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Public-Sector Pensions: The Transition Costs Myth

Monday, May 21, 2012

Public-sector employees and the pension industrial complex are using deceptive and self-serving arguments despite having an obligation to provide the public with solid facts.

One essential difference between traditional defined-benefit (DB) pensions and newer 401(k)-style defined-contribution (DC) plans is that DC plans can’t generate unfunded liabilities. Under a DB plan, the employer promises employees a fixed retirement benefit regardless of how the plan’s investments fare. In a DC plan, by contrast, employers promise employees a fixed contribution, say, 5 percent of salary. Once that contribution is made, the employer’s obligation is fulfilled.

DB pensions for state and local government employees are underfunded by between $700 billion and $4 trillion, depending on whose accounting you use. Most economists believe the latter figure is more accurate. In response, elected officials around the country are considering shifting public employees to DC plans.

In other words, the more broke DB plans become, the more we have to stick with them.

Public-sector employees—who enjoy their generous retirement benefits—and the pension industrial complex of plan managers, pension actuaries, and investment advisors don’t like DC plans. They’re pushing back with a novel argument: DB pensions’ massive unfunded liabilities create “transition costs” that make shifting to DC plans unfeasibly expensive. In other words, the more broke DB plans become, the more we have to stick with them.

But as University of Arkansas economist Bob Costrell shows in a new report for the Laura and John Arnold Foundation, that argument doesn’t hold water. Pension advocates rely on financial disclosure rules generated by the Government Accounting Standards Board (GASB) regarding how quickly a DB plan must pay down–or “amortize”–its unfunded liabilities. A plan that is open to new employees may amortize its shortfalls over a longer period of around 30 years, while a closed plan must amortize its unfunded liabilities more quickly. This faster payoff means a temporary period of higher pension amortization costs, which is termed the “transition cost.” The bigger the plan’s unfunded liabilities, the bigger the transition cost and the tougher it is to move to a DC plan that won’t create more unfunded liabilities. Catch 22.

But as Costrell shows, these transition costs are largely a myth. Pension advocates such as the National Institute for Retirement Security claim that “Accounting rules can require pension costs to accelerate in the wake of a freeze.” Costrell points out that GASB rules require nothing of the sort. GASB doesn’t determine plan funding, it only dictates accounting figures that pensions must disclose. State and local governments set funding policy and regularly violate GASB rules, sometimes paying more than GASB requires and–too often–paying less. If a government wished to follow their current amortization schedule even as they shift to a DC plan, there’s nothing whatsoever preventing them from doing so. And some states that have moved to DC pensions have done exactly that.

If a government wished to follow their current amortization schedule even as they shift to a DC plan, there’s nothing whatsoever preventing them from doing so. And some states that have moved to DC pensions have done exactly that.

Moreover, if a DC plan is made available as a new tier within the existing DB pension–as was done in Utah’s pension reforms–then these amortization rules don’t even apply. And for good reason. As Costrell points out, a pension’s unfunded liability is basically a debt that must be paid off, regardless of how many new employees enter a DB pension plan. Having new employees participate in a new DC pension makes no difference to what the old DB plan owes. Costrell shows that pension plans and their actuaries will admit all this, although it’s often hidden in the footnotes of their reports headlining massive “transition costs.”

Finally, GASB is likely to drop the amortization rules altogether as part of proposed accounting reforms. But you wouldn’t know all this from reading reports published by pension plans around the nation pushing the idea of unaffordable transition costs.

The transition costs myth is an example–I cited another one in a recent Real Clear Markets op-ed–of the pension industrial complex using deceptive and self-serving arguments despite having an obligation to provide the public with solid facts and analysis upon which voters can make important decisions regarding public pension reforms.

Andrew G. Biggs is a resident scholar at the American Enterprise Institute.

FURTHER READING: Biggs also writes “Liberals or Conservatives: Who’s Really Close-Minded?” “Public Pension ‘Air Time’ Is an Absurdly Generous Perk,” “How Many Hours do Public School Teachers Really Work?” and “Public Pension Stimulus Nonsense.” With Jason Richwine, he coauthors “Overpaid Public Workers: Actually, We're Moving Toward Consensus” and “Overpaid Public Workers: The Evidence Mounts.”

Image by Rob Green / Bergman Group

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