Policy Documents

Defined Contribution vs. Defined Benefit Pensions

October 13, 2008

According to the Pew Center on the States, state government employee pension plans nationwide have racked up nearly $360 billion in unfunded pension liabilities. There is also an additional $370 billion in unfunded liabilities for other retirement benefits, including health care. While those numbers represent a huge problem, they don’t take into account the billions of dollars in underfunded county and city-level government pensions.

The underlying cause of the problem is “defined-benefit” pension plans, which guarantee employees a pre-set benefit amount upon retirement. At all levels of government, politicians and administrators have “guaranteed” overly generous benefits while pushing the costs onto future generations of taxpayers by failing to fully fund the pensions.

Some states are using stop-gap measures, such as increasing retirement ages or limiting benefits, but these don’t fix the fundamental problems created by defined-benefit pensions. Only by following the private sector’s lead and switching workers from a defined-benefit pension system to a defined-contribution system can states and localities eliminate the burden of future pension liabilities, avert the pension crisis, and make budgeting more predictable.

Consider this comparison of defined-benefit pension and defined-contribution retirement plans.

Defined-benefit pension plans ...

Create huge unfunded liabilities
Defined-benefit pension plans will continue to face an increasing strain as millions of baby-boomer employees retire over the next two decades. Due to budget deficits and other factors, states are increasingly lagging behind the 80 percent funding threshold widely accepted as being adequate. A 2008 Government Accountability Office study on the funding status of state and local pensions found, “58 percent of 65 large public pension plans were funded to that level in 2006, a decrease since 2000 when about 90 percent of plans were so funded.”

Threaten future taxpayers
Peter Orszag, head of the Congressional Budget Office, estimates that in the past 15 months, and most notably in the past few weeks, employee retirement accounts have lost $2 trillion in value. By law, the trillions lost in public pension obligations must be paid out ... and taxpayers will be forced to foot the bill.

Restrict worker freedom
Defined-benefit pension plans prevent workers from having job flexibility and control over their own retirement. With vesting periods often 10 years or longer, many government workers are being boxed into a corner, staying with jobs they don’t like or passing up better opportunities just to lock in pension benefits.

Defined-contribution retirement plans ...

Contain runaway costs
Defined-contribution retirement plans are fully funded up front, preventing pension obligations from sneaking up on future generations of taxpayers and allowing for more stability in budgeting. These plans are more transparent and sustainable for governments and taxpayers, because they are funded up front.

Create worker freedom and retirement fund portability
Defined-contribution retirement plans are particularly appealing to younger workers, as they allow workers to take their retirement funds from job to job. It is common today for workers to switch jobs numerous times over their lifetimes; with defined-contribution retirement plans, these workers can save towards their retirement earlier and with more job flexibility. The Reason Foundation study cited below found, “70 percent of [California] state and local government employees lose all employer contributions because they leave their jobs before satisfying the 10-year vesting requirement.”

Create investment choice
Employees have ownership of defined-contribution retirement plans and choice over their retirement investments. If employees do not want to risk their retirement funds on the stock market, they can invest in savings deposits, money markets, or government bonds. Defined-contribution retirement plans allows workers to tailor their investments according to their own risk-tolerance and investment strategies.

The following articles offer additional information on defined-benefit pension and defined-contribution retirement systems.

 

Plight of the Benefits
http://www.heartland.org/article.html?articleid=19030
This article from Governing magazine examines Colorado Governor Bill Ritter’s attempts to fix the states pension mess. It outlines how the problem is spreading and how the private sector has already moved away from defined-benefit pensions.

The Gathering Pension Storm: How Government Pension Plans Are Breaking the Bank and Strategies for Reform
http://www.reason.org/ps335.pdf
The Reason Foundation tackles the looming crisis created by states continuing to use defined-benefit pension plans. This paper offers solutions to the pension problem and an analysis of why the current system is a disaster in the making.

Defined Contribution Pension Plans in the Public Sector: A Best Practice Benchmark Analysis
http://www.tiaa-crefinstitute.org/research/articles/docs/DCPlansinPublicSectorCrane
HellerandYako.pdf

This white paper from the TIAA-CREF Institute “addresses [the] best practice benchmarks for the design of public sector primary (core) defined contribution pension plans. It includes an examination of the environmental conditions and factors affecting these plans as well as general principles for the design of effective defined contribution plans. Selected public sector core defined contribution plans are reviewed against identified best practices.”

Pension Time Bomb
http://www.washingtonpost.com/wp-dyn/content/article/2008/09/10/AR2008091002726.html
George Will describes how a California city had to file bankruptcy because of its under-funded and over-generous defined-benefit pension plan.

The Ticking Time Bomb in State Pensions
http://www.boston.com/news/globe/editorial_opinion/oped/articles/
2006/11/28/the_ticking_time_bomb_in_state_pensions/

This article outlines how challenging the problem of defined-benefit pension plans has been in the corporate world and how the crisis will play out in the public sector.

Public-Sector Pension Crisis Worsens
http://www.heartland.org/article.html?articleId=18549
This article published in Budget and Tax News offers a few examples of states and municipalities that are having to pay for their pension funding problems. The article describes why the problem is happening and what can be done legislatively to prevent a massive pension crisis.

Let Employees Control Future of Retirements
https://www.cato.org/pub_display.php?pub_id=6556
Jagadeesh Gokhale and Peter Van Doren of the Cato Institute analyze how the market is best-suited to relieve the fiscal pressures caused by state pension funds.

Pension Liabilities Loom as States Try to Help Retirees
http://www.usatoday.com/news/nation/2008-06-11-pensions_N.htm
This article published in USA Today offers a good synopsis of how widespread the pension problems are. It also offers a wide array of policies different states are trying as a way of easing the burden on their budgets.


For further information on the subject, visit the Budget & Tax Issue Suite on The Heartland Institute’s Web site at www.heartland.org.

Nothing in this message is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. If you have any questions about this issue or the Heartland Web site, you may contact Legislative Specialist John Nothdurft at 312/377-4000 or jnothdurft@heartland.org.