States moving to DC pension saw higher taxpayer costs, less retirement security: report

A new report looking at four U.S. states that moved new employees from defined benefit to defined contribution or cash balance pension plans found the changes resulted in higher taxpayer costs and no meaningful improvements to the plans’ funding and liabilities.

The report, by the National Institute on Retirement Security, looked at Alaska, Kentucky, Michigan and West Virginia — four states that have closed their DB pensions and introduced alternative plan designs — to determine the impact of the changes. It found the move to DC or cash balance plans also reduced employees’ retirement security.

Read: A look at DC pension trends in the U.S.

“The data make it clear that closing a pension plan to new employees increases taxpayer cost and doesn’t close any funding shortfalls,” said Dan Doonan, NIRS’ executive director and a co-author of the report, in a press release. “What’s important to understand is that switching away from pensions starves the plan of employee contributions while the liabilities remain. This can reduce the economic efficiencies of a pension system as the number of retirees grows compared to the number of employees paying in. Ultimately, taxpayers are left with the bill.”

Alaska, for example, closed its two statewide DB pensions for teachers and public employees in 2005, moving new employees into a DC plan the following year in order to reduce the state’s combined US$4.1 billion unfunded liability in the plans. However, the report said, the state proceeded to underpay the actuarially determined employer contribution for both plans going forward and handicapped its own ability to manage the unfunded liability by stopping new employees from paying into the system.

It later made a one-time US$3-billion payment to the closed pension plans in 2014. Still, the unfunded liability was larger in 2017, at US$6.3 billion, than in 2005.

Read: DB pensions best option for Canadian employers, economy: report

“In the years since closing its pension plans, Alaska has been on a roller-coaster. It has experienced a yo-yo effect of underpaying and then dramatically overpaying its [actuarially determined employer contribution],” noted the report. “For all the money the state has spent, it finds itself in a worse financial position than it was 13 years ago.”

As well, the report found the balance of active and retired employees in the two DB plans has shifted since they closed, which — along with the plans’ shorter investment time horizon and negative cash flow due to spending down assets — will force both plans to adopt more conservative investments or assume more risk. “More conservative investments mean a lower assumed rate of return on plan assets, which typically increases costs,” it said.

Employees in Alaska’s DC plans were also more likely to experience greater financial insecurity in retirement than those in the DB plans. Because Alaskan teachers and public employees don’t participate in social security and must rely entirely on their pensions for a retirement income, this is a particularly problematic outcome,
the report noted,

Read: How plan sponsors can blend DB features into their DC pension plans

In the DB plan, public employees’ average annual pension benefit was US$21,398 and their average account balance was US$50,660. “There is a lot this number does not tell us,” the report noted, such as whether a small group of high earners are distorting the average balance number and how the average sum was related to members’ ages. “For example, $50,000 at age 25 would be a great start toward saving for retirement, but at age 60, that amount would provide only a small amount of lifetime income.”

The researchers also calculated that, for a teacher in Alaska who began teaching at age 25 and retired at age 60, the DC plan would yield a pay replacement ratio of 39 per cent of final pay, compared to 76 per cent of final pay for a teacher in the DB plan.

“For teachers with shorter careers or for education support professionals, who typically earn lower salaries than teachers, their projected pay replacement ratios are even lower,” the report said.

Closing the DB plans made it more difficult for the state to recruit and retain teachers, state troopers and other public employees, it added.

Read: How the CMHC closed its DC pension and returned to a DB plan