NCPA - National Center for Policy Analysis

Transition Costs: A Pension Reform Myth

November 7, 2014

As governments across the country face trillions of dollars in unfunded liabilities in their public pension plans, policymakers have begun to suggest that governments transition from offering traditional defined-benefit plans to offering defined-contribution plans. But those suggestions have been met with criticism, with detractors insisting that the switch itself would carry costs in excess of any benefits. Is that the case? In a new study from the Reason Foundation, Anthony Randazzo breaks down the myths surrounding "transition costs."

Pension funding can be confusing, but, in the simplest terms, traditional pension plans are "defined-benefit" (DB) plans, meaning that they are pre-funded by governments -- in short, governments promise specific pension benefits based on an individual's earnings, and governments are supposed to pay enough each year into a plan to cover the pension benefits earned that year. In practice, that doesn't happen, Randazzo explains: governments put less into pension funds in order to meet other budget needs, and unfunded liabilities begin to pile up.

Defined-contribution (DC) plans, on the other hand, are similar to 401(k)s, in that they ask employees and employers to make regular contributions into their pension accounts. Those contributions are invested, providing retirement benefits that, while not guaranteed, generate additional dollars and follow the employee. There are no unfunded liabilities in DC plans, because the government does not guarantee benefits.

Eliminating the unfunded liability problem plaguing state and local pension plans sounds like a great idea, so what's the hype over transition costs? Detractors argue two things:

  • The Government Accounting Standards Board (GASB) recommends that, upon closing a DB plan with unfunded liabilities, the government shorten the debt payment schedule and make larger debt payments today in order to eliminate the unfunded liability as soon as possible and ultimately reduce the amount paid on the debt. Such a policy would increase debt payments in the current term.
  • Closing DB plans would require employees or governments to pay more money in order to fund the plans.

Randazzo dismisses both points. As to the first argument, he reminds readers that GASB only makes recommendations -- higher debt payments are not required. Secondly, the idea behind making higher debt payments today is that, while expensive, it reduces the amount of debt paid over the long run, and he questions the idea of calling such long-run savings a "cost."

Detractors' second point, Randazzo writes, is faulty; DB pension plans are not designed to be funded by new entrants -- closing the plans would not require additional payments.

Source: Anthony Randazzo, "The 'Transition Costs' Myth: Why Defined-Benefit to Defined-Contribution Pension Reform is Commonly Misunderstood,", October 28, 2014.


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