April 15, 2015

Public-Sector Pension Reform in Pennsylvania and the Role of Transition Costs

Testimony before the Senate Finance Committee, Commonwealth of Pennsylvania
Key materials

Chairman Eichelberger, Minority Chair Blake, and distinguished members of the Senate Finance Committee: thank you for inviting me to testify on the subject of transition costs in pension reform in the Commonwealth ofPennsylvania.

As part of my research for the State and Local Policy Project at the Mercatus Center at George Mason University, I have studied the accounting, economic, and fiscal principles at work in public-sector defined benefit plans. I have analyzed the state pension plans of New Jersey, Rhode Island, Delaware, and Alabama. I have also studied and commented on the pension systems of New Hampshire and Montana. On May 1, 2012, I provided testimony to the Pennsylvania House State Government Committee on the funded status and financial health of Pennsylvania’s pension plans.1

As state and local governments assess the long-term sustainability of defined benefit plans, a growing number are choosing to close existing defined benefit plans and move either new hires or a portion of all employees to new systems. These systems may be defined contribution plans, as in Oklahoma, Michigan, and Alaska; cash balance plans, a type of defined benefit plan, as in Kansas and Kentucky; or hybrid plans that combine features of defined contribution and defined benefit plans, as in Rhode Island and Utah.

These reforms aim to stop the growth of unfunded pension liabilities and establish retirement systems with stronger foundations and sounder funding for retirees. In each of these states, policymakers have projected the growing costs of keeping defined benefit plans open to new employees and found that switching to a new system is the best course for employees, taxpayers, and governments.

In some cases, proposed pension reforms have stalled over concerns by policymakers that closing defined benefit plans and moving employees to a new system will generate transition costs. These costs, it is argued, add shortterm expenses to already increasing fiscal burdens resulting from underfunded employee pension plans. Transition costs diminish as the closed plan pays out benefits to the remaining retirees.

Closing a defined benefit plan does not add liabilities to the plan. Rather, it changes how the plan’s liabilities are accounted for and changes the investment strategy for the plan’s assets. It reveals the economic value of the plan and makes the funding of the plan’s benefits more sound. Closing a defined benefit plan doesn’t add new costs; it makes the costs transparent, and it makes it easier to ensure that the benefits for retirees are fully funded.

I will now explain what transition costs are and why they should not stand in the way of switching employees from defined benefit to defined contribution or hybrid plans. I will also address how pension plans, particularly closed ones, should invest their assets.

WHAT ARE TRANSITION COSTS?
Two types of transition costs are cited as budgetary barriers to switching public employees from a defined benefit plan to a defined contribution plan: accounting costs and investment costs.

Both of these short-term costs, it is argued, rise in a closed defined benefit plan. While they dwindle as the number of retirees in the closed plan approaches zero, governments are hesitant to add costs to already strained budgets. Let me explain some misconceptions about these costs and why these are not a barrier to pension reform. 

Claims of accounting-based transition costs stem from a misreading of Government Accounting Standards Board (GASB) accounting guidance regarding amortization schedules for closed defined benefit plans. Amortization refers to smoothing out debt payments—in the case of pensions—for past years of service. Plans are free to amortize, or structure the payments, of the closed plan’s liability using one of several approaches and can even stick with the existing amortization schedule. Alaska elected to use the existing amortization schedule for its closed plan.

Investment-based transition costs concern how the closed defined benefit plan should value and invest the plan’s assets. These costs arise from past accounting assumptions that have led plans to be underfunded by relying onunrealistically high-expected returns from riskier assets. Closed plans are required to switch to less risky and more liquid portfolios. This switch improves the closed plan’s funding and reduces the risks associated withunderfunding retiree benefits. When a plan’s assumed rate of return decreases, the present value of the liability increases, though the liability itself is gradually decreasing in the closed plan. Thus, investment-based transitioncosts serve a positive and necessary goal—fully paying out retiree benefits.

In general, transition costs refer to the employer’s contribution to the pension that funds employee benefits. This contribution has two parts. One is the normal cost, the annual cost for benefits earned by active employees in thecurrent year. The other is the amortization of the unfunded accrued liability (UAL), which covers unfunded benefits from past years. This latter portion is the focus of the accounting-based transition-cost critique.

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