Legislators should close underfunded defined-benefit system
In June, House Republicans called for a rigged study that would examine transitioning the state’s school employee pension system to a defined-contribution retirement system. Unfortunately, the study’s conclusions were rigged and the study’s release shows problematic conclusions.
When reading the report, a person would suspect that the state’s pension system is perfectly fine. The report shows that the state is offering benefits that aren’t overly generous compared to peers, that it is about as well-funded as its peers, and that the state has adopted typical investment risks.
If all things went according to plan, however, the state would not even consider pension reform; pension costs would be the relatively low and no one would complain. The state repeatedly considers pension reform, however, because things have not gone according to the plan and the pension system is severely underfunded — the state has only 65 cents saved for every dollar earned by pension fund members, a $22.4 billion gap.
The system is not underfunded simply by a streak of bad luck, but due to optimistic assumptions used by state politicians and a series of laws made by state politicians that have mandated smaller payments be put into the system. In addition to assuming a return that the state has not been able to achieve in the past decade, the state also extended its debt repayment and marked its assets to market, all of which have led to long-term problems.
Nor has this been a small and temporary phenomenon. Since 1990, the school employee pension system has been fully funded in just one year — and even then it was because of a gimmick that the state enacted. It’s been closer to full funding in some years, but underfunding has been a consistent problem. The cost to catch up on unfunded liabilities now represents the majority of pension contributions (See image nearby).
Michigan’s Constitution wanted the state to be more honest about properly funding state-run pension systems. Drafters wanted to ensure that politicians paid their pension promises when they made them. Yet the problem remains.
But this study, unfortunately, does not cover the question of whether politicians will underfund the system. The one passing mention it receives is a brief statement about “contribution volatility risk,” but without explaining the extent of the risk or the state’s experience with it. It also adds that “employers may be better able to accept this risk than employees.” While this is true, its inclusion shows that the study is more an example of theoretical differences in retirement benefits than a statement about the problems Michigan school districts, taxpayers, and politicians face on the school pension system.
In a pleasant omission, on the other hand, the analysis does not state that closing the pension fund will require the state to catch up on pension underfunding in a more expedited manner, as some in the state have wrongfully asserted.
But as expected, the study makes a mistake when comparing the “normal costs” of the pension system — the amount that politicians believe is necessary to prefund the benefits earned in a year — to the contribution rates in a defined-contribution system. Because they compare the artificially-low cost benefits of the pension system to the artificially-high cost benefits of the defined-contribution system (the study’s authors were told to use the more-expensive state defined-contribution system as a basis of comparison), the analysis shows a financial gap between costs. But because the pension system costs more than the “normal costs,” this analysis compares apples to lemons.
Likewise, the analysis on the adequacy of benefits is misguided. As a theoretical matter, there is no magical number about how much a person needs in retirement. A person can declare bankruptcy at any income level, as spats of celebrity bankruptcies show. Whether a person lives comfortably in retirement depends on much more than the type and generosity of an employer’s retirement system.
Still, the report’s analysis of this issue is problematic. The pension system can only give out what it receives in contributions plus investment gains. A person’s defined-contribution retirement system is the same. If investment returns are the same, then the system can only pay out what’s been contributed to it. The results from their adequacy plan simply show that the pension plan provisions have little to do with the contributions.
For instance, a person working for a school district for less than the vesting requirement would receive no benefits under a pension plan, even though he or she may have contributed and his or her employer may have contributed to cover the benefit. They would receive something in a defined-contribution system, however.
The adequacy of benefits is irrelevant to whether Michigan should transition to a defined-contribution system, though it may want to influence how large of a system is offered. Legislators should transition because a defined-contribution system eventually fixes the major problem of the pension system. By transitioning, the state will contain its ability to underfund the system. But a valid plan to fix the problems of the pension system was not included in the state’s rigged study.