Time for real pension reform

Let’s end the defined benefit system

In January, Gov. Deval Patrick filed a pension reform proposal that could save $5 billion over 30 years, through measures such as raising the retirement age and basing pension payments on an employee’s five highest years of salary, instead of the current three. The governor’s plan represents solid reform, but it doesn’t go far enough. Beacon Hill should take advantage of the unique opportunity created by the current budget crisis to transition state and local employees from a defined benefit to a defined contribution system.

This would require bold leadership. At present, only two states (Alaska and Michigan) have adopted pure, mandatory defined contribution systems for their employees. Even Republican governors who have made pension reform a signature issue, such as New Jersey’s Chris Christie and Wisconsin’s Scott Walker, have limited themselves to reforming their states’ existing defined benefit systems.

There are at least three arguments for a defined contribution system for state and local government workers.

First, defined benefit systems are no longer necessary to attract a qualified workforce and have outlived their purpose. The traditional argument for a defined benefit plan was that public workers were paid less than private sector workers, and thus their retirement and health benefits needed to be more generous to compensate. But it is doubtful that, in 2011, inadequate pay is a serious impediment to attracting qualified employees into the public sector. As the Boston Herald and Boston Globe never tire of reminding us, many employees of state and local government earn over $100,000 per year.  Even accommodating for the fact that government employees are, on average, better educated than private sector employees, who sincerely believes that no one will want to work in state and local government if they can’t expect a pension?  There is also the “golden handcuff” effect of defined benefit plans, which provide a powerful disincentive for anyone to ever leave the public sector and open up opportunities for younger workers and workers from different professional backgrounds.

The absence of golden handcuffs is one reason why defined contribution systems are better for workforce productivity. Even stronger evidence for the connection between productivity and defined contribution systems may be found in the fact that virtually all of the most productive American corporations that have risen to prominence over the past few decades, such as Google and Microsoft, have offered defined contribution plans.

Second, if nothing else, moving to a defined contribution system would restore equity with workers in the private sector. Nationally, 80 percent of state and local government workers still receive retirement benefits exclusively in the form of a defined benefit pension. In the private sector, only 10 percent of workers have this deal. Not only does a defined benefit system for public employees provide a safety net most other citizens don’t have, it requires taxpayers to compensate for the system’s market losses. It’s simply unfair to require private sector workers, who bear the investment risk for their own retirement, also to bear the investment risk for public employees. 

Some have argued that future taxpayers should share some of the burden for current employees’ retirement, as they will with debt-financed capital expenditures. But the ultimate cost of pensions cannot be known in advance, since it depends on a wide range of variables, including future investment return, life expectancy assumptions, and the whims of future legislatures. When political officials decide to issue 30 year bonds, they can be confident about the cost of the burden they are placing on future taxpayers. When they vote to increase pension benefits, they can only estimate.

Third, and perhaps the most decisive argument for this change, a defined contribution system is better for budget discipline. With a defined benefit system, the employer makes promises that it cannot know if it can fulfill, or at least not without great inconvenience. A defined contribution plan is more honest, and its cost to government and taxpayers much more predictable.  With a defined contribution system, future recessions would not force state and local governments into the bind of having to raise new revenues or cut services in order to pay for retirement benefits promised decades prior.  There is no such thing as an unfunded liability for a defined contribution system, since a defined contribution system is, by definition, always fully funded. 

So why, then, is there no real debate on Beacon Hill and at most other state capitols about making the switch?

The main two reasons are the strength of public employee unions and the fact that pension reform never produces any immediately realizable savings. In most states, it is legally impossible to alter the benefit structure of current employees, even non-vested ones who may have worked in state or local government for only days. Even if Massachusetts enrolled all new state employees in a defined contribution plan tomorrow, it would still be saddled with paying off the $20 billion unfunded liability owed to current and future retirees.

And defined benefit systems have real advantages. They are typically less expensive to administer, and they provide workers with a secure retirement.  America may very well be facing a terrible crisis of old age poverty a generation from now, due, in part, to low levels of participation in private sector defined contribution systems. Of course, in light of increased life expectancy, skyrocketing health care costs, and less generous Social Security benefits, any system will be under strain to provide Americans with a secure retirement. The question is who bears the ultimate responsibility: state and local government and taxpayers, as in public defined benefit systems, or individual retirees and their families, as in a defined contribution system.  

The ultimate responsibility for ensuring a secure retirement should rest with the federal government and individual workers and their families, not state and local government. Faced with declining revenues and rising fixed costs associated with health insurance and pensions, Worcester, where I work, has had to reduce its non-school workforce by more than 15 percent since 2008. In the next fiscal year, Worcester expects to spend more on fixed costs than on municipal operations (police, fire, and public works). This will not be the last recession, and thus we must look for ways to make structural improvements that will better equip governments to manage future fiscal crises. Moving public employees from a defined benefit to defined contribution system would be one way to do this.

Stephen Eide is a senior research associate at the Worcester Regional Research Bureau, a nonprofit, nonpartisan research organization.