By Jon Forman
To DB or not to DB. According to California Gov. Arnold Schwarzenegger, that is the question. Mr. Schwarzenegger has proposed closing the state's traditional defined benefit plans and forcing all new public employees into new defined contribution plans. According to the governor's budget statement, "Over time, this reform will save billions of dollars to all levels of government and will give employees the kind of portability and affordability that is common in private sector pension plans."
The governor wants California to adopt a constitutional amendment to prohibit the state or any of its political subdivisions from offering defined benefit plans to new employees. And because of legislative inaction, Mr. Schwartzenegger said he will seek a special election on whether new California state employees should be required to join a defined contribution and freeze entry to existing defined benefit plans as of July 1, 2007.
The governor is rightly concerned about the large and growing unfunded liabilities of California's traditional public employee pension plans. For example, as of June 30, 2003, the California Teachers' Retirement System was only 82% funded, and the five state public employee plans administered by the California Public Employees' Retirement System were only around 84% funded.
As a member of the board of trustees of the Oklahoma Public Employees Retirement System, I can personally attest to the fact that state legislatures are far too willing to increase pension benefits without paying for them. In that regard, Mr. Schwarzenegger's budget statement noted that a single bill passed in 1999 increased California's pension costs by $508 million a year (Chapter 555, SB 400).
There is simply no justification for shifting current pension costs onto future generations of taxpayers, but that is exactly what happens in a world of traditional defined benefit plans.
In addition, Mr. Schwarzenegger is right to complain about the lack of portability of traditional defined benefit plans. Traditional plans impose significant financial penalties on workers who change jobs frequently. For example, workers who leave before vesting often get no retirement benefits, and workers who leave soon after vesting get disproportionately small retirement benefits.
Traditional plans also create large financial incentives that keep middle-age workers on jobs they dislike until some arbitrary retirement age, and push older workers into retirement even when those workers would rather keep working. Do we really want burned-out teachers to stay in the classroom until old age and extraordinary teachers to leave while they can still dazzle their students?
But Mr. Schwarzenegger is wrong about the solution. Defined contribution plans present a sea of troubles. Compared with defined benefit plans, defined contribution plan investment returns are lower, the risks to individual employees are higher, and the costs of managing accounts are greater. Moreover, while defined benefit plans typically pay out benefits in the form of a lifetime annuity, defined contribution plans typically make lump-sum distributions that are often quickly exhausted.
California should reform its current defined benefit plans, not abandon them. The solution is to incorporate individual accounts into the current defined benefit system. These individual accounts should be hypothetical or notional accounts like those found in cash balance plans in the private sector. Along the same lines, Sweden, Poland and a number of other countries have recently replaced their underfunded social security systems with notional individual account plans.
A hypothetical individual account plan is a defined benefit plan that looks like a defined contribution plan. The plan accumulates, with interest, a hypothetical account balance for each participant. For example, a simple plan for a new employee might allocate 8% of salary from the employer and 8% of salary from the employee to each employee's individual account each year, and credit that account with, say, 7% interest on the balance in the account. At retirement, each worker would draw benefits in the form of a lifetime annuity purchased with the balance in her account.
Large defined benefit plans like CalSTRS and CalPERS do a better job investing money than thousands of individual workers using dozens of defined contribution plans ever could. Moreover, these large defined benefit plans could easily and cheaply manage thousands of hypothetical individual accounts. Large defined benefit plans also do a great job of paying the kinds of inflation-adjusted annuities that we all need in our retirement years.
In addition, individual account plans avoid the kind of perverse work disincentives that we see with traditional defined benefit plans. With hypothetical (or real) individual accounts, older workers would have every incentive to keep working and increasing their retirement savings, and younger workers would no longer face severe financial penalties for moving in and out of government service.
What do we want a state pension system to do? First, the system should ensure that every public employee earns a meaningful retirement benefit and that longtime employees are guaranteed an adequate income throughout their retirement years. Second, the system should have a minimum of work disincentives for employees coming in and out of government service. Third, the system should be affordable and well financed.
California could easily achieve these three goals by shifting to a hypothetical individual account system. New employees would get individual accounts immediately. Current employees would be allowed to stay with their traditional final-average-pay benefit formulas or shift to new individual account formulas. In any event, California would be able to lock in its employer contributions for new employees, and it could gradually pay off its unfunded liabilities. Every employee would earn a meaningful retirement benefit each year, and career employees would all get an adequate retirement income. And the politicians could claim all the credit — "ay, there's the rub."
Jon Forman is professor of law at the University of Oklahoma College of Law, Norman, Okla.