Should States Adopt Defined-Contribution Plans?

Blogging for Reuters, Felix Salmon comments, Why states shouldn’t adopt defined-contribution pensions:

Steven Greenhouse has a long article in today’s NYT about an attempt by the states to deal with their “strained” pension funds by moving to defined-contribution pension plans. Here’s the lede:

Lawmakers and governors in many states, faced with huge shortfalls in employee pension funds, are turning to a strategy that a lot of private companies adopted years ago: moving workers away from guaranteed pension plans and toward 401(k)-type retirement savings plans.

What’s a “huge shortfall”? Amazingly, nowhere in the 1,500-word article does Greenhouse actually say. Instead, we get incomprehensible tales like this:

Utah decided to adopt a 401(k)-type plan after the stock market plunge in 2008 caused the shortfall in the state’s pension plan to balloon to $6.5 billion…

Under the new plan, [state senator Dan] Liljenquist said, the state’s retirement contributions for new workers will be roughly half that for current employees, potentially saving $5 million a year for every 1,000 new workers hired.

So, the state of Utah has been putting insufficient money into its pension plan, and now there isn’t enough money there to meet upcoming liabilities. And the solution here is for the state, in future, to contribute “roughly half” of what it’s been spending up until now in pension contributions.

Needless to say, this makes no sense on either front. The liability to existing workers doesn’t go away if a different plan is adopted for new workers, so the problems at the pension plan aren’t being addressed. On top of that, it’s hard to see how contributing much less to new workers’ retirement is going to help them at all, either. From a pensions perspective, there’s no winner at all: the only entity better off is the state, from a cashflow perspective.

On top of that, Greenhouse makes no attempt to put numbers like $6.5 billion or $5 million in any kind of context. Are they big? Who knows.

The only way I could make any sense at all of Greenhouse’s article was to read it in parallel with Dean Baker’s paper on the origins and severity of the public pension crisis. The table he includes, which includes all state public pension funds, is invaluable; here, for instance, is Utah.

What this shows is that the Utah pension fund, at the end of 2009, was about $2.8 billion in the hole. If it rose by 15% in 2010, which is a pretty reasonable assumption given the performance of the stock market, the gap is likely to have been all but eliminated. But even the gap at the end of 2009 was less than one tenth of one percent of Utah’s state income.

All of these numbers are fuzzy, of course. Valuing assets is hard enough; coming up with a present value of future liabilities is much harder, and depends crucially on which discount rate you use. But Baker’s numbers are pretty reasonable, and show that there really isn’t anything to panic about here.

More generally, as Teresa Ghilarducci notes elsewhere on the NYT website (but not in the paper), the idea that moving from defined-benefit to defined-contribution plans is going to help anybody at all is highly problematic.

401(k) plans are bad deal for taxpayers. Dollar for dollar, a traditional pension plan yields more pension benefits than do 401(k) plans because 401(k) management and investment fees are three times higher. And professionals who manage money in pooled pension funds usually get higher returns than workers who manage their own 401(k) accounts. The only clear winners when pensions switch over to the 401(k) plans are brokers and bankers…

The unintended effect of widespread 401(k) plans is more volatility. In contrast to traditional pensions and Social Security, 401(k) plans fuel bubbles and make recessions worse. When the economy is booming, 401(k) plan asset values soar, making people spend more and work less. Not what you want in an expansion.

Worse, when the economy plummets and takes 401(k) assets with it, people do the opposite; they cling to the labor market and rein in spending – again, two things you don’t want in a recession.

On top of that, defined-benefit plans have a mutual-insurance component to them: shorter-lived workers subsidize longer-lived workers, helping to increase everybody’s standard of living.

The fact is that the states’ move to defined-contribution plans is a blatantly political one, born of Republican ideology conflating such plans with individual freedom and choice. For rich professionals who jump from job to job every few years, 401(k) plans do make a certain amount of sense. For public servants spending a lifetime in the police force or in elementary schools, by contrast, they emphatically don’t. As for the state pension plans, the only way that the state governments can help them make up their actuarial liabilities is if they pour more money into them. Not less.

In his comment in Forbes, E.D. Kain takes it a step further:

Worse, defined-contribution plans open up a Pandora’s box of potential problems down the road. Take the case of the West Virginia. In 1991 West Virginia lawmakers ended their defined-benefit plans for new teachers. All teachers hired after 1991 were placed on a 401(k)-style plan. Under a 401(k) employees pay into a personal retirement account and employers match their contributions up to a certain amount. This money is invested in stocks and bonds and is often left to the employee to manage. It’s also tax-free up to a certain percentage of income, and portable. But it turns out, 401(k) plans are not for everyone:

Fast forward to today. It turns out that for a very large segment of West Virginia teachers, the 401(k)-type plan hasn’t panned out too well. According to a study done by West Virginia’s Consolidated Public Retirement Board, the average account balance is just $33,944 and only a handful of teachers age 60 or older have amassed more than $100,000 in their accounts – a fraction of what the pension plan would’ve paid.

What happened? Despite receiving an annual matching contribution equal to 7.5% of their pay, many teachers are claiming that they were improperly steered into low-yielding annuities, even though the plan offered more appropriate investment choices. Others say they received no guidance or education on such important topics as asset allocation and rebalancing.

So the West Virginia teachers now want a do-over. Essentially, they want to treat the past 17 years under the 401(k)-style system as though it never happened. They are asking to be put back – retroactively – into the traditional defined-benefit pension plan. Like a bad dream, their paltry 401(k) balances will disappear, to be replaced by the more generous pensions they would have racked up had they been in the traditional plan all along.

Of course, millions of private-sector workers would also like a second chance. According to an analysis of 20 million 401(k) participants conducted by the Employee Benefit Research Institute and the Investment Company Institute, the median account balance of a worker in his or her 60’s, making between $40,000 and $60,000 a year (in the same ballpark as a retiring West Virginia teacher) was $97,588 at the end of 2006. To put that amount in perspective, it would generate only about $8,000 a year in retirement income if it were invested in an immediate annuity.

But back to West Virginia. Incredibly, the state legislature has already agreed to go along with this retroactive pension switchover – as long as 65 percent of teachers formally elect to make the voluntary changeover.

Did you catch that? The average balance on these plans was just $33,944 – not exactly a nest egg. Spread over just twenty years of retirement, that only gets you a little over $140/month. The median account balance at retirement of private-sector workers on a 401(k) plan is only $97,588, or just over $400/month. Compare this with a defined benefit of say $2,500/month for twenty years – the equivalent of a $30,000/year pension – and you get a total benefit of $600,000. This should give you a sense of how difficult 401(k) plans are to scale across the American workforce. As Salmon correctly notes:

The fact is that the states’ move to defined-contribution plans is a blatantly political one, born of Republican ideology conflating such plans with individual freedom and choice. For rich professionals who jump from job to job every few years, 401(k) plans do make a certain amount of sense. For public servants spending a lifetime in the police force or in elementary schools, by contrast, they emphatically don’t. As for the state pension plans, the only way that the state governments can help them make up their actuarial liabilities is if they pour more money into them. Not less.

Well that’s not the only way states can help their pension funds. They can also manage them more wisely and not put as much faith into Wall Street. The financial collapse and the housing bubble are the reasons these plans are in crisis to begin with after all.

Let me comment on these posts. Felix Salmon rightly notes that states like Utah have been putting insufficient money into their pension plans, exacerbating pension deficits. But he also questions the magnitude of pension deficits, alluding to Dean Baker’s paper on the origins and severity of the public pension crisis.

I'm not going to question Dean Baker's paper and I agree that the problem of pension deficits has been blown way out of proportion for ideological reasons. Having said this, deficits are real and they require tough political choices ahead which include increasing contribution rates, cutting cost-of-living adjustments, cutting benefits and if need be, raising taxes. Relying on rosy investment projections to deal with chronically underfunded pension plans is simply irresponsible and taxing the private sector which is still reeling after the 2008 crisis is political suicide.

But moving into defined-contribution (DC) plans is not the solution. I've said it before, defined-contribution plans have been a disaster for workers looking to retire comfortably. They underperform large, well-managed defined-benefit (DB) plans for the reasons cited above, namely, they're expensive (fees are outrageous), volatile, badly managed, and they don't have the best interest of workers at heart (just those of brokers and bankers).

Let me add this: large, well governed defined-benefit plans are able to manage assets internally as well as invest in the best public and private funds around the world. For example, look at the Canada Pension Plan Investment Board's (CPPIB) external partners in public markets, private equity and real estate. Do you really think any DC plan can compete over a long period with a large DB plan that's able to pool billions and invest in these top managers? Not in a million years.

Moreover, defined-benefit plans end up costing society a lot less over the long-term because they cut the rate of pension poverty, as well as cut the fees paid out to brokers, banks and insurance companies. But when ideology takes over, the arguments against DB plans become ridiculous: "It's socialism, communism, a reason to raise taxes!". Give me a break! There are problems with DB plans but the rush to scrap them and replace them with DC plans will only make matters worse, ensuring more pension poverty down the road.