ca.gov