Weighing Costs, Investment Risks of Pension Reform

Based on new research from the Mercatus Center, Biggs argues that all public-employee plans should be making less risky investments and that a plan closed to new hires should take only a little investment risk than an open plan.

Senate Majority Leader Jake Corman (R., Centre) said recently, "Pension reform is our number-one issue. It's something that has to be done."

There's no doubt about that. The Pennsylvania State Employees' Retirement System (SERS) is only 59 percent funded, down from 116 percent in 2001. And the government's contribution rate for SERS tops 20 percent of employee wages, about seven times higher than what private-sector employers typically contribute to 401(k) plans. Unfunded liabilities for SERS total $18 billion.

To address these shortfalls, some Pennsylvania policymakers have proposed closing existing public employee pensions to new entrants and instead enrolling newly hired employees in a "hybrid" system that would combine a smaller traditional pension with a 401(k)-style plan.

But some reform opponents claim that closing an expensive traditional plan could actually make it more expensive. Here's the logic:

Public pensions currently take a great deal of investment risk - about 80 percent of SERS assets are in stocks or other risky investments - in hopes of earning high returns that will keep contributions low. Once a plan closes to new entrants, critics argue, it must hold a safer investment portfolio that would earn lower returns. And lower returns would mean higher contributions. Actuarial firms working for the state made precisely these arguments when asked to comment on potential pension reforms.

There is something to this argument:

Academic research does demonstrate that for pension liabilities occurring in the very distant future - say, benefits earned by a young employee today that may not be fully paid off until the person is age 90 or even 100 - there is a case for holding stocks in pension funds. Benefits occurring in the near future, such as those being paid next year, are essentially fixed and should be funded with bonds.

When a plan is closed to new entrants, it has fewer long-term liabilities and more short-term payments, and so its investment mix should change. The question is, by how much?

Some analyses claim that a closed pension plan should immediately shift most of its assets to bonds, which would reduce expected returns by several percentage points and could increase contributions by 30 to 40 percent. For pension reforms designed to reduce costs, that can be a stopper.

But in new research done for the Mercatus Center at George Mason University, I reached two conclusions:

First, all public-employee plans - whether open to newly hired employees or not - should be making less risky investments. There's no real case for a pension that offers guaranteed, inflation-adjusted benefits to place 80 percent of its assets in risky investments. Indeed, the Society of Actuaries - one of the professional bodies that oversees the actuarial profession - recently pointed to public-pension investment practices "that go against basic risk-management principles."

Second, a plan closed to new hires should take only a little less investment risk than an open plan. The difference in expected returns wouldn't be two or three percentage points, but around 0.5 percent. Moreover, a closed pension plan should change its investment portfolio only gradually.

My analysis doesn't prove that traditional pensions should be closed and replaced with 401(k)-style plans. But it does show that one claim made against such pension reforms — that closing an expensive traditional plan would actually increase costs — isn't true.