Comparing Apples to Lemons in Pension Reform

When comparing the costs of the current "defined benefit" school retirement system to a defined-contribution system, some state analysts argue that the latter is more expensive.

Unfortunately, the claim is based on a rigged comparison. A defined-contribution plan will only cost as much each year as legislators want it to, something their official analyses ignore.

In addition, reports from the Michigan Senate Fiscal Agency, the Michigan House Fiscal Agency and the Office of Retirement Services have argued that the "normal costs" of the pension plan — the amount state officials believe is sufficient to pay for the benefits earned in a year — is an adequate assessment of the actual cost of prefunding future benefits. Clearly it has not been, considering that the fund has only 65 cents for every dollar earned by pensioners, a $22.4 billion gap.

The school pension fund has been a lemon. The sticker price may look affordable, but in the long-run its unreliability has been costing taxpayers a lot more than advertised. So it is not appropriate to compare these sticker prices with the cost of a retirement benefit "vehicle" that requires no comparable "maintenance" costs - a defined contribution, 401(k) type system.

Those official comparisons may (and do) ignore them, but taxpayers are nevertheless burdened with the costs of "catching up" on all that past pension underfunding. Specifically, it will cost an expected 16 percent of school payrolls for 25 years to pay down this deficit, if all goes according to plan.

In contrast, a defined-contribution plan does not allow the state to defer its costs into the future, nor does it carry an underfunding risk.

Legislators worried about the retirement system's potential to develop larger unfunded liabilities that would consume an even greater share of school budgets must know that with a defined-contribution plan they can they can always adjust the contribution rates. The House must know this because they’ve increased the matching requirements in their pension reform bill. The new terms are very similar to the normal costs for new employees of the pension system.

The Legislature is in control of whether converting to a defined-contribution system will save money, because they can set the level of employer contibutions. Unlike the current defined-benefit system, a 401(k) type system carries no risk of future underfunding "surprises" that would cost illions of taxpayer dollars.