Proponents are claiming Kentucky will face no transition costs from shutting down its defined benefit (DB) pension plans and moving employees into 401k-type defined contribution (DC) plans. That assertion ignores why there are transition costs from closing a plan.
DB plans are pre-funded, as the governor’s staff recently noted in an email to the General Assembly that cited an article from the Reason Foundation. Being pre-funded means DB plans are not designed for new workers to directly pay for the benefits of retired workers. Looking at that fact alone, one could conclude there are no transition costs from switching to DC because the legacy debts from the DB plan must be paid off regardless. But as we outlined in our recent report, closing a plan makes it more expensive to pay down remaining liabilities because of the lower investment returns the closed plan will earn for the decades it will continue to pay benefits.
One reason DB plans earn high returns over time is a mix of workers of different ages, which allows the plans to keep an investment portfolio aimed at maximizing long-term gains. Switching to DC ends that. When a government cuts off participation in a DB plan, the closed plan is made up of a steadily aging population rather than a balance of younger, middle-aged and older workers. The closed plan must continue to earn strong investment returns in order to have the funds needed to pay benefits until the last eligible retiree dies many decades in the future (investment returns make up nearly two-thirds of the ultimate benefit a worker receives in a DB plan).
Because a growing share of the closed DB plan’s members will retire and draw benefits each year, the plan must take on a more conservative and liquid portfolio over time than if the plan remained open to new members. That will lower its investment returns. Lower investment returns require higher employer contributions to pay off the liability, adding substantial costs in future decades.
The added cost from lower returns is a major reason many states that have considered moving employees into DC plans decided against doing so. Studies by states that have looked into the issue are summarized here, courtesy of the Keystone Research Center:
An analysis of the DB and DC plans conducted by the Arizona Retirement System in 2006 concluded: “If the goal of a retirement plan is to provide the least expensive method of providing a basic guaranteed replacement income to the members, then the defined benefit plan appears to provide a significant advantage for the majority of participants if the plan choices are mutually exclusive.”
A 2011 study for the California Public Employees’ Retirement System concluded that closing the DB plan would lower investment returns of plan assets due to a shrinking investment time horizon and the need for more liquid assets. The study also concluded that freezing the DB plan would incur the increased administrative costs of a DC plan and the costs associated with having two systems concurrently.
In 2005, Milliman, an actuarial firm hired by the Los Angeles County Boards of Retirement, studied the fiscal impact of placing Los Angeles County employees hired after July 1, 2007 into a new DC retirement plan instead of the current DB pension. Milliman estimated that the county’s DB plan contribution rate would rise by 3.66 percentage points, increasing required contributions to the closed DB plan by $206 million in 2008. While the contributions would then decline over time, the county would not see any savings in DB plan costs until 2018. The actuary also found that there could be a “transition cost” of the switch to a DC plan: Investment of assets may need to be more conservative because no new members would be added after July 1, 2007, reducing investment returns and requiring the employer to pay more to fund retirement benefits.
A study by Buck Consultants under contract to the State Auditor in 2001 concluded that “…it is more expensive for a defined contribution plan to provide a career employee with the same level of retirement benefits as a defined benefit plan…”
An actuarial study examined questions related to closing the DB plan (with no new hires becoming members of the DB plan). The study concluded, “The System’s current asset mix reflects its position as an institutional investor with a very long time horizon. In anticipation of the closed plan moving into a negative cash flow situation, the target asset mix would be rebalanced to produce a greater degree of liquidity, reflect a shorter time horizon for investment, and the resulting lower risk tolerance level. The System’s ability to invest in illiquid asset classes, such as private equity and real estate, would be reduced. The System’s shorter time horizon for investment would dictate a reduction in the higher return producing asset classes, which produces more volatility of returns. The System’s need to hold more cash equivalents to meet outgoing cash flows would also reduce the total return of the investment portfolio. As a result, the return on the portfolio would be expected to be lower than the investment return assumption on an ongoing basis. The lower investment return would result in higher contributions needed to provide the same benefits.”
A 2011 study for the Minnesota State Legislature found that the transition costs of switching new hires from DB pensions to DC plans “…would be approximately $2.76 billion over the next decade for all three systems.” The analysis explained that costs increase during a transition period because once a plan is closed to new members any unfunded liabilities remaining in the existing DB plan must be paid off over a shorter timeframe.
A 2010 Segal Company study of Nevada’s proposal to put new hires in a DC plan found that the state’s total pension costs would increase.
The New Hampshire Retirement System performed an analysis on proposed 2012 DC legislation related to the benefit plan design and funding. The report found that closing the DB plan to new hires would increase the unfunded liability by an additional $1.2 billion, and closing the DB plan to new workers would likely lead to changes in investment allocations, including an increase in more conservative investments with lower returns, because over time it would become a retiree-only system.
The New Mexico legislature requested analysis on the implications of moving from a DB program to a DC program for all new education employees in 2005. The analysis was conducted by Gabriel, Roeder, Smith & Company, and as the report explained, when a DB plan is closed to new hires, “…since a growing portion of plan assets must be used to pay benefits, a growing portion of assets will likely be held in short-term securities, thereby reducing investment returns.”
In 2011, a study was conducted by the National Institute on Retirement Security and Pension Trustee Advisors on behalf of the Office of New York City Comptroller John C. Liu. The study found that costs associated with traditional pensions range from 36 percent to 38 percent less than a DC plan providing equivalent benefits. Longevity risk pooling saves from 10 percent to 13 percent, maintenance of portfolio diversification saves from 4 percent to 5 percent, and superior investment returns saves from 21 percent to 22 percent.
Three different actuaries concluded that closing Pennsylvania’s DB pensions to new employees would gradually erode investment returns leading to a $42 billion increase in unfunded liabilities.
The Employee Retirement System of Texas in 2012 noted that, in many cases, the increased cost of freezing a DB plan, combined with the inefficiencies of DC plans made it sensible to “modify the existing plan design instead of switching all employees to an alternative plan structure.” The Teacher Retirement System of Texas concluded that even if contributions remained the same as in the current DB plan, participants in an individually directed DC plan would have only a 50 percent chance of earning investment returns high enough to get 60 percent or more of the DB plan benefit. The study found that it would cost 12 percent to 138 percent more to fund a target benefit through alternative retirement systems. Individually directed DC accounts were found to be the most costly, and a DB system the least costly. Finally, the study estimated that freezing the DB pension could cause the liability to grow by an estimated $11.7 billion — 49 percent higher than the current liability —due to lower investment returns resulting from a transition to a more liquid asset allocation.
A 2011 study for the state legislature analyzed the impact of establishing a DC plan as an option, among other potential changes to the Wisconsin Retirement System (WRS). The final report stated: “Actuarial analysis indicates that to provide a benefit equal to the current WRS plan, an optional DC [defined contribution] plan would require higher contributions than employers and employees currently pay.” The study recommended: “Given the current financial health and unique risk-sharing features of the WRS, neither an optional DC plan nor an opt-out of employee contributions should be implemented in Wisconsin at this time. Analysis included in this study from actuaries, legal experts, financial experts, and information from similar studies conducted in other states show that there are significant issues for both study items in terms of the actual benefit provided and potential for negative effects on administrative costs, funding, long term investment strategy, contribution rates, and individual benefits.”
In addition to these transition costs, a switch to DC can be more expensive if the employer contribution to the DC plan is more than the so-called employer normal cost of the DB plan (the amount actuaries estimate must be contributed each year for the benefit). The Reason Foundation admits that fact in the article linked above. In Kentucky’s case, the DC plans proposed by the consultant PFM do cost more than the state’s existing pension plans, according to data provided by the consultant itself and the systems’ actuaries.