A Response to the Defense of Status Quo for Failing Pension Systems

Commentary

A Response to the Defense of Status Quo for Failing Pension Systems

Opponents of pension reform in Nevada seem unwilling to admit that the system is broken and that its significant unfunded liabilities will impair state and local governments’ ability to provide basic programs and essential services for citizens. Rather than engage in constructive dialogue about the appropriate reform steps to take, they would rather deflect discussion and hope for some economic miracle or tax increase that will put billions of dollars more into a system that is critically ill. The following are responses to a sampling of statements made by Teresa Ghilarducci, a national advocate of defined benefit pensions, in a recent Las Vegas Review-Journal op-ed.

Claim #1: “The Nevada pension plan for state and local workers is among the best-governed and well-designed plans in the nation.”

Response: While the Nevada Public Employees’ Retirement System (NVPERS) defined benefit (DB) plan may be performing better than its peers in other states, it still has a $12 billion unfunded liability-or over $4,300 in debt for every taxpayer in the state-even after a record five year bull market. That means the state and local governments participating in NVPERS have promised its employees certain benefits but have yet to fund those obligations.

As a result of the unfunded pension debt, NVPERS contributions have been growing at the expense of spending on other governmental priorities. In 2015, the NVPERS contribution rate increased yet again to over 25% of salary which means state and local governments will now need to channel $25,000 annually to NVPERS for every employee making $100,000. Not only are these contribution rates unsustainable, they simply aren’t fair to the citizens of Nevada who will ultimately bear the costs of poor policy decisions in the past via more taxes or fewer governmental services now and into the future.

Claim #2: “PERS today is funded at 71 percent – and is on the road toward 100 percent funding over the next 30 years.”

Response: Anything less than 100 percent funding is low, and a 71 percent funded ratio is not healthy. And there is no guarantee that NVPERS will pay its annual required contributions (ARCs) in full or that its assumed investment return will be realized, so it’s far from certain that the pension debt will actually be paid off in 30 years. In fact, DB plans like NVPERS, by pushing pension obligations so far into the future after the promises were made, have a built-in incentive that encourages and facilitates underfunding.

While NVPERS has done a relatively good job, compared to other public pension plans, in paying its ARC over the last decade, the plan has not paid its ARC in full since 2010 (see table 1). Though the ARC payment gaps are small, they add up over time and are compounded by the assumed investment return, potentially resulting in substantial unfunded liabilities. The following table calculates data on employer-paid contributions in NVPERS June 30, 2014 Comprehensive Annual Financial Report (found on page 51 of the report).

Table 1

Year %ARC contributed
2010 95.7%
2011 95.3%
2012 93.4%
2013 95.6%
2014 93.1%

The plan’s average investment rate of return over the last 10 years is 7.43%, which is lower than the 8% return assumed by its actuary. The investment return gap also compounds over time, deteriorating the plan’s funded status.

One could argue that the plan can achieve the 8% assumed rate of return in the future, when the economic prospect is better. In 2012, the plan reported that it had earned an average annual return of 9.3% over the last 28 years. This historical performance may suggest that the 8% assumed rate of return is justified.

However, this argument has two problems. First, today’s economic climate is quite different from what it was three decades ago. The 30-year Treasury yield steadily declined from more than 11% in 1984 to less than 3% now. That means it takes a lot more risk to achieve the 8% return now than it did in the past. Second, given the fact that pension obligations are certain and protected by law, while the 8% expected rate of return is not “risk-free,” there is a discrepancy between the plan’s guaranteed pension promises and its ability to deliver them. And when things go wrong, it’s the future taxpayers, not current Nevada PERS’s managers, who shoulder the resulting fiscal burden.

Claim #3: “First, 401(k) plans are more expensive for taxpayers than a defined benefit pension. That’s because a large pool of money invested by financial experts yields far greater returns than small, separate accounts managed by individuals with no professional financial training.”

Response: It’s true that DB plans, due to its collective nature, are generally less expensive to operate than traditional defined contribution (DC) plans. But DC plans can be modified to achieve low administrative costs by offering index funds or adopting the collective defined contribution model. Second and more importantly, the author seems to imply that administrative cost is the only cost of a DB plan. DB plans can result in costs that negatively impact government finances and displace funds from other budget priorities to pension debt payment if they are not properly funded or if actuarial assumptions are not realized. DC plans avoid these kinds of problems, do not result in debt payments, and the risks are not solely borne by taxpayers. When these contingent costs are taken into account, DC plans are more fiscally sustainable than DB plans. In fact, 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.

Claim #4: “[O]pening a 401(k) system drains contributions from the traditional pension system, increasing overall debt. Think of it like a credit card. Just because you open a new credit card doesn’t mean that the debt on the old card goes away. And if you fail to make payments on the old card, interest will cause your debt to spiral out of control”

Response: Politicians have been using credit cards to pay for its employees’ retirements for far too long – and not even making the minimum payments in some cases. It’s time to cut up those credit cards and start actually saving for the future. That’s exactly what a 401(k) does.

DB plans are built to prefund the pension of every single employee under its purview without respect to any other systems out there, hybrid or otherwise. Creating a new hybrid system – which has components of both a DB and a DC system – does not drain any contributions from an existing DB plan. All the promises continue to be kept, hopefully with full required payments every year, normal costs partly contributed by employees, and any amortized debt payments made by the government.

And creating a new DC plan for new employees does not increase the existing unfunded liability. In fact, opening a new DC plan prevents new liability from being created in the first place, because unlike the DB plan, the DC plan has no future obligations and it is very difficult (if not impossible) for an employer not to pay 100 percent of its costs up front.

Thus, establishing a 401(k)-style or hybrid system is not analogous to “opening a new credit card”. Rather, it’s equivalent to “stopping further borrowing on the existing credit card.” Read more about transitioning from a DB plan to a DC plan here.

Claim #5: “401(k) plans do a poor job of managing Nevada’s most important resource – its workers. Pension plans attract and retain valuable, loyal employees. On the other hand, 401(k) plans encourage high rates of turnover, an extraordinary financial burden for state and local governments.”

Response: In the past, DB plans may have been better than DC plans at retaining individuals who intended to have long careers with one employer. However, due to the back-loaded structure, DB plans are not attractive to individuals who are more mobile and do not plan to stay in the same job for more than 15-20 years. Today’s workforce is more interested in mobility than spending an entire career with one employer. DC plans provide more portability and flexibility to the mobile workforce in the 21st century. This is especially applicable to younger workers who are increasingly working several careers in their lives and would like a portable retirement package that they own.

According to this Urban Institute study on the 2011 Rhode Island pension reform, most employees who have less than 30 years of service will receive more benefits in the hybrid plan, which relies primarily on a DC component, than in the traditional DB plan.

And when employers don’t have to increase contribution payments to pay down an unfunded liability, they are able to either pay their employees more or boost hiring, both of which serve to attract more workers.

Claim #6: “[A] 401(k) plan will devastate the retirement security of public workers. The Nevada hybrid proposal has the potential to cut retirement earnings by more than 50 percent. Given that Nevada public employees do not earn Social Security, this move could force future retirees into social welfare programs – another unforeseen cost.”

Response: Since Nevada public employees are not enrolled in Social Security, the 1% DB plan is roughly the equivalent to participating in Social Security and will provide employees with a foundational guaranteed lifetime income. Social Security provides roughly a 30% to 40% income replacement ratio for most workers, and the DB plan provides about that same amount depending on years of employment. The DC portion of the hybrid is designed to help fill the gap and attain the 75% income replacement ratio which many financial experts believe is an appropriate level in retirement.

Additionally, as opposed to the old-style of 401(k) plans, which were designed as a supplemental savings plan, the DC portion of the proposed Nevada hybrid is specifically designed as a retirement plan with a focus on lifetime retirement income. This kind of DC plan has existed for almost a century with extraordinary results and is currently used in the public higher education system in Nevada. Risks are carefully managed, costs are low and retirement security is the primary objective of the plan.

As discussed above, DC plans can be structured to bring about reasonable retirement security for public workers. Indeed, Assembly Bill 190 (Kirner) gives local and state governments’ budgetary predictability and flexibility to make sure that there are funds to pay the retirement costs well into the future. The legislation also provides for automatic enrollment, index funds, target-date funds, and choice of annuity. Hence, the DC component of a hybrid pension plan can be designed to specifically address concerns about retirement security such that can mimic many aspects of a DB pension.

Claim #7: “These aren’t theoretical arguments. States that have experimented with a transition to 401(k)-style systems have exacerbated rather than solved its debt problems. Michigan started enrolling all new state employees in a 401(k)-type plan in 1997. The system’s unfunded liabilities increased from $697 million in 1997 to $4.1 billion 13 years later. Alaska’s story is similar. Its 401(k)-type plan for new state and public school employees began in 2006. By 2013, the lawmakers’ changes doubled Alaska’s pension debt to $12.4 billion. In West Virginia, the situation was so bad that lawmakers chose to reopen its defined benefit pension system. The switch back vastly improved the health of the system. It is now funded at 59 percent rather than 18 percent.”

Response: In all of these states, the funded status worsened despite reform, not because of reform. The unfunded liabilities in these cases increased because the required contributions were not fully made, the assumed investment returns were not realized, and demographic shifts were not expected by the actuaries. All of these factors have nothing to do with the past reforms.

In other words, the funded status of these plans would have been worse if the reforms had not happened. One can visit reason.org to read more about the true stories of pension reform in Michigan, Alaska, and West Virginia.

In the end, both the taxpayers and those who have served Nevada in local and state government jobs deserve to understand the full context of the debate before them so that they are better informed about the needs and pathways to pension reform. Reform proposals before the legislature keep the promises made to those already in the system without increasing the debt on future generations. Further, policymakers acknowledge that Nevada needs a retirement system that is transparent, affordable, sustainable and secure for a changing workforce and future generations.

Lance Christensen is the former director of Reason Foundation's Pension Reform Project.

Truong Bui is a policy analyst at Reason Foundation, where he works on the Pension Reform Project.