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The Benefits of Switching to Defined-Contribution Plans


I thought Rolling Stone was a magazine about rock and roll, but apparently not. It also publishes articles like this rant about Third Point’s CEO Dan Loeb (for full disclosure, I know Mr. Loeb). The issue, the article says, is that Loeb is “on the board and co-founder of a group called Students First New York. And Students First has been one of the leading advocates pushing for states to abandon defined benefit plans — packages which guarantee certain retirement benefits for public workers like teachers — in favor of defined contribution plans, where the benefits are not guaranteed.” 

Not actually knowing what Loeb’s policy position on this pension issue is (being on a board doesn’t mean that one necessarely agrees with all the policy positions taken by the organization), the author of the article goes on to suggest that ”pension funds and unions don’t end up inadvertently funding their own political demise by investing with the Loebs and Tudors of the world.”  While I have no particular advice as to where pension funds should invest, nor do I have insights into what Loeb thinks on the issue, one thing is sure: Contrary to what the author of the article claims, it is probably in the interests of public-sector workers (and their unions, assuming they care about these workers) to switch to away from defined-benefit plans to defined-contribution ones. Defined-benefit plans are mismanaged and unsustainable, and the only reason this isn’t already obvious to all (despite a few high-profile examples) is that governments are propping them up with mythical math. Those same governments won’t have a problem seeking a taxpayer bailout for years of accounting mistakes.

But before I get into all this, it’s important to point out why government workers shouldn’t be entitlemed to guaranteed benefits regardless of how the plan’s investments may fare. Such plans are always financially unsustainable, which is why they’re a thing of the past in the private sector. What’s more, when the benefits are measured properly, public employees’ retirement benefits are much more generous that those of other Americans. How much more generous? Andrew Biggs and Jason Richwine did the math for the Illinois Teachers Retirement system, and found that a teacher who retires today after 30–34 years of service with final earnings of $84,466 will collect a $60,756 in benefits annually, plus cost-of-living adjustments, rather than the $43,000 advertised by the plan’s advocates. Thsoe benefits are higher than the earnings of 95 percent of retirees in Illinois. Compare that to a similar worker in the private-sector worker, who typically relies on Social Security and a 401(k). They calculate:

If the private employee had the same $84,466 final earnings as that veteran teacher, Social Security would pay around $17,750 per year. The remaining $43,000 has to come from elsewhere.

The private worker wouldn’t get far to that goal through his employer’s contribution to a 401(k). An employer contribution of 6% of pay every year—an amount that only one out of 10 employers exceeds—would generate a guaranteed income of around $3,850 per year in retirement. Benefit levels are low in part because, to replicate the government-guaranteed benefits a public employee receives, a worker with a 401(k) would have to have invested in ultrasafe (but low-yielding) assets such as Treasury securities.

To make up the rest, a private worker would need to save an almost implausible 45% of his salary for retirement. Compare that to the 9.4% of salary that Illinois teachers must contribute toward their pension plan. Many Illinois teachers pay even less because their school districts “pick up” all or part of the 9.4%, a practice that reforms in Wisconsin and Ohio have targeted.

The llinois plan’s level of generosity is similar to those in California, Ohio, Wisconsin, and many other states. 

Now, you may think that the disparity is irrelevant, or the benefits are actually justified because teachers are just that awesome. That may very well be. But it would still be a problem because the plans themselves are unsustainable. And guess who will end up paying the bill when they go under? Taxpayers might be a good guess. 

But that’s not all. State employees should equally be concerned about their current pension plans. In fact, though their benefits as promised are all but guaranteed in most states, reforming the pension system today is key to preventing some rather dramatic consequences when states run out of money on their pension plans in the near future. Several states, in fact, are scheduled to do so by 2020. No matter what data you look at, you can see that many state pensions — led by Illinois and New Jersey — have underfunded their liabilities for years, which means when their pension plans run out of money, these states will have to either raise taxes dramatically, cut non-pension spending massively, or alter their pension formulas for current employees. The question of whether states will be allowed to change the benefits for current retirees will depend on the courts, but the reality is that when there is no more money, there is no more money. We have seen this play out recently in Stockton, Calif.Central Falls, R.I., and Pritchard, Ala.

Unfortunately, few people are aware of the size of the problem. It’s usually reported that the states’ collective amount of unfunded pension liabilities is $500 billion. However, many economists, joined by a growing number of actuaries, have been saying this is a gross underestimation of the problem. Economists such as AEI’s Andrew Biggs, the Mercatus Center’s Eileen Norcross, the Kellogg School of Management’s Joshua Rauh, and the University of Rochester’s Robert Novy-Marx have noted that the unfunded-liability could be as high as $3 trillion. The disparity is the product of the difference between market valuation of pension liabilities (the one economists favor) and government accounting valuation of pension liabilities (the one typically used), which mostly boils down to a disagreement over the value of the discount rate. To understand what the discount rate is and why it is so important, I will quote once again the work of economist Douglas Elliott of the Brookings Institution. He explains:

A dollar today is worth more than the promise of a dollar a year from now, even if you are sure the promise will be kept. A dollar today could be invested and would therefore be worth more in a year. Alternatively, a dollar today could allow you to avoid borrowing a dollar from someone else, on which you would have to pay interest. If the promise is less than certain of being kept, then receiving the money up-front becomes even more valuable in comparison to the promise. Economists and other experts dealing with long-term promises use a “present value” approach to reckoning the value in today’s dollars of future payments. This involves estimating the future payments and then reducing the payments in each year by a discount factor based on: (1) the number of years from now until the payment and (2) the chosen interest rate, known as a “discount rate” . . . The discount rate is absolutely crucial to measuring the cost in today’s dollars, since the pension payments are spread over so many years, with the average payment typically occurring decades into the future. The compound effect of a discount rate being applied over so many years means that, for example, one dollar received 20 years from now would be worth 46 cents if discounted at a 4% rate or 21 cents at an 8% rate.

Economists argue that the discount rate should match the 15-year Treasury bond yield (roughly 2.5 percent today), but in most cases states use an 7–7.5 percent rate. Interestingly, a few years ago, the Congressional Budget Office endorsed the market valuation of pension liabilities. A switch to market valuation would make states’ fiscal outlooks much darker and reveal that what the defined benefit payoff that they take for granted is less than guaranteed.  

For all these reasons, moving away defined-benefit plans and toward defined contributions would be a sound policy move. It would prevent some dramatic benefit haircuts in the future, especially for employees already in retirement. That’s what happened in Rhode Island and Alabama, and we’re likely to see more of that happening in the near future. Further, taxpayers would certainly benefit from the move.



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