Stopping the Sinkhole

Lessons for Pension Reform in Pennsylvania

MAY 27, 2014 | Policy Report by SCOTT BEAULIER

Pennsylvania's two pension programs, the State Employees' Retirement System (SERS) and Public School Employees' Retirement System (PSERS), are in desperate need of reform. Pennsylvania’s unfunded liabilities have been steadily rising, presenting significant risks to the state’s economy and promising to burden businesses and taxpayers. Governor Tom Corbett's 2013 pension reform recommendations would shift new employees to a 401(a) defined contribution plan (similar to the 401(k) of the private sector) and adjust compensation formulas for current employees. If implemented, his recommendations could save Pennsylvania $12 billion in employer contribution costs and $40 billion in plan costs over the next 30 years.

Such reforms, while politically contentious, are not new in the private or public sectors. Difficult financial conditions and changes in employee and employer attitudes towards pensions have forced thousands of private sector firms to modify their pension programs over the past 30 years. Members’ plans have typically shifted from defined benefit (DB) towards defined contribution (DC) plans, a trend greeted with skepticism by many employees and hostility by unionized workers. However, much of the concern stems from a general lack of knowledge about DC programs and resistance to change.

A growing body of work by economists and financial experts suggests significant benefits for firms, public sector entities, and employees that shift from DB to DC programs. Employees gain greater clarity about their actual retirement benefits and workers are not punished for frequent job changes, as they would be in DB programs. Further, employers benefit from a greater ability to project DC program costs. Likewise, taxpayers have to pay less for public pensions as unfunded liabilities become manageable and, in the long run, are completely eliminated.

Over the past 30 years, solutions to pension problems have shifted towards DC programs. This transition, while disruptive for employees, provides the following important benefits to key stakeholders in both the private and public sector:

  • Portability. The Bureau of Labor Statistics estimates that the average worker changes jobs more than ten times in his or her career. Such churn means employees risk not becoming vested and losing significant DB benefits. In contrast, DC programs are paid directly to workers and allow accumulated funds to be carried with the worker across jobs and across states. 
  • Fully funded status. By definition, DC plans are fully funded. All of the funds promised to an employee, which are typically based on a percentage of salary, are paid up front and become the employee’s property. Firms or public sector entities never risk carrying a funding liability. 
  • Ownership. Workers with higher risk preferences can actually pursue their own investment strategies without DB restrictions, which often overinvest in fixed income and "safe" asset classes at the expense of higher returns. 
  • Potentially higher returns. A growing body of evidence suggests that a lifetime of DC retirement investments produce higher returns than individuals cashing out of a DB program. Financial economists have performed thousands of simulations that take into account key features of a person’s years in the labor force. The simulations consider employees leaving one job for another, employees leaving the public sector for private sector, employees retiring at different ages, etc. One main finding from these simulations is that when compared to public sector defined benefit plans, DC plans invested in a diversified portfolio consistently result in a larger lifetime nest-egg for people than the wealth accumulated in a DB plan. 
  • More predictable costs. Rather than being dependent on unknowns, such as life expectancy, stock market returns, and the financial conditions of firms or state economies,  DC plans make the employer responsible for a specified contribution each year. These contributions are easily predictable and less variable than DB contributions, making businesses more efficient and protecting taxpayers from public sector budgetary shocks.

Evidence from the private sector and some reformed public sector pension programs shows that pension reform is possible and creates significant savings to firms in the private sector and taxpayers in the public sector. Private firms, while enjoying more flexibility than public pension programs when reforming, still face many of the same challenges as public sector pensions. Therefore, as Pennsylvania considers reform, it is useful to examine the pension reform trend for insights about possible costs of reform and understand the "best practices" of pension reform.

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Scott Beaulier, PhD is the Chair of Economics & Finance and director of the Manuel H. Johnson Center for Political Economy at Troy University. He is also the Adams-Bibby Chair of Free Enterprise.  

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