Lack of understanding about funding costs clouds the debate over public pension reform.
There is much discussion and debate among interested stakeholders in the public pension plan funding crisis concerning reforming public pension plans by converting new employees or non-vested employees or both to some type of defined contribution plan, cash balance or hybrid plan. What all of these proposed defined contribution plans or hybrid plans have in common is the shifting of all or much of the investing risk to the employee to fund future benefits.
The reasons given to justify this transition are twofold: first, the investing risk for funding future benefits will be borne primarily by the employee instead of the public plan sponsor and, second, as a result, the actuarially required contributions by the sponsor will be reduced.
However, this debate confounds the politically difficult discussion and adoption of real solutions for today's funding crisis.
Adoption of a defined contribution plan by an underfunded pension system will have very little effect on reducing the current underfunded deficits, at least in the next 25 to 30 years.
According to Milliman Inc.'s “2013 Public Pension Funding Study,” $2.15 trillion of $3.77 trillion of liabilities of the 100 largest public pension plans are attributed to funding benefits for current retirees. That proportion amounts to 57%.
Because retirees cannot be shifted into defined contribution, establishing a DC plan will not have any effect on reducing more than half of the plans' total liabilities. In most defined contribution proposals, existing employees are not included in the transition to DC plans. Only newly hired employees are put in a defined contribution plan.
If current active employees are not included, the public plan sponsor is required to continue to fund future benefits earned by these employees during the rest of their actively employed years. This trend further extends any the challenge of making potential improvement of the current underfunded liability. Instead of a 15- to 20-year period that benefits are paid by the plan (the retirees' expected lifespan), the required funding to pay future earned benefits extends for a much longer period for active employees.
The shifting of funding risk to participants by a transition to defined contribution is not a solution to current underfunding. It is likely that meaningful reduction in the funding deficit would not occur for a much longer period, perhaps 30 or more years, as the defined benefit plan funding for active employees continues.
Throughout this period the public plan sponsor (and taxpayer) still continues to absorb the investment risk and longevity risk associated with funding lifetime benefits.
It is clear that solving the public pension underfunding in a period of less than 15 to 20 years will require that the underfunding of retiree liabilities be addressed as a major part of any real pension reform.
Possible real solutions could include a combination of policy changes: tax increases to raise sponsor contributions to make up past shortfalls; risk transference through buyouts or buy-ins; adopting liability investing strategies by matching assets to liabilities; and increasing the pool of assets used to fund benefits by issuing debt through pension obligation bonds. None of these choices come without political or legal risk.
This is not to say that the closing of defined benefit plans and adoption of defined contribution plans does not have merit and should not be part of the conversation seeking very long-term solutions to defined benefit plan underfunding.
But this discussion and debate should be separate from the solving of the current funding crisis. The only thing that occurs in this attempt to address the current funding crisis through an adoption of a defined contribution plan is the political expediency of “kicking the can down the road.”
John T. Hausladen is CEO of Plan Funding Solutions LLC, a pension consulting firm, based in Malvern, Pa.
