Public Pensions Mull Shift from DB to DC

(July 26, 2011)—A commission appointed by Arizona Governor Jan Brewer has recommended that the state enroll new employees in 401(k)-type plans rather than in the traditional defined benefit pensions—a step indicative of what some have called an inevitable nationwide trend towards defined contribution plans for public employees.

Governor Brewer, however, is set to table the proposal, although she will consider the commission’s other suggestions, the Verde Independent has reported, underscoring the resistance that public pension plans face as they weigh a move to defined contribution (DC) from defined benefit (DB).

Many American public pension plans face staggering liabilities because of decades of mismanagement, with politicians from both parties making promises to unions without making an effort to pay for them, aiCIO has reported. Even in states like New York, where pensions cannot legally go underfunded, pension liabilities are consuming larger and larger portions of the budget. The 2008 financial crisis exposed the dire situation that many states were in. The public, outraged over stories of lavish pensions when their own wallets were being squeezed, in 2010 elected in several states reformist governors eager to tackle the pension problems.

The governors have grappled with the issue in several ways, particularly by raising the retirement age, requiring workers to pay more toward their healthcare, and by ending the practice of pension spiking, the process in which public employees work overtime in their last year of employment to receive an inflated pension that is linked to their final year’s pay. Others have gone farther, such as in Ohio and Wisconsin, where Republican governors moved to strip public unions of the ability to collectively bargain for their benefits.

Even the most aggressive reformers, however, have shied away from a full-fledged adoption of a DC system, a move many analysts say is the inevitable solution to the long-term pension liabilities problem. That reluctance may soon change. A few states already have defined contribution systems in place, either as a mandatory program or as, in what is called a hybrid plan, an option for new employees. Alaska, Colorado, Georgia, Michigan, Ohio, Utah and several other states offer some form of defined contribution pension system for their public employees. Recent studies trumpeting the fiscal wisdom of the DC plans are seductive, placing pressure on state leaders sitting on the fence. A report in June by the Mackinac Center for Public Policy demonstrated that Michigan’s 1997 shift towards a DC system for its new employees has saved the state up to $4.3 billion in unfunded pension liabilities. In April, Governor Sam Brownback of Kansas predicted that the state would move to a DC system for new public workers. Even in California, Governor Jerry Brown has recently proposed a plan to give the California Public Employees Retirement System (CalPERS) $1.5 million to study the possibility of introducing a hybrid system for its new beneficiaries.

American corporate pension plans, with a few holdouts clustered around the auto and the defense industry, long ago abandoned DB for DC plans. But opposition to public adoption of DC plans remains intense, for the same reason why DC plans are so appealing to reformist governors—DC plans provide individual investment accounts, so if the stock market bottoms out, the individual, not the state, is left scrambling to make up the shortfall. But states may be reluctant to adopt DC plans for another reason: a move to DC would rob the old DB plan of contributions, thereby actually exacerbating the funding problem, at least in the short-term.

The current economic and political environment, however, means that DC plans for state employees will look increasingly desirable to governors and to the public that funds them. In Arizona, Governor Brewer is reportedly waiting to see how pension reforms passed by state lawmakers earlier this year will affect the state’s pension liabilities. If they prove inadequate, Brewer will likely reconsider the commission’s proposal.