The Agenda

Josh Barro on the Enormous Cost of Defined Benefit Public Pension

You’ve no doubt heard that state and local governments are facing an accelerating pension crisis that is likely to force make painful cuts to core services. Josh Barro explains the political dynamic behind the persistence and the soaring cost of defined benefit pensions in the public sector:

 

When times get tough, states cut back pension benefits, but usually only for new hires. The existing employees get their full benefits, and taxpayers kick in extra cash to offset poor performance by assets held by pension plans. (A handful of states have touched benefits for active employees in the last two years, but the vast majority of reforms apply only to future employees — and reforms affecting active employees or retirees may be blocked by courts in some states.)

But when the stock market soars and pension plans become overfunded, states sweeten pension benefits. New York, New Jersey and California are among the states that sweetened pension benefits as a result of the tech bubble, and are now regretting that choice. And unlike the cutbacks, which usually apply only to new hires, sweeteners usually provide retroactive benefits to existing employees and even retirees. For public workers, pension fund investments are a heads-we-win, tails-you-lose proposition.

For defined contribution plans, retroactive increases are unheard of:

But if a company raises its 401(k) match rate from 50% to 100%, nobody would expect them to go back and retroactively increase the matches paid in past years to active employees, let alone retirees.

Yet this is standard practice when states increase pension benefit generosity; for example, New Jersey awarded an across-the-board pension increase of 9% to all pension beneficiaries in 2001, active and retired. This move cannot be defended as useful for attracting a talented workforce; you raise prospective compensation to do that. It was a pure giveaway to public workers, and one that was not uncommon around the country.

If Josh is right about this, and I have no reason to believe he isn’t, the implications are extraordinary. One is reminded of the powerful media conglomerates that use their political muscle to force through retroactive copyright extensions. With this in mind, Josh suggests that pension reforms in New Jersey and Colorado might not yield the advertised long-term savings. Once the economy improves, and once a governor who relies more heavily on the support of the public sector unions and union households, these defined benefit plans will once again swell in size.

Josh goes on to make the case for a shift to defined contribution plans, and he takes on the counterargument that such a transition will necessarily entail large transition costs. Every state and local lawmaker — outside of Utah — should read Josh’s column, and so should those of us who hope to understand the sources of the rising state and local spending burden. 

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