Take note, Illinois: Transition costs not an issue in Pennsylvania’s pension reform

Pennsylvania’s reform efforts mirror the national trend of modernizing public and private retirement systems with 401(k)-style defined-contribution plans.

States across the country are modernizing their retirement systems by moving to defined-contribution plans for public employees. These plans are better for state budgets and employees alike.

Michigan was the trailblazer for 401(k)-style pension reform. In 1997, Michigan froze its state employees’ defined-benefit pension plan and created a self-managed, 401(k)-style retirement plan for new state employees. Alaska followed suit in 2005. And Oklahoma in 2014.

Pennsylvania is considering a similar move. But opponents of pension reform are attempting to block the efforts, arguing there are special costs that make it prohibitively expensive to freeze a defined-benefit pension system and move to a defined-contribution plan. These “transition costs” are a frequently debated topic in the pension sphere.

Andrew Biggs, a renowned expert in retirement policy and resident scholar at the American Enterprise Institute, very clearly laid out a case explaining why transition costs are not an issue in Pennsylvania’s reform efforts in testimony before the Pennsylvania House State Government Committee on March 24.

There are two common transition-cost arguments made by opponents of pension reform. The first is referred to as “accelerated amortization,” which is the idea that if a defined-benefit pension plan is frozen, the state must pay down the remaining unfunded liability faster than it otherwise would had it not frozen the plan. The second argument is that once a defined-benefit plan is closed, the plan must shift to using a less risky investment portfolio.

The short and simple response to both of the above points is this: neither argument is an issue in Pennsylvania’s reform efforts.

Of course, the complete response is a little more complex. Here are a few important points Biggs outlined in his testimony.:

Accelerated amortization is not a requirement:

• The accounting standards set by the Governmental Accounting Standards Board are simply for disclosure purposes. They are not funding guidelines. States that freeze their defined-benefit plan can determine how they pay down their remaining unfunded liability.

• Freezing a defined-benefit system and moving to a defined-contribution plan will not magically make all the existing unfunded pension liabilities go away. Nor will it make the old unfunded liabilities bigger. The frozen defined-benefit liabilities effectively become debt the state must pay down according to a repayment schedule determined by the state.

Argument on changes to investment portfolio doesn’t hold:

• Pension funds can fund their near-term liabilities using less risky investments than their longer-term liabilities. This practice is often referred to as “asset-liability matching.” A closed plan no longer accumulates long-term liabilities, so over time the stock share of its portfolio declines, as does the expected return on its investment portfolio. But this cannot increase liabilities, precisely because it is the reduction in liabilities that causes the change in the investment portfolio. Simply put, eliminating liabilities cannot increase liabilities.

• Some actuarial firms suggest that states should move to less risky investments after closing a defined-benefit pension system while others recommend that states should continue using the same investment practices they were using prior to the freeze. Regardless, this decision rests with the state.

• If a state does choose to move to a less risky investment portfolio, it’s a good thing for the state. Less risk leads to more stable contributions over the long run.

Biggs concluded his testimony with the simple point that if transition costs were prohibitively expensive, the massive, worldwide transition from defined-benefit to defined-contribution pensions would not have taken place.

Pennsylvania’s reform efforts mirror the national trend of modernizing public and private retirement systems with 401(k)-style defined-contribution plans. It’s imperative that Illinois – a state home to the nation’s worst pension crisis – follows the lead of other states and adopts 401(k)-style pension reform. Without it, the state’s budget and the retirement security of public employees will remain at risk.