August 12, 2015
By: Josh B. McGee
Illinois has a massive pension debt problem. Government employers owe workers at least $130 billion—money that should have been set aside to pay benefits. The state’s defined-benefit pension plans allow politicians to make long-term promises to public workers while pushing the cost onto future workers and taxpayers. Making good on its promises to public employees will be one of the state’s largest challenges in the coming decade.
But Illinois should go beyond developing a responsible plan to pay. It should establish systems that promote retirement security while reducing the potential for mismanagement of pension funds to undermine public finances.
To that end, many, including Gov. Bruce Rauner, have suggested moving to defined-contribution plans similar to the 401(k) plans that predominate in the private sector. In a typical DC plan, workers are promised annual employer contributions to individual accounts. Such a move would simplify benefit promises greatly and eliminate the state’s ability to underfund benefits, though it would encounter opposition from organized labor, current public-retirement system managers and the cottage industry of consultants who rely on public defined-benefit plans for work.
Some DC plan critics have claimed that defined-benefit plans have inherent advantages, resulting in better benefits at a lower cost. In a paper for the Manhattan Institute, I investigate whether claims of DB cost-efficiency hold up to scrutiny and find that they are unsupported by the data, are driven by false assumptions and ignore pension debt as a significant cost driver for DB plans.
The efficiency strawman of defined-benefit plans is built on two erroneous assumptions: Such plans achieve better investment returns, and such plans offer lifetime income in the form of annuities while defined-contribution plans do not.
When I used the U.S. Department of Labor’s large data set on private-sector retirement plans to compare the two plan types’ investment performance, I found that differences were small and generally not statistically meaningful. The upshot is that historically bottom-performing defined-benefit plans outperformed bottom-performing DC plans; top-performing DC plans outperformed top-performing defined-benefit plans; and in between these extremes, there is no discernible difference.
As for lifetime income in retirement, while it is true that many private-sector DC plans do not offer annuities, this is not an inherent feature of DC plans. The limited availability of annuities in the private sector largely is the result of misguided federal regulation discouraging their provision. Nevertheless, a number of private-sector DC plans provide annuities. And most public-sector DC plans—which do not face these regulations—provide favorably priced annuities.
Even though U.S. public plans have been creditors to state and local governments for the vast majority of their existence, claims that DB plans are more cost-effective ignore the steep cost of pension debt and the negative consequences of underfunding. Nowhere is this more obvious than in Illinois, where the rising cost of pension debt has led policymakers to slash benefits for new teachers, firefighters and cops, and where the state’s largest city and school district face potential bankruptcy in large part due to growing pension debt.
Retirement policy can be complex, but getting the plan design right is pretty simple. Primary retirement plans should have well-designed investment and payout options with defaults that reasonably ensure retirement security for workers who do nothing. DC plans can incorporate all of these features. Many already do, especially those sponsored by public-sector employers (see, for example, the plans sponsored by Colorado, Michigan, Ohio, Washington and the federal government).
Most important, DC plans would eliminate the future accumulation of costly pension debt, paving the way for a far brighter, more stable financial future for Illinois.