Best Practices in Incorporating Risk Sharing Into Defined Benefit Pension Plans
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Policy Brief

Best Practices in Incorporating Risk Sharing Into Defined Benefit Pension Plans

Public pension risk sharing can increase plan solvency, provide better accountability, and lessen the burden that unfunded liabilities have on taxpayers.

Introduction

For public sector pension systems across the United States, there has been a steady increase in unfunded liabilities—the difference between promised pension benefits and the assets in hand needed to pay those benefits—resulting in rising taxpayer costs and ultimately harming public employees’ take-home pay and benefits.

The most popular public pension plan design, the defined benefit pension plan, tends to be exposed to various forms of risk. Managing that risk and future costs is critical for the solvency of U.S. public pension systems, given that entering 2020 states were already carrying over $1.2 trillion in public pension debt.

Where did all this debt come from?

After all, most public pension plans were thought to be well funded up until the late 1990s. However, taking a closer look at the assumptions most plans used—covering a range of factors including investment return, inflation, discount rate, mortality, longevity, and more—shows a different picture. By leaving assumptions regarding investment return and discount rates too high, contribution amounts were lower than what was required to pay for retiree benefits. Leaving them too high for an extended period compounded that error and put public sector pension plans in the position they are in today, with assumed investment returns averaging 7.2 percent nationally, while actual returns over the past 20 years totaled just 6.4 percent.

Outside of the debt element of public pensions, employees and taxpayers must also look at the costs and benefits of the offered pension design itself. Are benefits too generous, forcing higher percentages of paychecks into the pension system? As an employee, are you planning on working the same job your entire career? And if not, are there more beneficial plan design options for employees like yourself?

A few outlier public pension systems have been ahead of the curve and shared the risks between employee and employer from the outset. Generally, however, these risks have either been ignored or have fallen on the shoulders of employers and taxpayers for much of the history of defined benefit plans in the public sector.

Using the risk-sharing principles outlined in this paper will lead to greater funding prosperity, more accountability, and an easing of the burden that unfunded liabilities have on taxpayers.

Full Policy Brief: Best Practices in Incorporating Risk Sharing Into Defined Benefit Pension Plans

This brief is part of the Pension Integrity Project at Reason Foundation’s Gold Standard In Public Retirement System Design series reviewing the best practices of state-level public pension systems and providing a design framework for states that are struggling under a burden of post-employment benefit debt. The series includes recommendations to help states move into a more sustainable model for employees and taxpayers. If you have any questions or would like more information, please contact the Reason Pension Reform Help Desk by e-mail at pensionhelpdesk@reason.org.

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