Maryland Governor Larry Hogan recently proposed creating a 401(k)-style defined contribution plan for state employees. Future state employees would have the option of participating in this plan instead of the traditional defined benefit pension plan. Current state employees would not be able to switch to the new 401(k)-style plan and future teachers would not have the option to participate. The problem with the governor’s plan is it would do nothing to address the unfunded liability in Maryland’s pension system and would harm the retirement security of future state employees.
First, it should be noted that Maryland state employees already have an optional defined contribution plan. They can choose to participate in this plan in addition to the pension plan, which is mandatory. This is how it should be. The 401(k) was originally created as a supplement to traditional pensions, not as a replacement.
We also know now from years of experience that 401(k)s fail to provide adequate retirement security for working families. Most workers are not investment professionals and many choose to invest their 401(k) contributions in portfolios with high fees and poor returns. Many workers also either go with the default investment option or make the decision once and then never check back again to see how their investment is doing. The law of inertia applies here: many workers will never realize they invested poorly until years later when they have lost the opportunity to choose a better option. Even if the investment performs well, the high fees associated with many investment options may eat away at an employee’s earnings. Finally, defined contribution plans expose workers to market risk. If the financial markets take a serious downturn, as they did during the Great Recession, a worker could lose most of their savings when they are on the verge of retirement.
Another concerning feature of Governor Hogan’s plan is that both employees and employers would be required to make lower contributions to the defined contribution plan than to the pension plan. Under the pension plan, employees contribute 7 percent and employers contribute an average of 17.5 percent; under the proposed defined contribution plan, both employees and employers would contribute 5 percent each. This means total contributions toward a worker’s retirement would be less than half what they are under the pension plan. At the end of the day, if you put less money in, you will get less money out.
Finally, one of Governor Hogan’s rationales for this new retirement plan is to address the long-term unfunded liability in the pension plan. His argument seems to be that if fewer new employees participate in the pension plan, then that will reduce the unfunded liability by reducing future obligations. The problem is that this has been tried before and it has failed. Twenty years ago Michigan completely closed its pension plan for state employees and forced all new hires into a defined contribution plan. Funding for the pension plan, which was over 100 percent when it was closed, plummeted without new employees paying into the system. A recent report from the state of Michigan found that the median account balance for workers in the new plan is $37,000- nowhere close to the amount needed to fund a secure retirement.
Governor Hogan’s proposal is a solution in search of a problem. Several years ago, the state of Maryland made changes to address the unfunded liability in its pension system. This included the state of Maryland making its full annual required contributions each year, as well as making additional contributions to get the system back up to full funding. Admirably, Governor Hogan has been committed to those goals during the first two years of his governorship. Instead of pushing an unnecessary and harmful proposal that would weaken retirement security for state employees, the governor should maintain his commitment to fully funding the pension plan and continue to hold the state legislature accountable.