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Commentary

Kentucky Can Accomplish World Class Pension Reform by Learning from West Virginia Mistakes

A recent op-ed in the Lexington Herald-Leader grossly misleads readers on the story of West Virginia’s pension reform. The West Virginia story is a warning, yes, but not that defined contribution retirement plans are bad. Rather, it’s a warning that both defined benefit (DB) and defined contribution (DC) plans can be run poorly without good governance.

The op-ed’s author notes that West Virginia closed its DB plan for teachers in 1991 and replaced it with a DC plan. So far, so good. He then cites a series of complaints about the DC plan that was created, and things spin off the rails quickly:

  • “Initially there were only seven investment options to choose from.”  — On its face this is not actually bad, as too much choice can be overwhelming to participants. Generally speaking, DC plans should offer 5 to 15 options for participants, with clear descriptions of the differences and a range of option types for different kinds of risk tolerance and retirement goals.
  • “Some of the options mirrored each other and didn’t properly allow for investment diversification.” — This certainly sounds like a failure of governance to ensure that the DC plan offered a good mix of options. Other public sector DC plans commonly offer investment options that reflect different risk profiles and options that automatically reallocate and rebalance contributions over a participant’s working life (e.g., target-date funds), so getting the investment mix right need not be rocket science.
  • “Additionally, the state offered no education for participants.” — This is abjectly a terrible failure on the part of the DC plan West Virginia set up, but Kentucky can easily avoid this problem with a statutory provision. Providing education and counseling is a best practice that every DC plan should offer. In fact, Arizona’s 2016 public safety pension reform set up an optional (and generous, at an 18% minimum contribution rate) DC plan for new police officers and firefighters, and the law requires the DC plan’s third-party administrator to offer investment education, counseling, and individualized plan advice to participants, via a federally registered investment advisor.
  • “By 2005 it became clear the 401(k) system would not provide an adequate retirement for its participants.” — With poor governance and investment options, this is not surprising. This is also a mistake that Michigan made when it first set up its DC plan for state employees in the late-1990s. However, Michigan has since fixed its program and runs one of the better DC plans in the country. West Virginia could have simply done the same. If Kentucky wants to create a DC plan for new teachers, it simply needs to follow best practices, such as a wide mix of investment options that can match different retirement goals, statutorially required education, and contributions between 15% and 20% (combined from the employer and employee) for those not in Social Security.

Collectively, these arguments in the Herald-Leader offer a very, very weak case against defined contribution retirement plans, and if Kentucky wants to avoid West Virginia’s experience, they simply need to design a DC plan using modern best practices, as other states are doing.

Just consider that the particular plan in West Virginia that is being discussed was set up in the 1990s and clearly didn’t follow best practices. Over the past three decades the financial industry has evolved immensely. There has been exponential growth in the kinds of products and services that are provided to DC plan participants. As just one example: when West Virginia launched its DC plan there were no target-date funds that automatically rebalanced portfolios with a desired retirement year in mind. Including target-date funds in a line up of options is now not just a best practice, but probably should be the default option for any plan auto-enrolling its members.

In short, we’ve learned a lot about how to build world class DC plans over the past few decades, and all of that knowledge can be applied in Kentucky. The DC plans recently built for teachers in Michigan and public safety officers in Arizona provide a good guide for Kentucky in ensuring any future DC plan for its teachers provides a meaningful retirement benefit.

Beyond the weak criticism of DC plans in the context of West Virginia’s DC, the author of the Herald-Leader op-ed went on to make a few more claims:

  • “The state was now having to pay toward the existing unfunded liability of TRS and pay for the new 401(k) plan as well… [this] was one of many unintended consequence of creating the new retirement system.” — That is not an unintended consequence, that was part of the plan. Creating a DC plan for new hires does not eliminate the debt in the plan for existing DB members. States should live up to their promises and pay out all earned DB plan pensions, and that requires paying off the debt overtime. The benefit of such an approach is that the state avoids racking up even more DB plan debt as more and more people are hired into the new DC plan.
  • “West Virginia ultimately did the right thing… we developed a plan to pay down the debt in the TRS pension plan. That commitment to our pension plan has been held up as a model and has turned our worst funded pension plan into one that is over 62 percent funded.” — Not really. What West Virginia actually did was take a $807 million a tobacco settlement and dump it into the pension fund. To be clear, this was a great policy choice. But it could have been done without re-opening the DB plan and it was not a “plan to pay down the debt.” Between 1991 and 2005, the funded ratio for West Virginia’s teacher plan climbed from around 10% all the way to 24.6%. Over two subsequent years tobacco settlement money caused the funded ratio to jump to 51.3%. That this coincided with re-opening the plan is simply a correlation, not causation. This is not evidence that somehow warns off creating a DC plan for new hires. (Nor is having a 62% funded DB system anything to crow about.)

Again, the author has created the false impression that adopting a DC plan somehow had made the DB plan worse (it had not), and that re-opening the DB plan was the catalyst to better funding (it was not). There is a gross misunderstanding of cause and effect. Not to mention absence of some really important facts.

The reality is that there are lots of ways to mismanage a defined contribution plan — having low contribution rates, bad investment options, and no education for participants are top of the list. There are lots of ways to mismanage shifting from a DB plan to a DC plan over time — we have written about them, and foremost among the problems is failing to pay down the DB plan’s debt and keeping unrealistically high assumed rates of return. But these are all problems that can be avoided.

If Kentucky, wants to create a DC plan for future hires the state can do so responsibly and in such a way that it helps preserve the retirement benefits for members currently in the pension plan. Creating DC plans for new hires helps to reduce risk for taxpayers and puts a cap on the growth rate of pension debt — and that can be a huge advantage for a state that wants to start paying its bills and stop kicking the can down the road.

Anthony Randazzo

Anthony Randazzo is director of economic research for Reason Foundation, a nonprofit think tank advancing free minds and free markets. His research portfolio is regularly evolving, and he maintains a wide interest in economic policy at both a domestic and international level.

Randazzo is also managing director of the Pension Integrity Project, which provides technical assistance to public sector retirement system stakeholders who are seeking to prevent pension plan insolvency. His research focus on the national public sector pension crisis has a dual focus of identifying the systemic factors that cause public officials to underfund pension obligations as well as studying the processes by which meaningful pension reform can be accomplished. Within the Project he leads the analytics team that develops independent, third party actuarial analysis to stakeholders considering changes to public sector retirement systems.

In addition, Randazzo writes about the moral foundations of economic theory, and is currently developing research on the ways that the moral intuitions of economists influence their substantive findings on topics like income inequality, immigration, or labor policy.

Randazzo's work has been featured in The Wall Street Journal, Forbes, Barron's, Bloomberg View, The Washington Times, The Detroit News, Chicago Sun-Times, Orange-County Register, RealClearMarkets, Reason magazine and various other online and print publications.

During his tenure at Reason he has published substantive research on housing finance, financial services regulation, and various other aspects of economic policy at the federal level. And he has written regularly on labor economics, tax policy, privatization, and Turkish-U.S. political and economic issues.

Randazzo has also testified before numerous state and local legislative bodies on pension policy matters, as well as before the House Financial Services Committee on topics related to housing policy and government-sponsored enterprises.

He holds a multidisciplinary M.A. in behavioral political economy from New York University.

Follow Anthony Randazzo on Twitter @anthonyrandazzo