News Story

How Some Michigan Cities Dodge the Unfunded Pension Liability Trap

Shifting to a 401(k) avoids hollowing out core functions

When a city fails to properly fund employee pensions in the year they are earned, it creates an unfunded liability that will require more money later to backfill the obligation. Since municipalities have limited budgets, they typically cut from police, fire, and other community services to pay the deferred pension costs.

Flint is one example out of many. The cost of catching up on past pension underfunding has skyrocketed, and the city now pays $20.4 million every year — a 50 percent increase since 2010. Filling this hole now consumes 42 percent of Flint’s general fund budget.

But some local governments have managed to contain these costs. Bloomfield Township closed its defined benefit system to new hires on April 1, 2005. It now offers the 401(k) defined contribution benefit that has become standard in private sector workplaces.

Township Supervisor Leo Savoie served on the board of trustees in 2004. He said the board moved to shift new employees out of the pension system to get a handle on long-term debt.

“We looked at how sustainable our benefit package was, and in order to make it viable and to keep legacy costs from crippling the community, we needed to switch from the defined benefit plan to the defined contribution plan,” he said.

By closing the defined benefit system, Bloomfield Township capped its unfunded pension liabilities. The city then borrowed $80.3 million by issuing 20-year pension obligation bonds to set the cost of already-earned pension benefits at around $6 million per year.

Savoie said if the city had not reformed its pensions, the defined benefit system would have cost $10 million to $13 million per year, and the city would have incurred a deficit of $5 million to $8 million per year. This would have choked off funding to essential government services such as police and fire. The city has 153 police and fire department employees.

“Two-thirds of what Bloomfield Township spends are employee costs, and if we had a $6 million deficit that we had to make up, we would have to cut 40 to 50 police and fire employees,” Savoie said.

He added that Bloomfield’s fully staffed and funded police and fire services allow the township to be “one of the best in the state” with an average response time of four to six minutes.

The head of Livonia's finance department, Michael Slater, said some employees in his city have concerns about defined contribution plans.

“The defined contribution plan is not guaranteed income,” Slater said. “Some say it is too risky.”

Livonia closed its defined benefit plan to all employees in 1998 and instead began offering contributions to 401(k) accounts. According to Slater, the major advantage is cost certainty. Payments to the retirement system are determined beforehand, based on employees’ salaries. Cities do not speculate on how much they will have to pay out.

Savoie believes a 401(k)-type plan provides a secure retirement.

“With 25-30 years of service, employees should be able to accumulate $1.5 million in the pension plan,” said Savoie, who is covered by the defined contribution plan. “Personally, I like it better than I do the defined benefit plan. It gives security and comfort.”

Savoie believes that defined benefit systems have disadvantages that go beyond often having unfunded liabilities. For example, if both a retiree and that person's spouse die while collecting retirement payments, the defined benefit plan does not transfer to another heir. But under a defined contribution approach, employees own their investments.

“With the DC plan, there is a pot of money we help employees invest, so if they act prudently and allow financial advisers to do their job, at the end of the day there is an asset that can be passed onto their kids,” he said.

Bloomfield Township’s defined contribution plan does not take more from the employee’s paycheck than the defined benefit plan. According to Bloomfield Township Finance Director Jason Theis, the police and fire’s defined contribution plan requires 3.5 percent of an employee's salary. Other employees are not required to make contributions.

The city’s defined benefit plan requires 5 percent from police department employees and between 1 and 3.5 percent for other employees.

In the defined contribution plan, unlike the defined benefit plan, the township’s payments are predetermined. Theis said the defined contribution plan requires the township to contribute 14 percent for police and fire and 10 percent for other employees.

Bloomfield Township’s audit states, “The Township must provide annual contributions sufficient to satisfy the actuarially determined contribution requirements as mandated by the plan.”

“Cities and townships should take a look at the perks of defined contribution," Savoie said. "It gives employees a good nest egg to live off and something they can give to their children, and it is a good resource to attract good employees."

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.