Too often it is claimed that closing public pension plans and moving all newly hired public employees into defined-contribution plans like a 401(k) or cash balance hybrid plans is needed for state and local governments to address budget shortfalls. However, implementing this move can increase costs. Below, we outline three reasons why.
1. Closing a defined-benefit plan can increase unfunded liabilities.
Unfortunately, there are several examples of states closing their defined-benefit plans with disastrous consequences for both public employers and employees. In Michigan, for example, state lawmakers closed the State Employees Retirement System (SERS) to all newly hired public employees in 1997. When the state closed the plan, SERS was one of the best-funded systems in the country, with a funded status of more than 100 percent. By the end of 2019, however, the plan’s unfunded liabilities had skyrocketed to 65.4 percent.
Source: The Center for Retirement Research at Boston College (CRR) and the Center for State and Local Government Excellence (SLGE)
Michigan’s state government was not the only one to close its plan. In 2013, the Kentucky General Assembly passed legislation that moved all newly hired public employees in the Kentucky Retirement Systems (KRS) into a cash balance plan. All five defined-benefit plans in the system witnessed an increase in their unfunded liabilities following this bill’s passage. The Kentucky Employees Retirement System (KERS) Non-Hazardous Plan’s funded status dropped as low as 13 percent by the fiscal year 2018.
2. Public pensions are cheaper to administer than defined-contribution plans.
According to the National Teachers Retirement Association (NRTA), providing retirement benefits through a defined-benefit plan costs 46 percent less than a defined-contribution plan. This is due to several factors. Defined-contribution plans like 401(k)s, for example, usually have higher fees than defined-benefit plans.
Also, in a defined-contribution plan, there is longevity risk, meaning employees can outlive their savings (unlike a defined-benefit plan). Defined-benefit plans pool this risk collectively, meaning that the plan is funded partly based on the overall average age of the members in the plan. Pooling risk collectively ensures the plan will have enough assets to pay out benefits indefinitely for all of its members.
3. Closing a defined-benefit plan can create higher public employee turnover, leading to increased training costs.
The example of Palm Beach, Florida closing its public pension plan to newly hired public employees illuminates how this action can increase costs. According to the National Institute on Retirement Security (NIRS), Palm Beach decided in 2012 to close its public pension plan to all newly hired public employees and move all of its current public employees into a hybrid plan combining elements of both defined-contribution and defined-benefit plans.
This move drastically impaired the town’s public workforce. Twenty percent of public employees retired after the change was made, and more than 100 police officers and firefighters left their jobs before retirement. Many of them took positions in nearby localities that offered a defined-benefit pension plan. The town of Palm Beach ended up paying a considerable financial cost for losing these essential public employees, with training costs for new hires ballooning up to $20 million.
Thankfully, four years later, the town shifted course and opted to restore the defined-benefit plan for its public safety officers. This experiment should serve as a warning sign to other lawmakers thinking of making the same change.
The above examples prove that protecting public pensions is a critical fiscal move for state and local governments. As many face difficult budget questions due to the coronavirus-induced economic crisis, it’s critical that they remember that shifting public employees away from defined-benefit plans is not the answer they are looking for.