State and local governments are facing difficult budgetary choices as government sponsored and maintained pension systems’ costs are skyrocketing and unsustainable, endangering other budgetary priorities. While there are many different options for pension reform, the most effective long-term reform for dramatically reducing—if not eliminating—unfunded pension liabilities is converting defined benefit plans (DB) to defined contribution plans (DC). This will minimize taxpayer risk and offers public workers the same type of retirement benefits that most private sector workers receive.
However, converting from DB to DC plans faces steady resistance from those who benefit from the status quo. Rather than confront the numbers directly, opponents of reform often cast aspersions at the reforms and make unfounded claims at the costs and shortcomings of reform. Acknowledging that all reforms have challenges and are only as good as they are implemented, Reason Foundation addresses and rebuts some of the most common arguments against reform.
Before tackling the arguments against DC plans in favor of DB plans, one should keep in mind a key difference between the two types of pensions. The critical difference between DC plans and DB plans is not necessarily in whether employers or employees contribute to the fund, how the assets are invested, but in who bears the investment risks in the timing of benefit promises and payouts—the employee or the taxpayer?
Generally speaking, in a DB system, benefit promises are made well before they must be paid out, and the employer bears the risks of the investment returns (as pension benefits are guaranteed regardless of the fund’s returns). In contrast, in a DC system, the employer is obligated to deposit money into employee accounts each pay period and employees bear the risks of the investment returns. This crucial distinction between the two pension types helps expose many weaknesses in attacks on DC plans and explain why DC plans are superior to DB plans.
Key arguments against DC plans and counterarguments
Argument 1: Switching to DC plans would be more expensive for up to several decades. Moving new employees into 401(k) plans would endanger existing pensions, increase costs to taxpayers, and increase the cost of paying pension obligations to current employees and retirees. A switch to 401(k) plans would destabilize the pension system financially, potentially saddling taxpayers with additional debt.
This argument, often misconstrued as “transition costs,” has been debunked by several pension scholars, including Josh McGee, Andrew Biggs and Michael Podgursky.123 There are two main claims upon which the transition cost argument relies.
The first claim is that, according to the accounting rules set by the Government Accounting Standards Board (GASB), shifting new hires to a new plan would oblige the sponsor of the closed DB plan to pay down, or “amortize,” its unfunded liabilities more quickly, which would result in higher amortization costs. This claim has two problems:
- First, given the fact that moving to a new plan does not change the amount of unfunded liabilities, paying off the pension debt faster would increase short term payments but produce even larger savings in the long term.
- Second, the GASB standards are for disclosure purposes only and never dictate funding policy. If states and municipalities wish to follow their current amortization schemes, there is nothing preventing them from doing so. More importantly, the language regarding amortization schedules has been removed from GASB’s recent update, making the claim entirely moot.4
The second claim is that when a DB plan is closed, the fund must invest more conservatively and in more liquid assets as it gets closer to closure. Since more conservative and liquid investments have lower expected returns, the plan would require higher contributions, hence higher costs. However, this claim is based on the myth of time diversification, which has been debunked by Nobel laureate Paul Samuelson and other economists.5 Basically, the extra earnings from risker investments are offset by the larger contingent liabilities on future taxpayers. A closed pension plan that takes less investment risk imposes smaller contingent liabilities on future generations, and so the total cost of the plan remains unchanged. As to liquidity, the shift to more liquid investments needs not happen until the last few years of a plan’s existence when the remaining asset base is small, and therefore the reduced returns are trivial.
All the focus on transition costs however misses an important point, which is the long term savings from the new DC plan that replaces the old plan. With more predictability, and much less risk imposed on the employer, a DC plan is less costly than a DB plan, as demonstrated in the private sector.6 This means more fiscal sustainability in the long run.
As a note in addressing the transition cost argument, it is important to understand how pension systems are funded. There are two main components to pension funding: the annual cost to prefund pension liabilities, known as “normal cost,” and the cost to pay off unfunded pension debt. Every year, actuaries determine how much a government should save to fully prefund accrued pension benefits. They estimate how much they will earn investing assets before paying out pension benefits, and estimate how long retirees will live. The result is the normal cost needed today to grow over time and payout benefits in the future.
When actuarial calculations for normal cost are inaccurate, a pension fund will accrue unfunded liabilities, that is, pension debt. This is measured as the value of a pension fund’s assets relative to the promised benefits. Pension funds project costs out over a fixed period of time, usually 15- to 30-years. Actuaries calculate how much a government should pay each year over that time frame to completely pay off the pension debt. This constitutes an amortized debt payment.
Employees typically contribute a fixed percentage of their pay towards normal cost. The government, considered the “employer,” contributes the rest of normal cost. These are usually calculated as a percent of the salaries for public sector employees.
If a government decided to transition towards a DC system, they could simply declare their DB plans closed to new members. Current members would continue accruing benefits and the government would continue its annual contributions, but each year normal cost for the DB system would decline. By the time the last member of the DB system retired, there would be no more normal cost payments required to fund the system. Any difference between the amount of promised benefits and assets available to pay those benefits would be debt, that is, an unfunded liability. The amortized debt payment is a separate part of pension funding, meaning employee contributions never subsidize debt payments.7
It is possible that the transitioning government might want to increase its debt payments as a part of a pension reform—a wise choice to reduce long-term costs. This would be a separate policy choice from transitioning to a DC system, though, and not a transition cost.
Argument 2: Defined contribution plans are more expensive to operate with higher administrative costs due to higher financial management and trading fees.
It is true that a traditional DC plan incurs higher administrative costs than a DB plan. However, the net costs to taxpayers from DC plans are much lower than DB plans because there are no unfunded liabilities that occur than need to be paid down.
There primary reason that DC plans can have higher administrative costs than DB plans is because of the personalized nature of individual accounts as opposed to managing a large pool of funds (as in a DB). According to a report by the Center for Retirement Research at Boston College, the average administrative and investment costs for DB plans (public plans) and DC plans (public and private plans) were 0.43% and 0.95% of assets, respectively.89 From an accounting perspective this is a worthwhile trade-off to millions or billions of dollars in unfunded liabilities.
That said, a DC plan can be modified in several ways to achieve low administrative costs without becoming a DB plan. One solution is pooling all individual accounts together and having them managed collectively by professional money managers instead of letting workers control their accounts. This model, called “collective defined contribution pension plan,” would reduce administrative costs the same way a DB plan does without imposing any risk on the employer/taxpayer.10 Another way to reduce the costs is to offer only index funds to employees. Index funds are passive investments —basically run by computer models designed to reflect whatever market index/sector they are trying to capture—that track the components of market indices such as S&P 500. A passive investment approach focuses on achieving long-term gains through a pre-determined strategy (usually based on computer models) that does not rely on forecasting or day-to-day management of the portfolio itself. These funds are very low-cost due to their “passive” nature. Combining the collective defined contribution pension structure and the use of index funds would further reduce the costs of managing the pension plan. Choosing a collective or passive investment strategy, however, may limit the individual workers’ ability to choose an individual investment strategy and get personalized service for their account outside of a pooled system.
Argument 3: Defined contribution pensions deliver lower investment returns, partly because individuals making investment choices do not match the returns of investment experts who manage defined benefit pooled funds and partly because individuals need to invest more conservatively as they approach retirement. By contrast, pension plans that retain a mix of young, mid-career, and older workers and retirees can maintain a diversified portfolio and invest for the long term. It is irresponsible to move new workers into 401(k)-style retirement savings plans at precisely the time when a chorus of observers have recognized that these plans have failed to deliver retirement security in the private sector.
Employees who are offered traditional DC plans may not attain optimal retirement security for several reasons. First, because of procrastination and shortsightedness, many workers fail to save enough early in their careers – missing the advantage of compound interest over decades – despite being given the opportunity to participate in a DC plan. Second, due to lack of financial knowledge (sophistication risk), many employees invest too conservatively to earn adequate returns in order to achieve their savings goals, and/or do not adequately diversify their pension investments and adjust their portfolios over time when they approach retirement to hedge against market risk.
These factors, along with high administrative costs that can chip away at assets, can put employees’ retirement security at risk. DB plans require employees to participate in the pension system (thereby eliminating the risk of procrastination) and have the pension funds managed by financial professionals who usually make better educated investment decisions with the potential to earn higher returns. Besides, by combining the accounts of older workers with those of younger workers, DB plans can create something called “intergenerational risk sharing,” allowing different age groups of employees to share risk and returns over time, which traditional DC plans do not offer.
However, with DB plans, pension boards can easily direct investment strategies to political goals (or “socially responsible investments”) and put those considerations ahead of the primary responsibility of maximizing investment returns for their pensioners. And depending on which politically desirable investments replace the undesirable investments, there could be more exposure and risk, as CalPERS discovered in 2011.11 Unless an individual feels compelled to invest or not invest in a particular portfolio for any number of social, moral or political reasons, DC plans do not have this problem.
Again, the supposed advantages of DB plans over DC plans do not come from any unique feature of DB plans. A few changes to DC plans can bring about the same benefits without adopting the DB plan core structure. Procrastination of saving can be easily dealt with by automatic enrollment; workers would, by default, be enrolled in the pension plan and have the option to opt out if they wish to. The use of index funds and the collective contribution pension plan (which employs professional money managers) can effectively deal with sophistication risk and bring about the same (if not better) level of investment returns provided by DB plans. It should be noted that most professional investors (even “superstar” investors) and mutual funds do not beat the market.1213 This means that non-expert individuals could outperform most active fund managers by simply putting their pensions in low-cost passive index funds. DB plans, therefore, do not have any advantage regarding investment returns if DC plans offer only index funds and/or adopt the collective structure, which also creates the same “intergenerational risk sharing” feature that DB plans have. Employees with even traditional 401(k) plans can do pretty well over the long term if they are disciplined about saving for retirement and make moderate investments with those savings.14
It is important to remember that retirement security should not be treated separately from fiscal sustainability. While DB plans may be able to generate reasonable returns from their investments, their built-in structure contains perverse incentives that breed financial distress. By shifting risk from employees to employers—ultimately taxpayers—and by creating a lag between pension promises and payouts that encourages and facilitates underfunding, DB plans pose a substantial threat to the long term fiscal health of state and local governments. The Brookings Institution argues that DB plans ensure retirement security at the expense of fiscal sustainability.15 In the long run however, the seeming trade-off between fiscal sustainability and retirement security will likely vanish, since financially troubled states and cities will not be able to deliver the promised pension payments.
In other words, the DB structure risks both financial distress and retirement instability when a longer time horizon is considered. This is not pure speculation but a real possibility, as state public pensions are just 39% funded with the total unfunded liability being $4.1 trillion based on a fair-market valuation.16 The danger is compounded by the fact that most DB plan managers assume over-optimistic rates of return, which pressure them to invest in riskier assets, exposing government budgets to 10 times more risk than in 1975.17 A recent report by the influential hedge fund Bridgewater Associates predicts that 85% of public pension funds could go bankrupt in three decades.18 Indeed, municipalities across the nation are looking for opportunities to significantly reduce their pension liabilities before—or even as—bankruptcy becomes an option.19
By contrast, DC plans are not only fiscal sustainable for states and municipalities by definition, but also capable of delivering adequate retirement security when structured in the right way, as acknowledged by the Center for American Progress.20
Argument 4: Defined benefit plans promote recruitment and retention of qualified employees. DC plans increase employee turnover and the associated costs have a negative impact on public service quality.
There certainly are individuals who find the idea of a lifetime pension attractive and may be more likely to take a civil servant or police department job because of the idea of retirement security. However, this is certainly not always the case with every public sector worker. And as labor mobility increases into the 21st century, and fewer individuals in the labor market stay at the same job or with the same employer all of their lives (as was more likely in previous generations), the attractiveness of a pension for recruitment will increasingly be a local factor.
Nationally, there is no clear evidence supporting the claim that it would be harder to recruit employees to the public sector without a defined-benefit pension plan. A recent paper by the Brookings Institution examines how DC plans and DB plans can improve public-sector workforce productivity and concludes that neither of the two pension types is superior in this in this respect.21 Theoretically, DB plans can improve the retention of high-quality workers by a “pull and push” mechanism. By guaranteeing future benefits that increase over time, DB plans “pull” experienced mid-career employees to stay with their current jobs and make them work hard to avoid getting fired. By withholding pension benefits from employees who are eligible for retirement—but continue working—DB plans “push” overpaid workers to give way to younger and lower-cost ones.
However, the mechanism in reality does not work as well as what the theory predicts for several reasons. First, the layoff rate for the public sector is considerably lower than that of the private sector, so public employees are not as concerned about job security. Second, there is no clear evidence that older employees who are eligible for retirement are overpaid. Some may be overpaid, but some are not. “Pushing” all these workers therefore is not necessarily desirable. Third, only individuals who are interested and willing to have long careers would be influenced by these pension incentives. A 15- to 20-year career is not long enough to reap the full benefit of a DB plan.
While the DC plans offered at The State University of New York (SUNY) differ in some respect from private DC plans by offering annuitized income, when given the choice, a report from the Empire Center showed that many of the CUNY and SUNY employees choose DC plans.22 It does not appear that offering a DC plan has made it harder for the universities to hire. The fact that many choose DC plans over DB plans shows that these personalized and portable pensions are attractive.
Traditional DC plans may have higher employee turnover rates due to their mobility feature: the pension account belongs to the individual who can usually roll the money into a new employer's pension plan if he or she changes jobs. This feature reduces the penalty associated with changing jobs, and hence increases job turnover. But it also means that workers who value mobility of benefits will find this feature attractive. Since people today change jobs often and few stay with an employer for decades, DC plans are more suited for the modern workforce. Further, public employers should ask themselves: “In terms of turnover, would it not be better to have the best talent work for you for a few years, than to permanently have workers whose only incentive is to maximize their pension payouts?”
Argument 5: Lower income workers retain lower returns on a DC plan when compared to a DB plan. DC plans favor higher income workers at the expense of lower income workers.
This claim rests on two arguments. The first argument is that in DC plans, lower-income employees have lower participation and contributions rates, thereby earning less pension benefits compared to higher income employees. This is probably because lower income workers have to spend a larger part of their incomes on essential living expenses, leaving them less money for retirement saving. While this may be true, it does not lead to the conclusion that DB plans, which typically force employees to contribute to the pensions at some fixed rates, are superior. Low income workers have low participation and contribution rates precisely because their earnings are low and they need to keep more cash on hand to deal with unexpected events (e.g. unemployment, emergency health care, etc.). Forcing them to contribute a fixed portion of their incomes, as in the case of DB plans, leaves them less room to cope with such contingencies. Traditional DC plans give workers more choice over what to do with their money.
One can argue that low income workers tend to lack foresight and financial sophistication compared to high-income workers, and hence tend to make bad decisions about their saving plans. But DC plans can solve this problem by making pension enrollment automatic and setting a default contribution rate. Considering the fact that DC plans can be customized to address sophistication risk without changing their core structure, DB plans have no inherent advantage in improving low income workers’ pension choice.
The second argument is related to the tax deductibility of pension contributions in DC plans. Economically, the cost of providing pension benefits is borne by the workers in the form of lower wages. Therefore, the value of being paid in the form of tax-deductible contributions instead of higher taxable wages is more valuable to higher income workers, who face higher marginal taxes. This argument, however, relies on the assumption that DC plans do not affect the total compensation that each worker receives, that is, pension contributions are perfectly offset by lower wages for all workers. This is highly unlikely because low income workers are more reluctant than high income workers to accept wage reductions in exchange for retirement contributions. Therefore, DC plan contributions reduce wages only modestly for low income workers, resulting in higher total compensation for these employees.23
These arguments also ignore the large inequality of pension benefits between partial-career and full-career workers in DB plans. Due to vesting requirements and the “backloaded” structure of DB plans (benefits are not earned proportionally to the worker’s years of service), public employees who do not remain in government employment for 20 or more years earn fewer retirement benefits than those who do. Pension scholar Andrew Biggs notes this fact in his recent paper.24
Pension accounts in DC plans, on the other hand, accumulate value relatively smoothly over time, and thus those plans do not generate this kind of inequality.
Argument 6: Switching to a DC plan would do nothing to solve the problem of unfunded liabilities. In fact, it would make the problem worse as the government would need to continue making payments under the old system even as current employee contributions are taken by the new system.
It is true that changing to a DC plan would, by itself, not eliminate unfunded liabilities. However, it does prevent the accumulation of new unfunded liabilities that would not have otherwise been accrued by the retirement system. And more critically, the transition to a DC plan would not make taxpayers worse off because pension plans do not rely on current employees to pay the benefits earned by retirees.
A DB plan’s total costs consist of two elements: (1) the normal costs of accruing benefits, and (2) the amortization costs for unfunded liabilities (akin to debt service). As discussed above, the normal costs paid by government employers are used to prefund the pension system. Amortization costs—the cost component used to pay down pension debts—are separate, and the government will still be responsible for covering amortization costs regardless of whether normal cost contributions flow to the old DB plan or to a new DC plan.
This is why transiting from a DB to a DC does not incur extra costs, nor does it undermine the old DB system by removing the contributions of current employees. The benefits of retirees are supposed to be prefunded from the year they were accrued. Any unfunded liabilities—benefits promised to workers that were not properly prefunded—would not be paid for by current employees, but instead through a separate amortization payment that is carried by the taxpayer.
In other words, even without the new plan, the normal costs paid by governments and employees cannot be used to pay for the unfunded liabilities, which must be covered by the government through paying amortization costs. Arguing that moving new employees to the DC plan exacerbates the unfunded gap betrays a serious misunderstanding about pension funding.25 One should remember that shifting from a DB plan to a DC plan does not add any extra cost to the system or create more unfunded liabilities.
Argument 7: DC plans do not pool longevity risk. When individuals convert their accumulated savings into an annuity—a fixed payment until they die—their annuity payment is lower because the provider of the annuity knows an individual is more likely to purchase an annuity if they are in good health and have a longer-than-average life expectancy. Since defined benefit plans do pool longevity risk across tens of thousands of plan members, they can base annuity payments on the average life expectancy of the population.
It is true that traditional DC plans do not pool longevity risk, and the cost of purchasing an annuity is can be expensive for individuals. In reality, pooling penalizes those who could buy lower cost annuities in order to subsidize those for whom annuities would be more expensive. Yet, if pooling were a preferred strategy, there are other ways to pool risk besides DB plans.
Aforementioned collective DC plans can effectively pool longevity risk the same way DB plans do without transferring the market risk to the employer/taxpayers or creating perverse incentives to underfund the system. Building an annuity option into a mass pension plan, even if it is DC plan, has a volume and pooling effect for companies offering annuities.
Argument 8: Our pension system is fairly well funded today. We’re not in a crisis now, so why should we reform pensions?
Even though a given government pension system may appear well funded today, pension funding conditions can change quickly. Overly optimistic DB pension actuarial assumptions tend to ignore the prospect for major market volatility, like the 2008-09 recession. This was the case in Utah, according to former State Senator Dan Liljenquist:
We had the best-funded pension system in the country going into the 2008 downturn, but during the downturn we lost about 22 percent of the value of our pension fund almost overnight. […] [E]ven though we were well-funded, that the 22 percent loss in value actually opened up a 30 percent gap in our pension funding ratio—our funding ratio dropped from about 100 percent in 2007 to a projected 70 percent by 2013—even though we had paid every penny that the actuary had asked us to over the previous several decades. […] [W]e realized that if this system was dependent on stock market returns—with the legislature and taxpayers required to come back and cover any funding gaps if the markets do poorly—then we felt like it was a risky proposition and one that we wanted to try and mitigate moving forward.26
It is sensible public policy to lower the financial risks to governments, taxpayers and retirees by shifting away from DB pensions and funding employee retirement benefits at the time they are accrued, as opposed to the common current practice of shifting an uncertain burden to future taxpayers. If DB pension fund returns were to fall short in the future, tax hikes and/or service cuts could inevitably follow, and pension benefits for retirees could be cut in extreme cases. Further, public services could be jeopardized by the “crowding out” effect, where current services are reduced or eliminated to cover higher pension system contributions. Reforming DB pension systems now can also minimize the risk of future policymakers increasing benefit levels in an unsustainable fashion for short-term political gain.
Transitioning from DB pensions to DC retirement plans—and paying the costs of employee retirement benefits today—can have a significant impact on risk. A 2012 analysis by two Brigham Young University economists estimated that Utah’s pension fund had a 50 percent chance of becoming insolvent by 2028 in the absence of that state’s 2010 pension reforms; with the reforms, there’s now just a 10 percent chance of insolvency.27
Lance Christensen is the director of Reason Foundation's Pension Reform Project. Troung Bui is a policy analyst at Reason Foundation. Leonard Gilroy is director of government reform at Reason Foundation.
8 Alicia H. Munnell, Jean-Pierre Aubry, Josh Hurwitz, and Laura Quinby, “A Role for Defined Contribution Plans in the Public Sector,” Center for Retirement Research at Boston College, State and Local Pension Plans Number 16, April 2011, http://goo.gl/KhS8TL
9 According to a November 2011 study conducted by Deloitte Consulting LLP for the Investment Company Institute, “Inside the Structure of Defined Contribution/401(k) Plan Fees: A Study Assessing the Mechanics of the ‘All-In’ Fee” (http://goo.gl/9QhJ28), the mean participant-weighted “all-in fee”, which includes administrative and investment expenses, for DC plans was 0.83% of assets. They have no statistics in the study for DB plans, though.
21 Patten Priestley Mahler, Matthew M. Chingos, Grover J. Whitehurst, op. cit.
22 E.J. McMahon, Optimal Option: SUNY’s Personal Retirement Plan as a Model for Pension Reform, Empire Center for Public Policy, February 2012, http://goo.gl/6ayAJZ. See the table on p. 9 of the study.
24 Andrew G. Biggs, Not so modest: Pension benefits for full-career state government employees, American Enterprise Institute, March 2014, http://goo.gl/SWvbV8. Biggs states, “For instance, an employee who retires from a typical public plan after 32 years on the job might receive a benefit equal to 68 percent of final earnings, close to the 70 to 80 percent replacement rate that financial advisers recommend. But an individual who works in government for half that time (16 years) and then shifts to a different job will not receive half that replacement rate, 34 percent of earnings. Rather, his replacement rate would be around 15 percent of earnings just before retirement, meaning that he must either save at extraordinary rates later in his career to meet the 70–80 percent recommended replacement rate or suffer from an inadequate retirement income…As a result of these policies, shorter-term public employees greatly subsidize the generous benefits received by full-career government workers.”
26 Leonard Gilroy, “Closing the Gap: Designing and Implementing Pension Reform in Utah—Interview with Dan Liljenquist, former Utah State Senator,” Reason Foundation, September 17, 2013, http://goo.gl/fipGs6
27 Richard W. Evans and Kerk Phillips, Simulating Utah State Pension Reform, Brigham Young University Macroeconomics and Computational Laboratory Working Paper Series No. 2012-01, April 2012, http://goo.gl/M5X9y1