Best Practices in Pension Administration.

This article describes innovations put into practice by pension system administrators at the state and local levels. It describes best practices in pension investing, retirement benefit design, and outreach to retirement plan members.

Within the field of public finance, pension administrators face a unique set of pressures that are changing the way pensions are administered. First of all, economic pressures to hold the line on costly post-employment benefits continue. Cost "drivers" include an aging workforce and the demographic shift of baby boomers approaching retirement. Second, the information technology revolution that is changing other areas of public finance are having the same impact on pension administrators, giving them new tools to improve customer service and better manage their overall pension programs. Third, the design of pensions is changing at the margins. This reflects the addition of DROP plans, defined contribution (DC) plans or hybrid DC plans, and other changes. Taken as a whole, these changes have created new, innovative management techniques-best practices-for delivering state-of-the-art pension benefits.

Background

For this article, best practices are defined as a) management techniques, b) operating procedures, or c) applications of technologies that improve pension administration. Furthermore, these are practices that can be replicated in another jurisdiction and are not uniquely applicable to one government.

The author examined several areas of pension administration, including pension design, investing, and outreach and education of pension beneficiaries. Examples of best practices were culled from previous research appearing in Government Finance Officers Association publications, GFOA Awards for Excellence, and speakers at GFOA training sessions. In addition, the GFOA Committee on Retirement and Benefits Administration was surveyed in January 2000 for additional perspectives on best practices.

Retirement Benefit Design

Whether responding to change or leading change, pension plan administrators have modified the design of the traditional defined benefit package. Offering early retirement and defined contribution options are two ways that the traditional model has changed. The different design strategies reflect varying responses to fiscal constraints and changes in the labor market (such as a desire by relatively mobile workers for portable pensions).

Wyoming's Early Retirement Plan. State and local governments face pressure to rein in personnel costs. In recent years, governments of all sizes have used early retirement as a means to reduce cost, since early retirement programs can shrink the overall staffing levels of a government and replace high-cost workers with low-cost workers. However, poorly designed early retirement programs can negate these efficiencies.

The State of Wyoming, aware of the need for a properly constructed early retirement program, offered early retirement incentives in 1995 which built upon the strengths of a similar effort in 1987. The 1995 program imposed a number of management controls which aimed to "lock in" cost savings:

1) a mandatory benchmark that 10 percent of vacated positions stay vacant indefinitely;

2) any replacement worker's salary be less than the incumbent's;

3) stringent limits on types of workers that could qualify for early retirement, with workers needing at least 15 years of service and being at least age 52; and

4) prohibiting elected officials or appointees of elected officials from participating (on the grounds that those "slots" would otherwise be quickly be refilled).

In addition, the state tracked efficiency gains using a number of indicators. This included the following indicators: number of workers' eligible for early retirement; number of workers taking early retirement/vacancies created; duration of vacancies (e.g., 46 months after the program began); and comparisons of salaries of replacement workers. Because of these efforts, the state achieved savings of about $150,000 per retiree which was three times the rate of the 1987 initiative.

Alternative Approaches to Defined Contribution Conversions. Webster Groves, Missouri, and Washington State redesigned their defined benefit plans to meet the varying goals of labor and management. While having important differences (see Exhibit 1, excerpted from the December 1998 Government Finance Review), the two governments both relied on early "buy-in" of employees, intensive education, and lump-sum payments to older workers to make the transition work. Regarding the lump-sum payments, these were calculated for each worker, so that he! she would receive the equivalent to what the worker would receive if he/she were to retire at the point of conversion (the present value of the accrued benefit or PVAB). (See Exhibit 1.)

1) availability of information to employees;

According to the Webster Groves director of finance and administration, some of the keys to a successful conversion were the following:

2) individualized projections of retirement benefits;

3) conducting an employee opinion poll to gauge sentiment, before the governing board of the pension systems approved the conversions; and

4) over-funding of the old defined benefit (DB) plan provided resources for more generous conversion terms (particularly older workers).

An additional component of the conversion was selecting a DC-plan administrator that offered low administrative costs, delivered initial and ongoing education to employees, provided alternative investment choices, and used multi-media education (e.g., in-person consultations, the Internet, and telephone). Finally, the Missouri locality rounded out the conversion package by providing life insurance and disability insurance through a Voluntary Employee Benefit Association.

The Washington State Teachers Retirement System (TRS) had a very different set of political circumstances. Instead of requiring approval by a retirement board as in Webster Groves, Missouri, the legal change required approval by the state legislature. With support of the state education association and different design features, the legislation was approved.

Unlike Webster Groves, Washington constructed a hybrid plan which provides both a guaranteed defined benefit funded by employer contributions and a defined contribution plan funded by employee contributions and investment returns. Existing members of TRS Plan 2 had the option of transferring to the new plan (70 percent of eligible employees transferred within 12 months). Plan 2 members who transferred within an initial period received a transfer payment equal to 65 percent (which was approximately equal to the PVAB) of their member account balance as of December 31, 1997.

Member Services

If the barrage of new Web sites and magazines on personal finance is any indication, members of public-sector retirement plans have a growing interest in knowing about--and maximizing--future retirement benefits. The first three pension systems below have taken steps to meet their members' demand for more and better data, while the fourth system has established a series of internal controls for ensuring accurate disbursements to beneficiaries.

Video-teleconferencing to Reach More Members at a Lower Cost. GFOA selected the New York State Teachers' Retirement System for the 1998 Award for Excellence in the communications and reporting subcategory of pension administration. The award recognized its innovative use of video teleconferencing that allows for a two-way exchange of information electronically.

The retirement system uses a number of techniques to educate its members about retirement benefits, including personal consultations. To a significant degree, video-teleconferencing has supplanted in-person appointments. In 1997-98, more than one-third of in-person consultations were replaced by video conferences. As a result, the system realized significant savings in the first year of operations, equivalent to $10,000 in avoided travel. By comparison, the one-time costs of establishing video-teleconference sites (including three permanent sites in the comparatively distant part of the state, western New York) were $6,000 per site.

Aside from the pure financial benefits, the program aids pension administrators in meeting information requests during periods of peak workloads. It also frees staff to do special projects, and it allows for new topics to be addressed rapidly. In contrast, in-person consultations require more lead time and are relatively hard to use for addressing unanticipated topics.

The program has worked as followed. First, the system conducted a two-stage pilot program. Second, a survey was conducted to determine satisfaction of members with the training sessions. More than 90 percent of them stated that the video consultations were as good or better than face-to-face meetings. Third, they established a permanent video training program and designated permanent sites. In terms of logistics, the technology and movement of information is controlled at headquarters in Albany (the originating site). Computers, cameras, display screens, microphones, and high-speed data lines are required. Using this equipment,

1) individuals at both sites see, hear, and speak to each other;

2) information (e.g., captions, records, etc.) can be displayed on the screen; and

3) hard copies can be printed at the remote sites.

The latter is important, because it allows a retirement representative to refer to a "shared" document (such as an estimate of benefits) as you would in person.

Information Technology to Support and Streamline Outreach. The Los Angeles County Employee Retirement Association (LACERA) has implemented new information technology (IT) that, among other benefits, improves its capacity to deliver member services. While improving member outreach, the LACERA initiative was part of a broader IT "roll-out" designed to bring systemic improvement to the organization's business processes under the rubric, "One Contact, One Answer, 100% Accuracy."

The technology solution integrated a number of technologies. These included:

* establishing graphical user interfaces on personal computers (to make computers more "user-friendly" and to standardize previously disparate interfaces);

* imaging documents, to efficiently archive and retrieve the association's vast collection of paper records;

* creating an online information system for maintaining the association's policies and procedures, using hypertext links; and

* implementing "workflow," which in general terms is the automation of business processes (e.g., purchase orders as they move up the chain of command in an organization).

More than 2,000 manual tasks have been automated using workflow.

At the heart of the IT upgrade was LACERA's "Knowledge Base" database. This provides LACERA's employees a common database that can easily be accessed through the graphical user interface. Aside from allowing customer service representatives to answer a future or current retiree's questions immediately, it enables an information request that cannot be handled immediately to be tracked over time. This allows for the status of an information request to be followed.

LACERA won the 1998 GFOA Award for Excellence in the pension category, technology subcategory.

Education in Handling Large Lump-sum Payouts. At the Houston Firefighters Relief & Retirement Fund, the city has extended its training program to prepare DROP participants for a more secure retirement. The program is part of its life-cycle retirement planning series that has a four-part curriculum. Part one is dedicated to newly hired firefighters and any plan members with under 10 years of service. Part two targets mid-career workers with 10 to 20 years, part three 20-plus years, and part four retirees. The DROP plan is part of the sessions aimed at the 20-plus cohort.

Unlike its primary retirement benefit, the DROP plan allows for large lump-sum payments when an employee leaves the system. According to the Executive Director, lump sums can accrue to $500,000 over a 10-year period. While certainly an attractive option to have, it creates new risks for employees: "blowing" their lump sum on risky financial schemes, whether as a result of unscrupulous financial advisers providing bad advice or other reasons. In response, the fund elected to take preventative measures through education.

The education program is carried out in two phases. In phase one, an introduction to retirement planning is given in a large group setting (spouses invited). In phase two, smaller break-out groups meet. The fund covers topics such as projected net worth and future liabilities. Handouts are used to prompt more accurate estimates and explore various scenarios (e.g., taking care of a disabled dependent).

Subsequently, the trainers address tools for investing--e.g., various asset classes such as stocks, bonds and their subcategories--and risks associated with each. It is important to note that the fund does not give investment advice. However, it alerts DROP participants that they may need to seek advice from a professional investment adviser. Finally, the fund staff do DROP projections of future lump-sum pay-outs. Here they discuss pay-out options and basic tax considerations (without giving specific tax advice).

Internal Controls to Deliver Accurate Payments. Employee education is one facet of service to members of a retirement system. In addition, member service includes ensuring accurate payment to retirees. While seemingly straightforward, for large systems like the California Public Employees Retirement System (CalPERS) that task is complicated by the number of calculation that must be made (321,000 payments per month, as reported in 1997), the nine different retirement formulas in use, and 55 employer contract choices. Given this level of complexity, the risk of error is significant.

To mitigate risk, the system uses a number of checks or internal controls to ensure accurate payment. The system carries out:

1) internal staff audits;

2) independent outside audits, to sample transactions for accuracy; and

3) workshops and annual statements for members that allow them to verify their own benefit accruals.

The internal and external audits focus on a range of business processes that precede the issuance of a benefit payment. For example, the CalPERS Office of Audit Services carries out compliance audits of outside contractors to ensure that government agencies are appropriately enrolling employees into the retirement system and accurately reporting their earnings. Their efforts are aided by technology that searches for "outliers" in reported earnings (e.g., special compensation, unusual pay rate increases, or conversion of sick leave to retirement service credits).

In addition to the auditing function, CalPERS enables employees to act as another "check and balance." Annual statements give them an opportunity to verify their accounts (e.g., changes in service credits and contributions to the account). Employees have the right to dispute a CalPERS benefit decision in an administrative hearing. In addition, training materials and the Web site (with retirement benefit calculators) buttress these efforts.

Pension Investing

As fiduciaries, pension administrators must invest pension assets for the benefit of plan members only, using the general criteria of what a "prudent person" would do. The following case studies represent examples of prudent investment procedures that benefit not only plan members, but other stakeholders affected by pension system performance (namely, taxpayers and legislators).

Benchmarking Investments. The New York City Controller's Office acts as the investment adviser to five separate funds serving teachers, Board of Education employees (non-teachers), police, firefighters, and other municipal employees. As such, it manages and monitors the investments of funds in order to ensure a) compliance with statutory requirements, b) conformance with asset allocation targets, and c) adequate investment returns in relation to a particular performance standard. The benchmarks are developed collaboratively with the five pension funds.

Since investment return is generally determined by asset allocation, setting the percent of assets in each asset class is central to their activities, and style drift is a primary concern. "Style drift" is the phenomenon whereby a manager with a particular emphasis on certain categories of securities or an investment class shifts over time to a different investment approach, either intentionally or not. Benchmarking is useful in recognizing and preventing this. In addition, the benchmarking activities enable the city to determine whether it garners an adequate return over time within a particular investment sector from each investment manager.

The city uses a number of benchmarks that track each of the components of its portfolio, including benchmarks in the following areas:

* domestic equities--The Russell 3000 index, which tracks the performance of larger-capitalized and smaller-capitalized firms' stock, is the overall domestic stock index that investment performance is benchmarked against, but individual investment managers are compared against standards, selected to match the portfolio they manage (value, growth, small cap);

* international equities--the primary index is the Morgan Stanley Capital International EAFE Index;

* domestic bonds-the city's index is based on the Salomon Brothers broad investment grade index, which tracks the universe of U.S. investment grade bonds; the city adjusts the index to exclude Treasury and U.S. agency bonds that have less than five years of maturity remaining. The investment management assignments and their benchmarks are subdivided into four types of issuer: corporate, mortgage, government, and Yankee bonds (the latter referring to dollar-denominated bonds issued outside the United States); and

* high-yield bonds--benchmarked against the Salomon Brothers index of bonds deemed double-B or single-B by rating agencies.

It is important to note the Controller's Office benchmarks against not only the above indices, but also against the median performance of fund manager peer groups, broken down into asset classes, sub-classes and styles. Standard measures include time-weighted rate of return (over various time periods) and measures of risk or volatility (e.g., beta, which assesses the degree to which a particular investment manager's portfolio goes up or down, in comparison to the market segment in which it operates).

Transparent Financial Reporting of Investment Performance. In fiscal year 1998, the GFOA recognized 121 pension systems for outstanding comprehensive annual financial reports (CAFRs), through the Certificate of Achievement for Excellence in Financial Reporting. The Tennessee Consolidated Retirement System (TCRS) has produced a CAFR that, aside from being user-friendly, is technically accurate, has a broad array of financial data, and is well organized.

In terms of investment reporting, the system's CAFR sets forth in a separate investment section information showing:

* overall investment returns for one-, three-and five-year periods;

* similar information broken out by investment class;

* returns by investment class related to appropriate benchmarks (e.g., TCRS's domestic equity portfolio is compared to the S&P 500, Russell 2000, New York Stock Exchange, Wilshire 5000, and Dow Jones Average);

* asset allocation in five mutually exclusive categories;

* investment manager fees in relation to asset under management; and

* a summary of the state's investment policy.

Additional tables shows three measures of asset "concentration:" top 10 equity holdings of individual securities, 10 bond holdings, and sector balance. The latter indicates, within an asset class, how much the system invests in a particular sector such as consumer goods or technology.

Summary

In all facets of pension management, retirement plan administrators are meeting the challenge of a new environment, which is characterized by a mobile workforce requiring greater information about their retirement benefits, by economic pressures related to tax constraints, and by new enabling technologies that promise to expand organizational capacity. The pension systems identified in this article have responded by crafting management procedures and techniques that have redefined what constitutes the best practices in the field of pension administration.

NICHOLAS GREIFER is a manager in the GFOA Research Center. He conducts research and policy analysis relating to pension administration and cash management, and serves as the editor of Public Investor. He is a graduate of the University of Michigan School of Public Policy.

NOTES

(1.) While working for the City of Houston, employees do not manage DROP funds. Instead, a personal account accrues interest in line with the performance of the overall fund. The account is credited with a rate of earnings based on a rolling five year period of investing.

         ALTERNATIVE APPROACHES TO DEFINED CONTRIBUTION CONVERSIONS
Jurisdiction Conversion Type        DC Plan    Assets Transferred
                                    Type       to DC Plan
Washington   New members mandate to Hybrid     Employee contributions
TRS Plan 3   Plan 3. Plan 2 (older)            + interest and
             members allowed to                bonus (PVAB)
             transfer
Wbester      Complete               Money      PVAB + "make whole"
Groves, MO                          purchase   allocation
                                    with match
Jurisdiction Contribution Formula              Vesting
                                               Schedule
Washington   Four fixed rates and two variable 100%
TRS Plan 3   rates based on age (default rate  immediate for
             of 5%) Employer contributions     DC plan
             fund DB Plan
Wbester      Employee: 5% (plus optional       5-year gradual
Groves, MO   3%) Employer: 4-10%