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DB vs. DC: Not as Easy as A – B - C

In a December 13, 2010 Wall Street Journal editorial, Minnesota Governor Tim Pawlenty stated, “. . . we need to end defined-benefit retirement plans for government employees.” Pawlenty isn’t alone: replacing public plans with defined contribution plans, which would follow an undeniable trend in the private sector, is being discussed in state legislatures around the country.

Defined Benefit vs. Defined Contribution: The basics

The desire to shift from defined benefit to defined contribution is understandable. Many public pension plans are severely underfunded, a condition worsened by the Great Recession. The resources necessary to stabilize these funds threatens the financial stability of their government sponsors. By contrast, defined contribution plans—think 401(k) plans—come with a more predictable cost and do not require larger employer contributions should the financial markets trend further downward. In other words, the risk of investment loss in a defined benefit plan is on the employer—in the public context, the taxpayer. In a defined contribution plan, the employee bears the risk.

Costs beyond retirement

Given the shift in risk allocation, it makes sense that public policy makers would consider such a switch. The transition in the private sector has led to more predictable and controllable costs. However, in the private sector, a company’s financial obligation to an employee ends when the employee retires. If the retiree runs out of retirement savings, he or she may not turn back to the employer.  As a result, individuals who did not save enough or did not invest well enough often turn to public assistance. Should a retiree run out of savings in the government sector, the taxpayer is not necessarily absolved of financial responsibility. If a public employee fails to save or invest well enough, they—like a private sector retiree—often will seek public assistance. The difference is when retirees who have not saved enough turn to public assistance, they are, by definition, going back to their employer—the taxpayer. This cost must be considered by policy makers as they decide to switch from defined benefit pension plans to defined contribution plans.

Retirement plans by the numbers

There are other costs to consider. Contrary to popular belief, the conclusion in a 2008 National Institute of Retirement Security (NIRS) study found it to be more cost effective to provide $1 to a defined benefit plan than to provide $1 to a defined contribution plan. In a related study, NIRS reported that the poverty level of seniors who do not have a defined benefit pension is significantly higher than those with defined benefit pensions. Other potential costs include the cost to pay down unfunded liabilities for legacy defined benefit plans for existing employees because a switch to a defined contribution plan would not necessarily end this liability. Finally, because defined contribution plans require a great deal of record keeping and data management, administration costs can be significantly higher. This difference requires a deep understanding of the administration business and oversight of third party administrators. 

Policy makers beware

Before deciding on a switch, government leaders should make sure all costs are factored into the design of new public employee retirement systems. Shifting the investment risk from government to public employees may be the right thing to do in light of financial shortfalls. In fact, employees have as much responsibility for their retirement as their employer does to compensate them fairly for the jobs they perform. However, policy makers should also consider the full long-term and short-term costs of a transition. Failure to do so will result in kicking the deficits can down the road to another generation of taxpayers.

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