Defined benefit (DB) pensions are having a moment. Following IBM’s
IBM
It shouldn’t come as a surprise that employers are reconsidering pensions. The U.S. now is fully four decades into the 401(k) experiment, and it is abundantly clear that these plans just can’t do the retirement job alone. Most middle-class Americans are unable to accumulate enough savings to be self-sufficient in retirement without a pension.
In fact, a recent report revealed the dismal level of retirement savings for Generation X, a generation that is quickly approaching retirement and the first generation to mostly enter the workforce following the shift from pensions to 401(k)s and other DC plans. For Gen Xers, the bottom half of earners have only a few thousand dollars saved for retirement, and the typical household has only $40,000 in retirement savings. These low savings levels are highly alarming, but not surprising.
Meanwhile in the public sector, there is growing evidence that closing pension plans has had a multitude of negative consequences: higher costs for employers and taxpayers, greater negative cash flow for plans, more employee turnover, and less retirement security for employees. A new report examines in great detail the experiences in five states that moved away from pensions and the unexpected consequences that resulted.
In Michigan, Taxpayer Costs Balloon After Closing the Pension
One state included in the report is Michigan. In 1997, policymakers closed the State Employees’ Retirement System (SERS) plan. That plan was on strong financial footing, overfunded with 109 percent of assets on hand to pay future costs. After the pension was closed, funding took a turn for the worse. That’s because the state was still obligated to pay retirement benefits to employees in the closed pension, but the plan was starved of needed future contributions. Over the past 26 years, the funding ratio of the Michigan SERS plan plummeted to 69 percent, while total retirement costs for taxpayers ballooned by a whopping 780 percent. There are several factors contributing to this decline in funded status, with the combination of higher negative cash flow and down markets presenting serious challenges to closed plans.
Figure 4 from No Quick Fix: Closing a Public Pension Plan Leads to Unexpected Challenges
Because the Michigan State Employees’ plan has been closed for so long, the plan is now paying a higher share of its plan assets as benefit payments. This makes it harder for the plan to recover from a market downturn, since fewer assets were held until markets rebounded. A bit of good news is that Michigan SERS achieved investment returns that surpassed the average of all state plans in the Public Plans Database. But the plan realized more losses when selling assets at a discount to make benefit payments from 2008 through 2013.
Despite claims at the time that closing the pension would reduce retirement costs for the state and taxpayers, retirement costs have risen 780 percent. The plan’s actuary is required to calculate whether or not the state has saved money from closing the defined benefit plan and switching to the defined contribution plan. For years, the actuary has reported that not only has the state not saved money from switching to the DC plan, the switch has actually cost the state and taxpayers more money. In 2021 alone, the state saw an additional $46.6 million in costs.
There were claims that moving away from pensions would produce better results in terms of retention and financial costs. But there is no evidence of these benefits in Michigan, even 26 years after the pension plan was closed.
Alaska Faces High Worker Attrition After Abandoning Its Pension
The state of Alaska followed Michigan’s path about a decade later. But Alaska went a step further: it closed both its plans for public employees and teachers. Over the past 17 years, this fateful decision has resulted in serious workforce challenges in a state that already faced difficulties hiring public employees due largely to its geography.
Alaska naturally faces workforce hurdles by virtue of its geography. While it is a large state, it is sparsely populated, especially out of the few larger cities. This means teachers, state troopers, and other employees in remote towns and villages may spend months there with little access to the resources in metropolitan areas. The state is also far from the Lower 48 states, which means it’s asking a lot for someone from the lower 48 to come and work in Alaska.
Figure 9 from No Quick Fix: Closing a Public Pension Plan Leads to Unexpected Challenges
It’s clear from the available data that employee retention has collapsed in Alaska since the switch from pensions to the DC plans. Turnover in the early years of employment is much higher among Alaska public workers, especially for teachers. Comparing 2005 data (before the DB plan was closed) with 2021 data (when new hires are in the DC plan), there were 18 percent fewer teachers in Alaska with five to 14 years of experience in 2021 as compared to 2005. The plan’s actuary calculates the projected quit rate for newly hired teachers based on actuarial experience. The actuary’s analysis found that while the rates for the DB and DC plans are more similar in the first five years when workers are figuring out if they want to continue as teachers, the quit rate soars in the DC plan after the first five years, which coincidentally is the vesting period for the DC plan.
This data can be used to forecast the number of years of service the state would expect to receive from its active employees. For a group of 100 female teachers vesting in their plan at age 30, the plan would expect 38 of those in the DB plan to still be teaching 25 years later, but only 11 of those would remain under the DC plan. The numbers are even worse for male teachers. The report adds up the cumulative difference to project service between the two plans:
● 100 Male teachers: 104% more service projected in DB plan.
● 100 Female teachers: 64% more service projected in DB plan.
● 100 Male Peace Officers: 67% more service projected in DB plan.
● 100 Female Peace Officers: 74% more service projected in DB plan.
Figure 11 from No Quick Fix: Closing a Public Pension Plan Leads to Unexpected Challenges
The data make it crystal clear that switching from the pension to the DC plan has failed to serve Alaska from a workforce management perspective. It has been suggested that Alaska now is a training ground where professionals can start their careers and then move on after learning the job. Not only does this make staffing expensive and difficult, but it also impacts the quality of services. Alaska can do better for its citizens.
Kentucky’s Financial Commitment Shows, Turnover is Challenging
Kentucky did not follow Michigan and Alaska’s path and switch to a DC plan, but it did establish a cash balance plan for new hires in the five plans under the Kentucky Public Pensions Authority (KPPA). There have been serious funding concerns about the plans in Kentucky due to a long history of underfunding by the state legislature. Fortunately, the commonwealth seems to have finally turned a corner, making a commitment to fully funding the plans going forward. This has substantially improved cash flow trends in the plans that were facing liquidity concerns.
While the financial improvements are a true accomplishment for Kentucky, the state has experienced workforce challenges since the switch away from the pension to the cash balance plan. The employee termination rates through the first five years are quite high, especially for the two Kentucky Employee Retirement System plans, the Hazardous plan most of all. In recent years, half of new hires leave the KERS Hazardous plan within 16 months, and only 17 percent of new hires in that plan reach five years of service. There is more happening in Kentucky to impact workforce problems than just the switch to the cash balance plan. But the data certainly fails to prove that workers today want alternative benefit designs, as was claimed. It’s noteworthy that the incumbent governor ran a successful re-election in part on a pledge to go back to a DB plan for three of the five plans under KPPA.
Figure 24 from No Quick Fix: Closing a Public Pension Plan Leads to Unexpected Challenges
In the end, there are a few key takeaways from these state experiences. First, tracking changes in turnover needs to be a deliberate decision if a DB plan is closed, as DC plans do not need to track that data. Also, the off-ramp of closing a pension plan adds financial risk to plan sponsors and taxpayers who still must pay for accrued benefits, and it takes many decades to end the relationship between a pension and its last beneficiary. Finally, there are many examples of well-run DB plans that have made plan modifications and can serve as an alternative to a radical and costly shift away from a pension.
We Could Be on the Cusp of a Pension Revival
The governor of Kentucky is not alone in calling for a return to a DB pension plan. Serious consideration is being given in both the public and private sectors to restoring DB pension plans.
In the private sector, a JP Morgan Asset Management analysis found that recent legislation and economic conditions have created a favorable environment for corporate pension plans. A well-funded and well-managed defined benefit pension plan can be financially efficient for plan sponsors and can even contribute value to the corporate balance sheet. And employers searching to differentiate themselves in a competitive labor market have identified defined benefit plans as a means to do so. IBM may well be the trend setter.
On the public side, the years of rising costs and funding decline in states like Michigan and Alaska have made it apparent that switching from pensions to DC plans did not save money. And in a tight labor market, public employers are at a disadvantage without the magnetic effect of pensions. The result is worker shortages and high employee turnover rates.
There are plenty of signals that we may look back years from now and remember 2023 as the beginning of a pension renaissance. Time will tell if more employers have put pensions on their list of New Year’s resolutions.