Pennsylvania’s $50 billion public pension problem isn’t going to solve itself. Reform is a must, which is why Senate Majority Leader Jake Corman has rightly called for structural changes to the public pension systems before considering higher taxes.
A reform being considered now would put new state and school employees into a defined-contribution (DC) plan. Transitioning to a DC plan for new hires—a necessary move to extract politics from pensions—is an important first step on the road to real pension reform.
But not everyone is convinced.
A common assertion put forth by critics of this approach is that such a switch would increase “transition costs,” forcing taxpayers to foot the bill. The argument is as follows: Transferring new state and school district employees to a DC plan will increase costs for taxpayers as the pool of employees paying into the current DB plan shrinks, requiring more conservative investments and higher contributions.
Still awake? Good.
This argument against switching to DC plans is flawed. Eileen Norcross, program director and research fellow at the Mercatus Center explained why in her testimony last week:
Closing a defined benefit plan does not add liabilities to the plan. Rather, it changes how the plan’s liabilities are accounted for and changes the investment strategy for the plan’s assets. It reveals the economic value of the plan and makes the funding of the plan’s benefits more sound. Closing a defined benefit plan doesn’t add new costs; it makes the costs transparent, and it makes it easier to ensure that the benefits for retirees are fully funded.
But what about the specific contention that closing a DB plan requires moving to more conservative investments, leading to an increase in costs? Norcross refutes this myth:
The investment-based transition costs argument is a casualty of the flawed accounting standards that have created large, unfunded pension liabilities that states must now address. The use of GASB 27 over the years created an accounting and funding illusion that allowed public plans to ignore investment risk and undercontribute annual plan payments. It is why plans experienced such large and unanticipated losses during the 2008 market crash and why plans suffer from large unfunded liabilities today.
To summarize, unrealistic assumptions about future investment returns can increase costs—not a transition to a DC plan. In fact, unrealistic assumptions create dramatic risks for taxpayers that may be alleviated by moving new hires to a DC plan:
…the probability of Pennsylvania meeting its pension obligations by the year 2030 without additional contributions is not even 50 percent, but significantly lower: 31 percent for the Public School Employees Retirement System (PSERS) plan and 16 percent for the State Employees’ Retirement System (SERS). The need to make up this shortfall is the reason for saying that closing a defined benefit plan generates investment-based transition costs. But these costs lessen the risk of pension underfunding and may even eliminate the risk.