Defined contributions are an essential part of pension reform

Published 8:23 am Thursday, October 19, 2017

By Bob Martin

Opponents to pension reform argue transition to defined contributions programs increase the unfunded liabilities problem because the existing system relies on the money from new hires to keep going; that is, the current program is a pay as you go program, even though it was not designed to be one.

If the inflow from new hire pension contributions stops, unfunded liabilities increase, making the problem worse. Since the program is underfunded, any reduction in the flow of funds into the program will increase unfunded liabilities; hence, reform must have a plan for the long-term funding of the existing plan.

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On the other hand, suppose new hires are signed on to the existing program. Since there are more retirees than new hires, every new hire signed on to the defined benefits program adds more to long-term liabilities than the retirement fund can support.  Unfunded pension liabilities must grow. Further, part of current retirees’ retirement is funded directly from new hire’s contributions. The money used to support current retirees is not invested in the fund to provide support for the new hires’ eventual retirement. Is this something the new hires would agree to? Doesn’t this pass the “hot potato” to new hires?   

This is the same management theory that led to the original pension crisis. If the government places too much value on short-term solutions and ignores the long-term consequences, its actions will inevitably lead to an unanticipated accumulation of liabilities. For instance, when the state chose not to pay its obligations to the pension fund and to spend that money for other programs, it was placing a high value on short-term gratification and a low value on the future cost of a pension crisis.

Politicians prefer policies that provide short-term relief, even if the long-term consequences are quite substantial. If there is a pension fund managed by the state, the government has an incentive to mismanage the fund until the long-term consequences assert themselves.

If the defined benefit system is managed going forward as it was in the past, every new hire will generate the same or higher unfunded liabilities in the future.  Each new hire added to the existing defined benefits pension system simultaneously adds new funding to the pension fund and long-term unfunded pension liabilities to the system, even if they are not recognized at the time.

Opponents also argue transitioning to a direct contributions system raises the cost of the existing pension fund because it shortens the “duration” of the existing fund. It is argued a fund with beneficiaries who are of mixed ages can make investments that take a long time to mature, while a fund whose beneficiaries are all retired or about to retire can only make short-term investments. It is further argued that high-return investments take a longer time to mature, so funds full of retired beneficiaries cannot earn high returns. There are several problems with this argument.

First, return on investment is directly related to risk: the higher the return, the higher the risk. A portfolio of investments with high returns always looks impressive on paper. However, if you adjust all the investments for the risk inherent in each type of investment, you may find that the average return is less than the rate on comparable CD’s. This high-risk strategy clearly has not worked in the past, since part of the current problem is low returns on the funds.

Second, academic studies reveal realized rates of return on managed stock portfolios rarely exceed the rate of return on a highly diversified stock index fund. This reflects the fact that capital markets are efficient. There is no money just waiting to be picked up on Wall Street.

Another factor to consider is the relative risk associated with the two types of pension programs. In a defined benefits program, the risk is: can the employer honor its obligations? The current unfunded pension liabilities crisis demonstrates they may not be able to. In a defined contribution 401(k) program, the risk is the investment portfolio you choose may not do well enough to provide for your retirement.

Managing a 401(k) seems like a daunting task, but it is not and you will have a lot of help. Choose a few highly diversified no-load investment funds (index funds, SPDRs, or ETFs), hold those investments and ignore the ups/downs in the market, invest steadily, choose a small proportion of bonds when you are young and a larger proportion of bonds as you near retirement.  Above all else, do not panic and sell when the market crashes like it did in 2009. Hold on to your index funds and ETFs. The market will recover, as it did after 2009.

If the state does not make the change to defined contribution (DC) retirement plans, it will bear more risk in state finances. That risk threatens all its public services. The bond market will include that risk in the evaluation of state debt. The cost of borrowing will be higher if the state keeps the defined benefits (DB) pension system. The ship needs to be righted and the excess ballast should be shed.     

Bob Martin is Emeritus Boles Professor of Economics at Centre College.