In many states costs to taxpayers to fund public employee retirements have been skyrocketing, forcing disruptive choices involving more taxation, more borrowing, more cuts to government services, or some combination. These increasing liabilities are complicated by the fact that in many instances the regulators controlling pension funds have overestimated the value of future investments and the rate of return they can expect from the investments held by the pension fund.
Most states still use “defined-benefit” system for state workers. These are more expensive and generous than those in the private sector; their liabilities are open-ended; and they limit public workers’ job flexibility. The private sector already has realized that defined-benefit pension plans are unsustainable, and as a result more than 80 percent already have switched to defined-contribution plans such as 401(k)s. Defined-contribution plans provide employees more control over their retirement funds and allow workers to change jobs without long vesting periods.
There are several reform paths states can follow to provide substantive retirement benefits to state workers while keeping costs and future liabilities under control. One option state legislators should consider is moving as many state employees as they can to a cash balance (CB) plan. Under a cash balance plan, employee retirement benefits are accrued in individual employee retirement accounts maintained by the state. These accounts grow as workers and their employers make annual contributions to the plan and as investment returns, which are commonly referred to as “interest credits,” are accumulated on those contributions.
Under the CB plan, an employee’s cash balance accounts are guaranteed a minimum annual investment return. Earnings that are higher than this guarantee can either be shared with employees or saved to balance out low-performing years. The accounts are pooled together and professionally managed by the retirement plan’s manager, keeping costs down. Once an employee retires, he or she receive a lifetime benefit based on the value in his or her account, which is paid out in a manner that’s similar to an annuity, with several options on how benefits are received.
Cash balance plans feature many of the benefits of traditional defined-benefit and defined-contribution plans. CB plans provide the guaranteed monthly retirement, income use of pooled investments, and access to annuities. Further, the portability of benefits, predictability of costs, and level of employee risk is more typical of defined contribution plans.
By setting a minimum investment return and sharing any additional earnings, CB plans help employers more easily plan for future costs, which protects state budgets during down periods while ensuring employees receive their benefits. CB plans also reduce the number of assumptions policymakers must make to accurately project costs, making the process more transparent and any liabilities more difficult to hide.
California, Kansas, Kentucky, Nebraska, and Texas all currently provide some public-sector employees with a cash balance plan as their primary retirement savings vehicle. While the Kansas and Kentucky plans are newer, the older state plans are all relatively well-funded, though not 100 percent funded. As of 2012, the Texas County and District Retirement System was 88 percent funded and the Texas Municipal Retirement System was 87 percent funded. The Nebraska state and county plans are 92 percent funded, and the California cash balance plan was, as of 2011, 105 percent funded. Each of these CB retirement plans are far better funded than the defined-benefit plans in most states.
One of the primary arguments against moving away from a defined-benefit system is that it allegedly eliminates the ability to draw and retain talent. However, according to a 2016 Manhattan Institute study by Josh B. McGee and Marcus A. Winters, a school system adopting a CB plan would only see a modest number of experienced mid-career teachers leave but a significant number of experienced late-career teachers would postpone retirement. The study’s authors conclude the actual effect of implementing a CB plan would be a slight increase in the school system’s total level of teacher experience and quality.
Like with all retirement plans, a cash balance system is not perfect; there is still some risk involved, and the transition away from a defined-benefit system may not be smooth. Many states have incorporated CB plans into a hybrid model that includes a defined-benefit model or limited enrollment for new employees. These are all options state lawmakers should consider when working to fix their costly pension plans.
The following documents examine cash balance plans in greater detail.
Better Pay, Fairer Pensions III — The Impact of Cash-Balance Pensions on Teacher Retention and Quality
In this Manhattan Institute study, Josh B. McGee and Marcus A. Winters examine cash balance (CB) plans for school system employees. They say their simulations suggest switching to a CB pension plan would be expected to slightly increase a school system’s total level of teacher experience, and thus slightly increase the school system’s total level of teacher quality.
Public Pension Cash Balance Plans: A Primer
In this Issue Brief published by The Pew Charitable Trusts, the authors argue a well-designed cash balance plan can help government employers meet their recruitment and retention goals while keeping costs down and improving long-term fiscal stability.
Hidden Debt, Hidden Deficits: 2017 Edition
Joshua D. Rauh of the Hoover Institution applies market valuation to pension liabilities for 649 state and local pension funds. Rauh finds that despite the introduction of new accounting standards, the vast majority of state and local governments continue to understate their pension costs and liabilities by relying on investment return assumptions of 7-8 percent per year.
Properly Funding a Defined-Benefit Plan Requires Solid Average Returns and Some Luck
Adam Millsap of the Mercatus Center discusses the problems created by overly optimistic investment-return assumptions and how they add risk to defined-benefit pension plans. “The risks associated with the variability in returns is another reason why many pension reform advocates recommend defined contribution plans rather than defined benefits plans. Defined contribution plans don’t promise a specific amount of benefits, which means they are not subject to the same underfunding risks as defined benefit plans,” wrote Millsap.
Public Pension Investments: Risky Chase for High Returns
Truong Bui writes in Budget & Tax News about a recent Pew report that shows there has been a systematic shift with many public pension plans. Over the past 30 years, an increasing number of public pensions have moved away from fixed-income investments and toward equities and alternative investments.
Keeping the Promise: State Solutions for Government Pension Reform
This report from the American Legislative Exchange Council describes the variety of pension plans governments use today and the advantages and disadvantages of each plan. It also provides several tools legislators can use to ensure governments can affordably fund retirement benefits for their employees.
The State Public Pension Crisis: A 50-State Report Card
The Heartland Institute examines problems facing public pension systems, including the enormous burdens they pose in some locations. The report ranks each state on the operation and disposition of its pension plans and suggests ways to solve states’ pension system problems.
Pension Funds Expected Rates of Return: Biggest Lie in Global Finance
The Illinois Policy Institute examines the high expected rates of return on pension investments used by state and local governments, arguing the high rates are misleading taxpayers into believing pension funds are more stable than they actually are.
Nothing in this Research & Commentary is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit the Budget & Tax News website, The Heartland Institute’s website, and PolicyBot, Heartland’s free online research database.
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