Will Switching Government Workers to Account-type Plans Save Taxpayers Money?

Will Switching Government Workers to Account-type Plans Save Taxpayers Money?
An excellent paper by Monique Morrissey published here

Here are some highlites from her paper for the entire article go here

Although benefit cuts, increased employee contributions, and a rebound in stock prices have improved pension fund finances, severe under funding remains a challenge in places where the problem predated the recession and was the result of lawmakers neglecting to make required contributions over many years. This is helping to sustain the idea that we can no longer afford to provide teachers, police, firefighters, and other civil servants with secure defined-benefit pensions.

Earlier would-be reformers pushed for 401(k)-style defined-contribution (DC) plans prevalent in the private sector. But disastrous results in West Virginia, Michigan, and Alaska have shifted attention to “hybrid” plans, such as cash balance plans, that combine elements of defined-benefit and defined-contribution systems. Advocates of these types of plans say they are a compromise between those who want to maintain traditional pension plans and those who push for a transition to a 401(k)-style system. However, DC and hybrid plans, which can collectively be referred to as account-type plans, fail on three important points:

• They do not help states save money. Traditional defined-benefit pensions are more efficient than DC plans and most hybrid plans due to economies of scale, risk pooling, and other factors. Moreover, changing plan type introduces transition costs. Thus, it is not surprising that states that switched to DC and hybrid plans did not save money except to the extent that they simply cut benefits or required workers to contribute more toward their retirement.
• They create more workforce management problems than they solve. For example, many cash balance plans provide the biggest benefits to job leavers, promoting high turnover in public-sector jobs, which require a high level of skill and experience.
• They increase retirement insecurity. Account-type plans introduced around the country threaten the retirement security of young and old alike. While a well-designed hybrid plan could theoretically help younger workers without undermining the retirement security of midcareer and older workers, none of the plans offered in the current political climate has done so.

However, since these plans are typically introduced alongside cuts to benefits workers have already accrued, this point is often lost on elected officials and the general public. Since cost savings have strong appeal at a time of budget austerity and cash balance plans are the hot topic in pension debates, this report will focus primarily on cash balance plans’ impact on employers and taxpayers. However, it will also consider claims that cash balance and other account-type plans improve workers’ retirement security.

Overview: Defined-benefit, defined-contribution, and hybrid plans

This section provides a brief description of four types of employer-based retirement plans discussed in this paper: traditional defined-benefit (DB) pensions, 401(k)-style defined-contribution (DC) plans, and two types of hybrid plans that combine DB and DC features (two-tier DB-DC plans and cash balance plans).

Though all four types of plan exist in the private sector, there are differences in how benefits are funded. In the private sector, participation in traditional DB pensions and cash balance plans is automatic and benefits are entirely employer-funded. Meanwhile, participation in DC plans is voluntary and employers typically contribute less than employees, usually through partial matching contributions.

In the public sector, participation in a primary retirement plan of some type is usually automatic and workers typically contribute a fixed share of salary toward their retirement benefits, though there may be additional voluntary contributions to DC plans. In recent years, public-sector workers have been responsible for roughly half the cost of new pension benefits, though there is significant variation across plans (author’s analysis of CSLGE and CRR’s Public Plans Database 2010; Munnell, Aubry, and Sanzenbacher 2015).

How workers value pensions

The overall cost-effectiveness of pooled pensions over defined-contribution plans and most hybrid plans is not seriously in dispute. But some advocates of account-type plans suggest that they may save employers money by appealing to a modern mobile workforce. In this view, final-average-salary DB pensions give older or long-career workers too many benefits and younger or more mobile workers too few, so redistributing benefits may allow employers to reduce compensation costs with no adverse effect on recruitment or retention.

However, there is little evidence that public-sector workers of any age prefer account-type plans. The suggestion that these workers place a low value on traditional DB pensions is belied by the fact that they negotiate higher employee contributions rather than simply cutting benefits in the face of budget cuts. A study by the Center for Retirement Research comparing the experiences of public employers around the country found that pensions serve to retain skilled workers who would command higher salaries in the private sector, and that workers value pension benefits even if they fund the benefits themselves (Munnell, Aubry, and Sanzenbacher 2015). Meanwhile, a study purporting to find evidence that Illinois teachers were not willing to pay much for pension benefits actually showed that the vast majority of teachers who had the chance to purchase additional benefits did so.

Conclusion

It is often assumed that traditional defined-benefit pensions are expensive and that switching to account-type plans, including cash balance plans, is a way to save state and local governments money. This is not correct. Generally, the only way to save money in the short run is to cut benefits or increase employee contributions. In the long run, benefit cuts are unlikely to save taxpayers money because public-sector workers value these benefits and are paid less than private-sector workers. Instead, cuts will likely lead to offsetting increases in other compensation or impair recruitment and retention, degrading the quality of public services.

Another criticism of traditional DB plans is that they are inflexible and benefit older workers at the expense of younger workers. However, benefit formulas and eligibility rules can be adjusted to change the timing and distribution of benefits. For example, increasing the salary averaging period will tend to reduce the back-loading of benefits, though it will also reduce benefits overall unless offset by other changes, such as an increase in the benefit multiplier. The value of benefits earned by younger and more mobile workers can be increased a number of ways, such as indexing them to inflation and shortening vesting. However, these changes will cost money at a time when most pension funds remain underfunded due to the lingering effects of the 2008 downturn. They will also increase turnover.

Plans that shift investment risk to workers are often shown as providing a steady accrual of retirement wealth, even though account balances will fluctuate, creating unpredictable and even perverse retirement incentives. Though cash balance plans with fixed interest credits do not have this effect, they often provide the biggest benefits to job leavers, promoting high turnover.

Even a cash balance plan with a fixed interest credit that equalizes the present value of benefits of younger and older workers will nevertheless result in greater retirement wealth for workers who participate when they are young, since contributions to their accounts have longer to accrue interest. In contrast, Social Security, a pay-as-you-go system tying benefits to wage-indexed lifetime earnings, provides similar retirement benefits to workers regardless of age. That younger workers have better outcomes even under such “fair” cash balance plans would not matter much if participation were universal, as in the Economic Policy Institute’s Guaranteed Retirement Account plan, because most workers would accrue benefits at different life stages (Ghilarducci 2007). But it is important to keep in mind that even a fair cash balance plan does not result in equal retirement outcomes for younger and older participants.

Employers, and by extension taxpayers, care more about minimizing compensation costs relative to productivity than whether the present value of retirement benefits is a fixed percent of pay. This includes taking into account how workers value different types of benefits and how this affects recruitment and retention.

DC plans have been a disaster in the private and public sector. In West Virginia, Michigan, and Alaska, high costs and low account balances prompted these states to abandon DC plans in favor of a traditional DB plan, a two-tier DB-DC plan, and a cash balance plan, respectively (Pension Review Board 2012). Because problems with DC plans are so apparent, advocates of account-type plans are promoting hybrid plans instead. Though these are better than stand-alone DC plans, it is too soon to tell how these plans will work. Advocates of account-type plans ignore or downplay evidence that these plans cost more, exacerbate retirement insecurity, or both. Rather than a more equitable and efficient system, some account-type plans turn retirement into a gamble while others provide the biggest benefits to job leavers, promoting high turnover. These plans, at least in their current incarnation, are oversold and poorly understood, and we risk embarking on another failed experiment.