NCPA - National Center for Policy Analysis

Public-Sector Pensions: The Transition Costs Myth

May 24, 2012

In stewarding the retirement benefits of their extensive workforces, state and local governments face unprecedented levels of unfunded liabilities.  These liabilities, which can essentially be seen as debts owed by governments determined by a financial timetable, threaten to overwhelm fragile governmental budgets, says Andrew G. Biggs, a resident scholar at the American Enterprise Institute.

Pensions for state and local government employees are underfunded by between $700 billion and $4 trillion, depending on whose accounting you use (most economists subscribe to the latter).  The need to address this issue has compelled several governments to gradually shift their workers from defined-benefit (DB) plans to defined contribution (DC) plans.

The essential difference between DB pensions and newer 401(k)-style DC plans is that DC plans can't generate unfunded liabilities.

  • Under a DB plan, the employer promises employees a fixed retirement benefit regardless of how the plan's investments fare.
  • In a DC plan, by contrast, employers promise employees a fixed contribution -- say, 5 percent of salary.

Public-sector employees and the pension industrial complex of plan managers, pension actuaries and investment advisors are pushing back, citing enormous "transition costs" as a fundamental reason to stick with DB systems.

  • Pension advocates rely on financial disclosure rules generated by the Government Accounting Standards Board (GASB) regarding how quickly a DB plan must pay down its unfunded liabilities.
  • A plan that is open to new employees may amortize its shortfalls over a longer period of around 30 years.
  • But if a plan should close (as it usually does if it switches from DB to DC plans), it would have to pay down its liabilities on an accelerated timetable.
  • This faster payoff means a temporary period of higher pension amortization costs, which is termed the "transition cost."

However, researchers have found arguments employing the enormous transition cost to be largely bunk and filled with fear-mongering.  The GASB standards have little to do with mandating a specific level of funding for retirement accounts, and even so, states regularly defy the board's policies.  Thus, the constant touting of transition costs should do little to deter movement to DC plans.

Source: Andrew G. Biggs, "Public-Sector Pensions: The Transition Costs Myth," The American, May 21, 2012.

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