KY Policy Blog

Switching to 401ks Is a Lose-Lose

By Jason Bailey
February 12, 2018

It’s a bad idea for Kentucky to shut down its pension plans and move new teachers and public employees into less efficient 401k-type defined contribution (DC) plans. State and local governments would pay more while workers would receive a smaller and less secure benefit. It’s a lose-lose proposition for employees, the quality of public services and the commonwealth as a whole.

DC plans cost more than Kentucky’s existing pension plans

A switch to DC plans will fail to save money because the employer contribution for new workers in Kentucky’s existing defined benefit (DB) plans is already very low. When a new teacher or public employee is hired, the only employer contribution owed for pensions is referred to as the “normal cost” (other contributions are catch-up payments due to past underfunding, which are owed regardless of benefits for new workers). The normal cost is very inexpensive for both teachers and state employees:

  • For teachers, the cost is only 5.74 percent of their pay (and teachers put in much more, contributing 9.105 percent of their pay). That is less than the contribution every private employer puts in for Social Security alone, 6.2 percent of pay, which the state doesn’t owe in the case of teachers.
  • Pensions for new state non-hazardous employees hired under the current plan (known as the Tier 3 cash balance plan) cost only 2.26 percent of pay (workers put in 5 percent). For local employees, employer costs are a meager 1.27 percent of pay.

These modest expenses are already in line with, or even slightly less than, the new DC plans proposed in the draft pension bill released in the fall. Its DC plan for teachers would cost employers 6 percent of pay (4 percent paid by the state, 2 percent by school districts). And the DC plan for other public employees would cost employers between 2 and 5 percent of pay, depending on how much employees contribute.

While the benefit itself is no cheaper, there are also huge added costs associated with closing down pension plans to new workers. Closed plans must continue paying benefits for decades, but a growing number of workers in the plans retire each year. That forces the system to maintain a more liquid and conservative portfolio. The result is lower investment returns, which means employers must make much bigger contributions until liabilities are fully paid. Other states abandoned 401k proposals after actuarial studies showed these big additional costs.

In Kentucky, the actuary to the Teachers Retirement System (TRS) estimated the draft pension bill would add $4.4 billion in employer costs over the next 20 years. Closing the plan to new workers was a big driver of those added expenses, as it would trigger lowering the TRS investment return assumption from 7.5 percent to 6 percent. Each percentage point drop in the return assumption for the teachers’ plan adds $302 million in annual employer costs.

Similar analysis of the pension bill’s cost was done for Kentucky Retirement Systems, but never allowed to become public.

Switch would harm retirement security, ability to attract a skilled workforce and local economies

Even while increasing costs, switching to DC plans would provide an inferior benefit for teachers and other public employees. Experts say it costs between 42 and 93 percent more for a DC plan to provide the same level of retirement benefit as a DB plan. That’s because investment returns are lower, fees are higher and DC plans don’t provide security from running out of money before the end of life. In the case of teachers, the draft pension bill would leave them among the few Americans without the protection of any sort of DB plan (since they are not in Social Security).

Lower and less efficient benefits will make it even harder to attract and retain a skilled workforce to deliver quality public services. Kentucky public employees already make less in total compensation than comparable workers in the private sector. And state workers haven’t received raises in 6 of the last 8 years.

A loss of benefits harms not just employees and services, but local communities as well. Public pension benefits inject $3.4 billion into the Kentucky economy each year, supporting local businesses and creating jobs.

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