Flaws of adopting cost cutting in switching to DC plans

Thinking back to 2007 — before the financial crisis — public pension plans in the aggregate had nearly 90% of the assets on hand required to pay retirement benefits due decades in the future. However, like all investors, public pension funds took a deep hit when the financial markets melted down in 2008. With markets in a downward freefall, pension assets plummeted, unfunded liabilities grew and pressure mounted on state policymakers to enact reforms. Even states with well-funded plans were prudent to closely examine their retirement systems, while policymakers in states that had fallen behind on their contributions prior to the Wall Street crisis faced tough decisions.

Since that time, 48 states have enacted reforms to their pension plans. The overwhelming majority of states acted to ensure the sustainability of their traditional pension structures by adjusting benefits and increasing employee and employer contributions. Specifically, the states enacted one or more reforms: 40 states reduced future pension benefits; 30 states required employees to increase their contributions; 21 states reduced cost-of-living adjustments for retirees; and 11 states statutorily increased the employers' pension contributions.

Now, public pension systems appear poised to emerge stronger than before the financial crisis thanks in large part to state policymakers' resistance to calls for extreme measures, while undertaking prudent state reforms and enjoying economic recovery. Indeed, a recent analysis by the Boston College Center for Retirement Research finds that such substantial reforms have put states on track to closing funding gaps, and many states might eventually reduce their pension costs to levels below what plans paid before 2008.

Although the environment back in 2008 appeared fertile for a wholesale switch to individual defined contribution accounts from defined benefit pensions, it never happened. That begs the question — why did policymakers stick with their defined benefit plans in the face of financial pressure and the corporate trend away from them?

One explanation is that the move away from defined benefit plans in the private sector is rooted in federal regulations that aren't applicable to public systems. These rules create sizable funding volatility and unpredictability for corporate plan sponsors.

Another explanation is that state policymakers heeded the data in actuarial analyses that indicated closing public pensions would not address funding shortfalls. Take for example the experience of West Virginia's pension reform in the 1990s, which now is a cautionary tale for policymakers. West Virginia learned the hard way that a switch to defined contribution accounts from defined benefit plans does nothing to close unfunded pension liabilities, and can leave employees unable to retire.

Here's what happened. To address historical underfunding of the West Virginia Teachers' Retirement System, the state closed the TRS and moved teachers hired after 1991 to 401(k)-type defined contribution accounts. More than a decade later, both the DB plan and the new DC plan faced challenges. The TRS DB plan was less than 20% funded, while teachers with DC accounts found their balances inadequate. Since West Virginia wisely reinstated its pension plan, the TRS DB finances have improved significantly and teachers are better positioned to retire.

While teachers made their required contributions to the TRS DB plan out of every paycheck, until 1991 state policymakers operated the system on an expensive a pay-as-you-go model that built up a significant unfunded liability. West Virginia adopted an actuarially based plan to reach full funding for the liability in the closed pension plan in 1994. But with the plan closed, demographics shifted quickly. By 2005, TRS paid pension benefits to nearly two retired teachers for every active teacher still contributing to TRS. When combined with funding percentage levels in the low 20s, this was a major concern.

Meanwhile, all new teachers made their mandatory 4.5% of pay contribution to the DC plan and employers contributed 7.5% of salary. However, the teachers' investment decisions were conservative and generated lower investment returns. As a consequence, teachers approaching retirement under the DC plan on average had less than $25,000 in their accounts and could not afford to retire, according to a 2005 study.

With these poor results, lawmakers cut their losses in 2005. They closed the 401(k) plan and reopened the pension plan to new teachers. This generated an immediate savings for the state because the “normal cost” for TRS was roughly half of the required employer contribution to the 401(k) plan.

On the demographic front, nearly 36,000 active teachers make the 6% contribution to the DB plan and about 32,000 retirees receive a monthly pension check. Now more sharply focused on the state"s 2034 pension full-funding deadline, West Virginia demonstrated its renewed commitment to catch up on past pension funding payments by using $807 million from its tobacco settlement fund to shore up the TRS plan.

Today, the West Virginia TRS pension plan continues to improve. The system's financial statement as of July 1 reported funding was at 58% of liabilities. That means that in the eight years since reopening the TRS pension, the state narrowed by half what historically was a sizable pension funding gap.

Other states have watched and learned from the West Virginia experience. Ultimately, kicking transition costs and unfunded liabilities down the road can have dire consequence for employees, employers and taxpayers. States have chosen to keep their DB pension model and are taking positive steps to fund their promises rather than embracing theories that there is no cost to switching to a DC plan from a DB plan. n

Diane Oakley is executive director of the National Institute on Retirement Security, a Washington organization supported by pension plans and other retirement organizations.

This article originally appeared in the January 20, 2014 print issue as, "Flaws of adopting cost cutting in switching to DC plans".