News Story

Myth And Muddle Blocking Pension Reform

Unfunded liabilities for government pension plans nationally are measured in the trillions of dollars. The mounting debts siphon off a growing proportion of taxpayer money, often at the expense of core government services including public safety.

In the private sector many businesses avoided this debt-inducing problem years ago by switching from defined-benefit pension systems to defined-contribution systems, of which 401(k) plans are the best known but not the only example.

There’s no quick way out of this fix governments have got themselves in, but they can stop digging a deeper hole by no longer enrolling new employees in the liability-prone conventional pension systems, instead providing generous defined-contribution retirement benefits. However, efforts to do so often hit a brick wall in the form of a theory that “transition costs” associated with the reform are too expensive.

That’s what happened in 2012 after the Michigan Senate voted to close the state’s defined-benefit school pension system to new hires. When the measure was sent over to the House it ran up against the “transition cost” argument. Other reform legislation was passed and the system was kept open.

Anthony Randazzo, director of economic research with the Reason Foundation, is one of a growing number of experts asserting that the “transition costs” theory is an illusion. Randazzo recently authored a four-page primer on the topic titled "The 'Transition Costs' Myth, Why Defined Benefit to Defined Contribution Pension Reform is So Misunderstood."

Michigan Capitol Confidential: To most people, talking about pension systems isn’t very exciting.

Randazzo: When you talk about these things, like actuarial accounting and unfunded liabilities, the eyes of most people gloss over. Even for me when I try to look over an academic paper on subjects like this I’d often rather think about sports and why the Lions couldn’t score a touchdown. That’s one reason why it can be difficult to get people excited about this. But it is such an important issue that we have to keep trying to make it understandable.

Michigan Capitol Confidential: Let’s start with the basics. In a defined-benefit system an employer promises a specified monthly benefit upon retirement, with the amount based on the employee's earnings history, years on the job and age. The amount does not depend directly on the pension fund’s individual investment returns. In a defined-contribution system the employer, employee or both make contributions into a tax-deferred savings account on a regular basis. Each employee has their own account which belongs to them individually. Amounts credited to these accounts (through employer contributions and, if applicable, employee contributions) plus investment earnings on the money in the account. Only contributions to the account are guaranteed, not the future benefits. Government officials often claim the “transition costs” of no longer enrolling new employees in the old-style system make it too costly to make the change to a defined-contribution system. You argue that these “transition costs” are a myth. What’s the basis for that myth?

Randazzo: The myth is based on two mistaken assumptions that certain steps need to be taken when switching from a defined-benefit system to a defined-contribution system. They are:

(1) That government must start making bigger debt payments to the defined-benefit system after it is closed.

(2) That a defined-benefit system needs new members in order to keep it solvent.

Neither of these assumptions are true. Regarding the first mistaken assumption; it might be recommended that a government increase the size of its debt payments after the system has been closed in order to pay off the debt sooner, but there is no legal requirement that it do so.

Regarding the second mistaken assumption, defined-benefit systems are supposed to be fully funded on a yearly basis by employer and employee contributions plus investment earnings. These systems are not based on new workers subsidizing older workers.

Michigan Capitol Confidential: So we have this disagreement between independent pension experts and individuals with an interest in the current systems. What’s at the core of this disagreement?

Randazzo: I think it is a disagreement between philosophies. It’s true that a defined-benefit system could be changed to a defined-contribution system that would be more expensive. But to prevent this, all you would have to do is put in a defined-contribution rate that ensures lower costs. Therefore, if the defined-contribution system - that’s put in place to try to solve a growing debt problem being created by a defined-benefit system - ends up costing too much, to me, that’s not a transition cost, it’s just the result of a bad policy decision.

Michigan Capitol Confidential: And yet those who claim that transition costs are real don’t see it that way.

Randazzo: I think some of that comes from trying to paint the worst case scenarios for making the transitions. One of the toughest things to understand is actuarial accounting. It took me years to understand it. Actuarial accounting is not a real science. The structural challenge with defined-benefit pension systems is that they require many actuarial estimates about the future, and if any of them are wrong they can leave taxpayers on the hook for serious pension debt. Also, in some cases, actuarial accounting can be less than transparent. There is a city in the Midwest right now where actuaries are estimating the value of pension liabilities using a methodology that would be illegal if the city were a private-sector company, and is in contradiction with what the leading academic research says is the most appropriate way to handle risk. If that city used a more reasonable method of estimating the value of its pension liabilities, the city likely has twice as much debt as they currently think. The tricky part is that the actuaries for the city are just going off what the local pension board tells them to assume, so really the responsibility lies with the mayor and the pension board. When you strip away all of the layers that start with a press conference talking about whether a pension system is healthy or not, and then go past whether the actuaries are doing a good job in actually projecting the costs of a system, you wind up with a dozen or so people on a pension board making decisions in a context of which most citizens are completely unaware.

Michigan Capitol Confidential: And you would argue that switching to a defined-contribution pension system would do away with most of the guesswork.

Randazzo: A defined-contribution system is 100 percent more transparent than a defined-benefit system because it requires zero actuarial assumptions about the future, and zero backroom negotiations with pension boards and union members. The costs of a defined-contribution system are clear every year: it is simply whatever the government body has chosen to be the contribution rate to each employee’s retirement account. The cost is known each year, and taxpayers don’t have to worry about whether investment returns will equal assumptions, or whether people will wind up living longer than expected and costing the system more money than it has projected pensions to cost.


10 Facts About Pension Systems In Michigan

Alleged 'Transition Costs' Avoidable In Detroit

Pension 'Transition Costs' Remain A Myth

Michigan Capitol Confidential is the news source produced by the Mackinac Center for Public Policy. Michigan Capitol Confidential reports with a free-market news perspective.