Over the past several years, a key Pennsylvania political debate has centered on the issue of public pensions. Conventional wisdom from the General Assembly said that in order to deal with our significant debt problems, we have to end traditional pensions as we know them and move into a different kind of system altogether.
That argument has a lot of convention, but not a lot of wisdom.
Since they are nearly-universal in the private sector, there is a natural assumption that 401(k)-style plans are a more cost-effective way to provide retirement benefits to employees. But just the opposite is true.
In fact, the various 401(k)-style proposals suggested by Gov. Corbett and the General Assembly over the past few years ranged from bad to worse — either saving the state no money or adding billions of dollars to Pennsylvania’s pension bill. The result? Increased costs for Pennsylvania taxpayers and a less secure retirement for Pennsylvania teachers, nurses, social workers and thousands of others. Legislators need to take that into account before reconsidering pensions in 2015.Why pensions are more cost-effective
As a result of a simple rule of finance: a large pool of money invested by financial experts yields far greater returns than small, separate accounts managed by individuals with no professional financial training. According to a recent report from the National Institute for Retirement Security, “Still a Better Bang for the Buck,” traditional pensions are 48 percent less expensive than 401(k)-style plans providing the same level of benefits. Read that again to make sure it’s clear: traditional pensions provide the same benefit at half the cost.
There are a few basic reasons for these dramatic cost-savings. First, as mentioned earlier, pension plans enjoy higher investment returns and lower fees than 401(k) plans. Second, pension plans never have to switch to a low risk, low reward investment strategy. Individual investors do have to as they become older, shifting out of the stock market so that savings don’t nose dive right before retirement. Pension managers can always maintain a balanced portfolio with high average returns.
And lastly, pension plans pool longevity risk, meaning that they only have to save for the average life expectancy of a group of individuals. Individuals will feel pressure to save enough money to last at least several years beyond the average life expectancy. Therefore, it’s more costly for individuals to ensure against outliving their money.What happened To Pennsylvania’s pensions?
Defined benefit pension plans are not inherently problematic. Issues arise when legislators consistently fail to pay the state’s required contribution into the system, which is exactly what happened in in Pennsylvania. In the 1990’s, when the stock market was booming, Pennsylvania’s pension funds were performing beautifully. In 2000, the Teacher’s Retirement System was funded at an astounding 123 percent.
A few years later, the stock market crashed. At exactly the time when we should have been putting more money into the system to balance investment losses, legislators let the state and school districts slash their pension contributions for 10 years — creating the debt problems that we have today.Why Gov. Corbett’s remedies didn’t work
In 2012, Gov. Corbett proposed moving future workers into a 401(k)-style system. Independent actuaries who studied the plan (The Hay Group and Buck Consultants) estimated that such a transition would cost the state $42 billion in transition costs and fees — a figure that ultimately killed the proposal.
Later in 2013, Gov. Corbett and Rep. Mike Tobash proposed a “hybrid” system for new employees — a plan that combines elements of a DB and DC plan. This time, independent actuaries found that the plan saved few taxpayer dollars — and that the cuts in benefits were greater than the savings to the state.
When the General Assembly returns in January, they should realize that the problem is not the structure of Pennsylvania’s defined benefit pensions, nor overly generous benefits that average $25,000 per year. The issue is having the fiscal discipline to make the necessary payments into the system. If legislators do this, they can preserve retirement security for generations.