Maryland Governor Larry Hogan Proposes Optional Defined Contribution Plans for State Employees

The Hogan Administration’s new proposal to create an optional defined contribution (DC) plan is a first for Maryland. State employees who are part of the Public Employees’ Retirement System can already contribute to a supplementary defined contribution on top of their defined benefit (DB) pensions. But Hogan’s proposal would give new state employees — excluding teachers — the option to forgo a DB plan entirely in favor of a DC plan. While in and of itself, this is almost certainly insufficient to solve the funding crisis facing the $45 billion retirement system that Governor Hogan inherited, it would definitely be a step in the right direction and is one piece of what could be a complete pension reform package if bundled with meaningful funding policy changes.

Presently, Maryland’s pension systems are in a bad way. In 2002, the state adopted a “corridor” funding policy, where contribution rates wouldn’t increase as long as the plan was between 90% and 110% funded. Needless to say, not making required contributions on an actuarial basis—where contributions are calculated to ensure that the plan is fully funded—is not a sound strategy. It also didn’t help that high investment returns during the housing bubble tempted legislators to underpay the required contributions.

Plus, Maryland’s State Retirement and Pension System has not consistently met its investment targets. For example, Maryland has just a 5.8% return over the past 10 years — which falls profoundly short of the 7.75% assumed return the state was using back in 2007.

Despite reforms in 2011 that increased pension contribution rates, there’s much work to be done. The two major plans administered by the state—the public employees’ plan and a separate Teachers’ Retirement System—are 68% and 73% funded, respectively. And the actual solvency is probably even worse since those estimates are based on assumed rates of return of 7.55% as of FYE 2016.

Public sector labor leaders have criticized Hogan’s proposal as undermining the retirement security of public employees. In fact Hogan even left teachers out of his reform due to resistance from teachers’ unions, even though the DC plan is just an option and new hires are defaulted into the DB plan unless they make an election for the more mobile retirement plan.

The arguments often leveled against DC plans in favor of DB plans are numerous and varied, but two arguments are particularly troubling—that DC plans can’t eliminate current liabilities and that they jeopardize employee retirement security.

On this first point, it’s clear that the creation of a DC plan won’t eliminate unfunded pension liability, but no reasonable advocate of DC plans ever advances this argument. Pension crises are like oil spills; first you need to cap the well, and then clean up the spill. Changing the plan only addresses the first part. And if a funding crisis is going to persist then DC plans can at least help slow down the rate of growth of unfunded liabilities in a DB plan.

“But,” DB boosters argue, “it’s necessary to bring in new employees to address the current unfunded liability.” No. As Reason’s Anthony Randazzo has discussed, pension benefits are supposed to be pre-funded. All accrued benefits are supposed to be paid for by contributions from employers and the employees, plus investment returns.

New members will increase cash flow, but that is irrelevant to a plan’s funded status. New members mean new benefits to pay later. Saying increased contributions will improve funded status is like saying a faster flow of water will refill a reservoir that is drying up.

On the second argument, there’s no reason to believe that a DC plan can’t guarantee retirement security. It’s true that market crashes can put DC plan members behind the proverbial 8-ball if they retire immediately after a crash, and most people aren’t savvy enough to “beat the market” and achieve higher-than-average investment returns. But the best DC plans for public sector employees are not set up like 401(k) plans with no guidance on investing, but instead ask an employee to define their retirement goals and risk tolerance and put the employee into a managed fund designed to accomplish that goal. Arguably, a well structured DC plan can be more cost efficient and provide a greater sense of security than a DB plan that is perpetually underfunded and could face a solvency crisis (just ask retirees in Dallas, Central Falls, RI, or some of the recent CalPERS districts that are insolvent).

There are certainly merits to DB plans when they are fully funded, and mismanaged DC plans can be toxic in their own way. However, if advocates of DB plans think the case for the status quo is as clear as they make it out to be, they shouldn’t stand in the way of options for future employees and should stand behind their beliefs.