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Executive Summary
A
pproximately five million state and localemployees are exempt from Social Securityand instead participate in retirement plansadministered on the state and local levels. Thehistory of those retirement plans provides valu-able information for policymakers attempting toreform the federal program.State and local retirement plans generallyprovide plan participants with more benefits andgreater flexibility over retirement age and planpayout than does Social Security. Those stateand local plans can provide superior benefitsbecause they predominantly "prefund" futurebenefits, either by saving and investing the pro-gram's income or by allowing the participants tosave and invest their contributions in accountsthat will provide for their own future benefits.Prefunding also provides security for futureretirees: while Social Security is facing a severeshortfall in revenue, most state and local plansare fiscally sound and, in many cases, thriving.Defined-contribution plans, such as the cityof San Diego's, are evidence of the feasibility of a system based on mandatory individual invest-ment. Participants in those systems enjoy mar-ket rates of return on their contributions andhave ownership of their retirement income,which means they do not face the risk that thegovernment will decide to cut their benefits.State and local defined-benefit plans demon-strate the financial benefits of a funded system,but show that there is a danger, when govern-ment invests, that political pressure will influ-ence investment practices.1
Carrie Lips is Social Security Analyst for the Cato Project on Social Security Privatization.
March 17, 1999SSPNo. 16
State and Local Government Retirement Programs: Lessons in Alternatives to Social Security
 by Carrie Lips
 
Introduction
When President Franklin Delano Rooseveltsigned the Social Security Act into law in 1935,the program covered some private-sector work-ers and excluded state and local governmentemployees. At that time Congress was con-cerned about the constitutionality of the federalgovernment taxing state governments.
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Stateand local government workers remained outsidethe Social Security system until 1950, when theact was amended to allow states to provideSocial Security coverage to those employeeswho were not already covered by a public retire-ment system. By 1954, this provision had beenbroadened to allow state and local governmentsto provide Social Security to all of their employ-ees regardless of whether they were alreadycovered by a public retirement system. Even so,state and local government agencies wereallowed to opt out of the Social Security pro-gram until 1983, when the law was changed toprevent them from leaving the federal retire-ment program.
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However, those systems thathad never entered the program or had opted outprior to 1983 were able to remain outside SocialSecurity.Today, approximately 5 million workers, whohave annual salaries totaling roughly $132.5 bil-lion, remain outside the Social Security pro-gram.
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Those workers participate in retirementprograms that are administered at the state andlocal levels.Those state and local retirement programsvary in their structure, financing, and benefits.While such plans exist throughout the country,75 percent of the income earned by individualsexempt from Social Security taxes can be foundin seven states: California, Colorado, Illinois,Louisiana, Massachusetts, Ohio, and Texas.
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Individuals in those programs work in a varietyof government jobs; among the largest groupsare teachers and law enforcement officials.Although the details of those state and localretirement programs vary, the participants in theprograms generally receive greater benefits andenjoy more flexibility than do participants inSocial Security. State and local plans can pro-vide superior benefits because they predomi-nately “prefund” future benefits, either bysaving and investing the program’s income orby allowing the participants to save and investtheir contributions in individually ownedaccounts. State and local plans also attempt tomeet the specific needs of their employees andprovide individuals with more flexibility regard-ing retirement age and method of benefit pay-ments.The success of the defined-contribution plansdescribed in this study demonstrates the feasi-bility of a mandatory retirement system basedon individual investment. The defined-contribu-tion plans offer participants greater returns andindividual ownership of their retirement sav-ings. In addition, defined-contribution plansavoid some of the problems associated withdefined-benefit plans, such as political influenceon investment selection.Some policymakers view state and localworkers as a potential source of revenue for theSocial Security system and recommend mandat-ing that all newly hired state and local govern-ment employees participate in Social Security.However, closer examination of state and localprograms reveals that those programs are morethan just a potential source of FICAtaxes(Social Security payroll taxes). They provideuseful information about the benefits and haz-ards of some aspects of retirement programs—information that should guide the debate aboutthe future of Social Security.Instead of jeopardizing state and local work-ers’retirements by forcing them into SocialSecurity, policymakers attempting to reformSocial Security should work to incorporate intothe federal program the best elements of thestate and local retirement plans by movingtoward a system of individually owned and pri-vately invested personal retirement accounts(PRAs).
State and Local GovernmentNon-FICA Retirement Plans
There are two types of state and local retire-ment programs: defined-benefit and defined-contribution plans. The majority of state andlocal government workers are covered bydefined-benefit plans run by their employers.However, as this study will indicate, thedefined-contribution plans that do exist are verysuccessful and provide valuable information onthe feasibility of administering a reformed,defined-contribution Social Security program.Defined-contribution and defined-benefitplans differ in who controls the program’s assetsand how benefits are determined. In both cases,participants (and/or their employers) are re-quired to pay a percentage of their salaries to the
The success of the defined-contributionplansdescribed inthis studydemonstratesthe feasibilityof amandatoryretirementsystem basedon individualinvestment.
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program, as in the Social Security system.Although contribution rates are often dividedbetween employers and employees, overwhelm-ingly economists recognize that the full cost of benefits is borne by the employee since the sharecontributed by the employer would have other-wise been passed on to the employee in the formof compensation.In defined-contribution plans, the money thatis contributed by and on behalf of the plan par-ticipant goes directly into an account that is theproperty of the individual. Throughout the par-ticipant’s life, the contributions amass and earnadditional revenue. At retirement, plan partici-pants use the assets in those accounts to providebenefits.In defined-benefit plans, contributions gener-ally go to the program to be used at the planmanager’s discretion—to pay current beneficia-ries or as savings for future benefit payments.Benefits received by participants are not direct-ly related to the amount they have contributed orthat the employer has contributed on theirbehalf. Instead, benefits are determined by for-mulas that typically take into account the work-er’s salary, length of service, and, sometimes,age at retirement.
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Some state and local retirement programsgive beneficiaries the option of different benefitpayment structures, but typically retirementbenefits take the form of lifetime annuities, pro-viding beneficiaries with monthly checks.Unlike Social Security, most state and localretirement plans allow participants to retirebefore age 65 and receive full benefits. Defined-benefit plans generally impose a minimum ser-vice requirement or require that the combinationof the worker’s age and years of service reach aset sum.
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That additional flexibility on retire-ment age is an important feature of those plans,especially since many of the participants are inhigh-stress jobs like law enforcement or firefighting.Almost all state and local programs providedisability and survivor insurance.
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Awide rangeof benefit levels is provided. In defined-benefitplans, surviving spouses often receive an annu-ity equal to what the worker would have beenentitled to if retirement had occurred on the dayprior to death. Long-term disability benefits aretypically 60 percent of earnings.
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Survivor anddisability benefits often require that participantswork a set span of time before becoming eligi-ble for benefits.At retirement, workers participating indefined-benefit plans are also often given achoice regarding the extent (or existence) of sur-vivor coverage. Retirees can select a plan thatfits their life situation: if single and childless, aretiree can save money by choosing a plan with-out a survivor benefit. In defined-contributionplans, the assets in the plan participant’s accountare inheritable.The overall performance of the many stateand local programs that cover employees out-side the Social Security system is difficult toquantify. However, studies have been conductedthat provide broad findings on the merits of stateand local government programs in comparisonto Social Security.William E. Even and David A. MacPhersonconducted a study published by ThirdMillennium comparing seven non-FICAdefined-benefit retirement plans with SocialSecurity.
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The seven retirement systems ana-lyzed were selected to represent a wide range of plans in terms of membership, geographic loca-tion, and state versus local administration.
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This study found that the non-FICAplansreplace a significantly higher percentage of pre-retirement income than does Social Security.They estimated that for a given earnings historythe average non-FICApension paid a benefitbetween 3.3 and 7.5 times the annual benefit of Social Security.
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These general findings are supported by a1994 study conducted by the Department of Labor, which surveyed employee benefit plansin state and local governments and obtained rep-resentative data for 15 million employees.
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That study provides broad findings about thebenefits typically provided by state and localretirement programs and includes informationon workers who are outside the Social Securityprogram.As shown in Figure 1, except for workerswith the fewest number of working years andthe lowest salaries, the non-FICAretirementplans provide a higher replacement rate thandoes Social Security.These findings, which indicate that SocialSecurity’s retirement benefits are less than thoseprovided by other defined-benefit programs, areconfirmed again in a study conducted by theGeneral Accounting Office (GAO). The GAOanalyzed the potential effects on state and localretirement plans and participants in those plansif the law were changed to mandate that all state3
In defined-contributionplans, themoney that iscontributedby and onbehalf of theplanparticipantgoes directlyinto anaccount thatis theproperty of the individual.
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