The Pennsylvania State House held a hearing on Tuesday about reforms that would shore up the state’s public-employee pension program. The hearing was overdue. Annual required contributions to the state’s defined-benefit plan have soared to more than 20% of employee payroll from only 4% in 2008. Legislators in the state, like many elected officials nationwide, are looking for a way out.
State Rep. Warren Kampf has introduced a bill to shift newly hired government employees to defined-contribution pensions similar to a 401(k) plan. Defined-contribution pensions offer cost stability for employers, transparency for taxpayers and portability for public employees.
But the public-pension industry—government unions and the various financial and actuarial consultants employed by pension-plan managers—claims that “transition costs” make switching employees to defined-contribution pensions prohibitively expensive. Fear of “transition costs” has helped scuttle past reforms in Pennsylvania, as in other states. But the worry is unfounded.
The argument goes as follows: The Governmental Accounting Standards Board’s rules require that a pension plan closed to new hires pay off its unfunded liabilities more aggressively, causing a short-term increase in costs. Thus the California Public Employees’ Retirement System, known as Calpers, claimed in a 2011 report that closing the state’s defined-benefit plans would increase repayment costs by more than $500 million. Similar claims have been made by government analysts in Minnesota, Michigan and Nevada. The National Institute for Retirement Security, the self-styled research and education arm of the pension industry, claims that “accounting rules can require pension costs to accelerate in the wake of a freeze.”
But GASB standards don’t have the force of law; nearly 60% of plan sponsors failed to pay GASB’s supposedly required pension contributions last year. That includes Pennsylvania, where the public-school-employees plan last year received only 42% of its actuarially required contribution. GASB standards are for disclosure purposes and not intended to guide funding. New standards issued in 2014, GASB says, “mark a definitive separation of accounting and financial reporting from funding.”
In fact, nothing requires a closed pension plan to pay off its unfunded liabilities rapidly, and there’s no reason it should. Unfunded pension liabilities are debts of the government; employee contributions are not used to pay off these debts. Whether new hires are in a defined-contribution pension or the old defined-benefit plan, the size of the unfunded liability and the payer of that liability are the same.
More recently, pension-reform opponents have shifted to a different argument: Once a pension plan is closed to new hires, it must shift its investments toward much safer, more-liquid assets that carry lower returns. Actuarial consultants in Pennsylvania have claimed that such investment changes could add billions to the costs of pension reforms.
This argument doesn’t hold. It is standard practice for a pension to fund near-term liabilities with bonds and to pay for long-term liabilities mostly with stocks. A plan that is closed to new entrants stops accumulating long-term liabilities. As a result, the stock share of the plan’s portfolio will gradually decline. But that’s because the plan’s liabilities have been reduced. Plans would not be applying a lower investment return to the same liabilities. They would apply a lower investment return to smaller liabilities.
Many public pension plans apparently believe that a continuing, government-run pension can ignore market risk, while a plan that is closed to new entrants must be purer than Caesar’s wife. The reality is that all public plans, open and closed, should think more carefully about the risks they are taking. But the difference in investment returns between an open plan and a closed one should be a minor consideration for policy makers considering major pension reforms.
Shifting public employees to defined-contribution retirement plans won’t magically make unfunded liabilities go away. Pension liabilities must be paid, regardless of what plan new employees participate in. But defined-contribution plans, which cannot generate unfunded liabilities for the taxpayer, at least put public pensions on a more sustainable track.