Since the Great Recession in 2008, warnings of an impending pension crisis have been splashed across the business pages of newspapers across the country. Despite these boisterous decrees, America’s public pension funds are stable. We explore the roots behind the false pension crisis narrative and examine the facts.
Today we continue our series exposing the myth of the “pension crisis.” As we discussed in a previous post in this series, pension critics often make inaccurate claims about the unfunded liabilities in pension plans. These critics will then claim that the way to reduce an unfunded liability is to close the pension plan and place newly hired public employees in an alternative retirement plan, such as a 401(k)-style defined contribution plan. The reality, however, is that closing a pension plan does nothing to address existing pension obligations and, in fact, can make it more difficult to pay off an unfunded liability.
Yesterday we wrote about public pensions in Kentucky. Kentucky’s public pensions are among the most poorly funded in the country and, therefore, have large unfunded liabilities. Kentucky’s governor has repeatedly called for closing the pension plan to future public employees and placing all new hires in a 401(k)-style defined contribution plan. Defined contribution plans are risky and unreliable and this move would harm the retirement security of Kentucky’s public employees. This proposed switch would also do nothing to address the unfunded liability in Kentucky’s public pension plans.
Unfunded pension liabilities are a form of debt and once that debt is acquired, it has to be paid. The pension debt Kentucky has accumulated will be there whether new employees are participating in the pension plan or not and it won’t magically go away because the pension plan is closed. It will actually be more difficult for the state to pay off its unfunded liability if the pension plans are closed.
Defined benefit pensions are an efficient way to save for retirement because they balance new members joining and paying into the system as older members retire and begin to collect benefits. Since pension plans can invest on an infinite time horizon (there is never a point in time at which the plan has to end), the plan can maintain an optimal investment portfolio that contains high-risk, high-reward investments as well as low-risk, low-reward investments.
When a pension plan is closed, however, it can no longer investment on an infinite time horizon. At a certain point in time, all of the participants in the plan will be retired and will be collecting benefits and no new employees will be paying into the plan. As the number of retired members in the plan continues to increase over time, with fewer and fewer active members contributing, the plan must shift to more conservative, lower-return investments in order to maintain the assets they already have. This makes it more difficult to pay down any unfunded liability already present in the plan.
In years when the pension fund earns investment returns that exceed the plan’s assumed rate of return, that extra money can be used to pay off any accrued unfunded liability. If the plan is closed and must invest more conservatively, it is less likely to achieve high returns that would allow it to pay down any unfunded liability. This is not just a theoretical idea. In Michigan, the state closed the public pension plan for state employees in 1997. When the plan was closed, it was actually overfunded at 109 percent. By 2012, the funded level of the plan had fallen to 60 percent. Without new hires participating in the plan, the plan was less able to respond to the losses of two economic downturns. West Virginia and Alaska both experienced similar problems with rising unfunded liabilities after closing pension plans.
Closing a pension plan is never the answer to addressing unfunded liabilities and existing pension debt. Promoters of the pension crisis myth may claim that closing a pension plan will alleviate the so-called pension crisis, but nothing could be further from the truth. Every time it has been done, closing a pension plan has made the situation worse for public employees, retirees, and taxpayers.