Public Employees Should Demand Defined Contribution Plans

Detroit public employees will have accruals under their current Defined Benefit plan frozen as of the end of the year and they are not happy about it though the younger employees should be ecstatic.

In 2008 the National Institute for Retirement Security (NIRS) released a report supporting Defined Benefit plans against the coming assault.  This month the TIAA-CREF Institute got around to disagreeing in their report but they missed the three main arguments against Defined Benefit plans in the public sector:

Costs of Bad Assumptions It’s simple trust fund math: money goes in, earns inflationary gains, and gets paid out.  Who pays in and who gets paid out are immaterial for this example.  The point is that if a system allows for artificially understating input then the expected output will not be there.  Public pension actuarial funding methodology (i.e. politicians getting actuaries to stooge for them) has developed into just such a system.

Costs of Administration: Defined Contribution plans call for putting in a pre-defined percentage of salary and getting out what happens to end up in that account.  That’s about all the calculating that needs to be done.   Defined Benefit Plans need to have benefits and contributions determined by hordes of administrators, both inside and outside of government, purportedly to make the plans equitable and understandable though that’s not how it has worked out in practice.

Costs of Repudiation: When the money inevitably runs out and promises need to be broken then lawyers step in to clean up all details….for a fee.

Under a Defined Contribution plan public employees may not get as much as they might have been told they would under a Defined Benefit plan but they will know enough not to expect what they can’t possibly get.  The costs of lying to them are beginning to pile up….for them.

18 responses to this post.

  1. Posted by Tough Love on October 21, 2013 at 12:44 am

    John, You omitted the biggest argument of all against Defined Benefit plans in the public sector … That they are ALWAYS unnecessarily too generous because:

    (a) By granting very generous pensions, the elected officials in return get Union campaign contributions and the block votes from the membership … irresistible to ANY politician
    (b) By using overly optimistic assumptions, it’s very easy for elected officials to say that promised pensions cost far less than they likely will. Supposedly (but incorrectly) that leaves funds available for the elected officials to spend on programs and service to keep them ingratiated with the voters,.
    (c) there is no downside to the elected officials’ over-promising. While politically benefiting TODAY, won’t be around when the bill comes due
    (d) Unlike Defined Contribution Plans, only Defined Benefit Plans are subject to material end-of-career pay (and hence pension) “spiking” … a rampant problem.
    (e) The basis nature of Public Sector DB Plans (with not only very rich formulas, but with VERY costly “provisions”) makes it much more difficult for Taxpayers understand (and hence complain about) just how much greater Public Sector pensions are than their own

    That being said, I agree with you that younger, shorter service workers are better off with DC than DB Plans. The DB charade will end badly, with (in some Plans) those already retired (and soon to retire) being paid their annuities via the contributions of the younger members, leaving little to nothing for them when it all blows up.

    Reply

  2. Posted by jackdean on October 21, 2013 at 7:10 am

    Another good one . . .

    Reply

  3. Posted by Signed, I follow your blog and similar more than my employer would be comfortable with on October 21, 2013 at 10:13 am

    I believe there are good and clear points on both sides of “the debate”. Whether we are defining the debate as “traditional versus financial economics”, “DB versus DC”, or “stoogies versus whistleblowers”, “the debate” seems to all be coming together as one. But I think both sides are in error. Why? Because they are viewing it as all or nothing.

    What we really need to do instead is revolutionize. Really take the time and think about both the strong aspects of both main types of plans and the potential and actual weaknesses of both. And from those points, develop a new answer. And not just one answer, because the second area in which I think the dialogue on “the debate” is failing is thinking there is a one size fits all answer. Instead, we should be seeking out the answer that is appropriate to the demographics, political and economic environments, and history of each public pension fund.

    Some of the strengths of the defined benefit plan include having a relatively consistent blend of ages and thus not being at as much risk as an individual’s life cycle, being able to achieve economies of scale in expenses, being able to achieve lower volatility for a given return level due to being able to divide between more investments, having more time/knowledge to spend on it, having access to more investments, and more. DB plans also are less fraught to the failures of individuals as rational actors that are appearing from the research in behavioral economics. And they are less reliant on the failing rational expectations hypothesis.

    You have made clear arguments for some of the weaknesses of DB plans, with the political environment being perhaps the most compelling as well as the need to meet HR goals with younger employees.

    So lets stop either burying our heads in the sand or universally attacking and instead dialogue and find a better solution for ALL of the stakeholders, including the taxpayers (present and future), most importantly.

    Reply

    • Good points but I am not arguing about the efficacy of Defined Benefit plans. They are ideal retirement vehicles but you need honest numbers behind them, something that the public sector environment (where the demand is for low contributions and high benefits and you have the actuarial profession acceding to all parties) does not allow.

      Reply

      • Posted by Signed, I follow your blog and similar more than my employer would be comfortable with on October 22, 2013 at 1:57 pm

        One particular area that I rant against (primarily in my own head) is the push for one type of pension reform that is labeled as “hybrid”, a combination DB/DC where they basically just take a basic (or the existing) DB plan and multiply it by half and then take a basic 401(k)-style DC plan and multiply it by half and say they are done.

        It actually reminds me of portfolio allocation in some ways. It doesn’t make sense to just look at each retirement vehicle in isolation, decide each have problems, and so put part of your money in each so that when you lose, you lose less. It makes sense to look at the characteristics of each, in the case of retirement vehicles, the specific types of risk and who bears them, and in the case of asset allocation, the variability and covariances of the options.

        Use the strengths and balances of each to combine to make a systematic retirement vehicle with intentionally retained risks.

        This half and half approach is frankly imbecilic to me.

        Reply

    • Posted by Tough Love on October 21, 2013 at 11:03 am

      Quoting … “Instead, we should be seeking out the answer that is appropriate to the demographics, political and economic environments, and history of each public pension fund. ”

      And importantly to add, one that is reasonably comparable in benefit level to that typically granted Private Sector Taxpayers in comparable occupations. I think this is the biggest impediment to the “rational” change you seek. With current Public Sector pensions SO MUCH greater (both via rich formulas and very costly provisions), the impact (and fear) of changes that materially address this unfairness is so unpalatable to the Unions, that they refuse to put ANY givebacks of material value on the table for discussion.

      Reply

      • Posted by Signed, I follow your blog and similar more than my employer would be comfortable with on October 22, 2013 at 1:52 pm

        Sometimes having a compensation analysis completed can help this process, both on the member side and on the taxpayer. While you can look at general studies looking at total compensation, getting specific information to a community is much more informative. That said, there’s definitely a range in quality on the product produced by these analyses.

        I’ve never really understand pension envy as an argument against pensions. I see it more as an argument for needing to find a better answer for single employers and their employees. So to my mind, the best way to address pension envy is with knowledge, education, and clear communication.

        Taxpayers typically can know the pay rates at different grades and steps, why not provide complete information including all aspects of compensation? And would also benefit employees looking at starting careers.

        Reply

  4. Posted by Javagold on October 22, 2013 at 8:40 pm

    public unions should be outlawed……start from there and then we can talk

    Reply

  5. Posted by Pat on October 23, 2013 at 12:15 am

    And how did the vitriol on public unions come into this? Was it the mention of pension envy? Maybe that envy extends to the unions, the only organizations who defend the otherwise powerless workers. It is no coincidence that the fall of the private unions is correlated with the elimination of good wages and benefits.

    Reply

  6. Posted by MJ on October 24, 2013 at 6:58 pm

    There is no pension envy @ Pat. Any reasonable person can deduce that the overly generous pensions and benefits cannot be sustained much longer. It is only a matter of time when the collapse happens–what it will look like is anyone’s guess. The government gives and the government takes away. Who will pay for the overly generous promises? I would define it more as short sighted lunacy. Publics should be demanding significant reform in order to secure some level of retirement. Nothing to envy about a sinking ship when one already knows the outcome.

    Reply

  7. Posted by Rick on October 24, 2013 at 7:09 pm

    In my state, the advent of the state retirement system, in virtually its current form, predated public unionization by about thirty years. I believe this to be a common occurrence, as public retirement systems were a product and consequence of the Progressive Era, while public unionization occurred largely in the ’60’s and ’70’s. They were partly a response to corruption in civil service as well as an attempt to foster employee longevity. When talking about how the DB mess is to be cleaned up, I think it is important to remember that the employees did not cause the mess, but rather the public administrators (read: politicians in both parties). Cleaning up the mess should not result in a mere cynical pension fund raid to compensate for political incompetence and corruption. The employees simply accepted a job with known benefits–as we all do. By the way, the causational narrative of politicians granting pensions in return for union largesse is mostly false. It is mostly false, firstly, because the chronology is wrong (as said) and secondly because there are not enough public sector employee/voters (16% of employment in the U.S., including all defense sector employment) and they don’t vote as a monolithic block. I agree that public unions should go away, but that is because they should not have the right to strike, and without that they are powerless and therefore without utility. Public unions are paper tigers.

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    • Posted by Tough Love on October 25, 2013 at 2:04 am

      Rick, While I I don’t know your State, and while Public Sector DB Plans did exist many years ago, the formula factors were lower, the peripheral provisions were much less encompassing, and the full (unreduced) retirement ages were lower. In addition to the less generous formulas and provisions, the older full retirement age, combined with a shorter life expectancy decades ago resulted in much shorter payout periods …. and hence much lower Plan costs.

      The Public Sector Unions, via campaign contribution and election support BRIBERY of our self-interested elected officials brought about the changes with made these DB pensions grossly excessive (by any reasonable measure) and unsustainable.

      And …. while the employees dd not “cause” this mess, clearly, they are the financial beneficiaries of these underhanded deals (with nobody look out for Taxpayer interests) so THAT’s where Taxpayers must go to remedy this situation… to reduce those promised pensions. A reneging of all Public Sector pensions of greater “value” (encompassing BOTH the richness of Plans formulas AND provisions) than those granted the typical Private Sector Taxpayer is a justifiable response from the Taxpayers.

      Reply

      • Posted by Tough Love on October 25, 2013 at 2:06 am

        Correction ….. The 1-st sentence above should have said …”and the full (unreduced) retirement ages were HIGHER”

        Reply

        • Posted by Rick on October 25, 2013 at 10:51 am

          Well,…that wasn’t the history in my state, anyway. All of the factors you mentioned were in place by the 1940s, at least for the state civil service, and the impression I had was that the smaller systems here were generally on the same developmental model and path. In any case, it seems like a subject ripe for research (which might already have been done) because a random sample of sufficient size drawn nationally would show an answer within reasonable levels of confidence. If these systems were shown to be largely in place with most variables, particularly the formula factors, as they are now, by the 1950s (which I believe to be the case)–the “causational narrative” I mentioned is significantly less believable.

          You are correct that campaign contributions frequently constitute bribery, and that includes sources (corporations, for instance) other than unions. On the union side, right-to-work legislation will accomplish the valuable service of emasculating the public unions. I just doubt the strength of the causal link you speak of. In my state, public unions existed only to take the dues from the employees and protect marginal employees. Not good stuff, but otherwise–they were weak and ignored.

          This is not irrelevant to the subject of the disposition of the pension funds. It is generally true that public systems should go from DB to DC (I’m not so sure about military and quasi-military, like police, forces–much could be said about that)–and that will go some way toward solving the problem, but the question of blame does enter politically. In Detroit in particular, while it is clear that, legally, pensioners are lumped in with the other unsecured creditors, it is far less clear why, ethically, that should be the case, when bondholders are told at purchase and repeatedly thereafter that they could legally lose all of their money and meanwhile employee/pensioners are and were told just the opposite for a full career and had history to look at as well. If Detroit results in a pattern of bondholders getting equal or lesser “haircuts” than the pensioners it starts to look like the kind of “taking” of property under the Constitutional meaning that rightfully motivates the anti-tax proponents.

          Reply

          • Posted by Rick on October 25, 2013 at 10:56 am

            Correction: I should have more accurately said “anti-tax protestors” rather than “anti-tax proponents.”

  8. Posted by Rick on October 24, 2013 at 10:43 pm

    The State of Michigan went to a defined contribution system about 15 years ago and is now, because of that, in much better shape than it was previously. The City of Detroit could have followed that example, and, consequently, has no excuse for its mismanagement. The employees and pensioners will lose out, but the pain could be lessened by sensible changes now. The unions did not cause this, but they are making things worse by trying to preserve the status quo while the crisis swirls around them.

    Reply

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