Economic Development

Defined Confusion

Cutting pensions saves states money, right? Maybe eventually.
by | December 2007
 

Rhode Island Governor Don Carcieri received some discouraging financial news recently. Carcieri would like to change his state's pension system for new employees. His hope, naturally, is to save money. But like other policy makers, he is finding that such a switch could prove costly, at least in the short run.

A study commissioned by Carcieri's office found that moving state workers toward a 401(k)-style retirement system would cost the state $151.5 million the first year and $520 million over seven years. After that, the state should start seeing some savings and begin to get out from under its heavy pension liability load.

Pension plans traditionally have offered workers a guaranteed amount of money, based on a formula that took into account their earnings and sometimes inflation, from retirement until death. Most private companies have moved away from such "defined-benefit" plans toward the 401(k)-style "defined-contribution" model, which offers no benefits after the worker has spent down whatever dollars she and her employer have put into her account. State governments, with their widespread reputation for secure lifetime benefits, have been slow to go along, but are starting to do so.

Three states--Alaska, Michigan and West Virginia--now require new workers to enroll in a defined-contribution plan. Such plans are available as an option in six other states. They are all relatively new and untested. Anna Fairclough, an Alaska state representative, says she worried for a time that her state's new pension system could lead to problems with worker retention. "We're on the cutting edge," she says. "I hope we're not on the bleeding edge." So far, though, Fairclough says that while wage competitiveness presents an obstacle for the state in attracting new workers, the altered retirement package does not.

Certainly, workers are not likely to find a better retirement package from most private-sector employers than from governments. Even under a defined-contribution plan, states are likely to offer a percentage of employees' income that is higher than most private companies are willing to provide.

Agreeing to this higher percentage is one reason 401(k) plans can be expensive for states. First, they face the short-term cost of having to make up dollars that new workers would have paid into their existing systems under the old defined-benefit plans.

And in the past, states could sometimes skip their payments into the pension funds when financial investments were doing well enough to cover the costs. The new system doesn't allow that. Since it's the contribution that is defined, cash payments must be made. For this reason, the teachers' union in Rhode Island estimates that the move to defined contributions would cost the state hundreds of millions of dollars, not just over seven years but perhaps over as many as 30. Carcieri's budget office questions those figures.

Missing payments are sometimes the main reason pension funds fall short. But the reality is that as more government workers reach retirement age--and fewer private-sector workers can count on fixed pensions--there will be enormous political pressure for states to switch to defined contributions.

Such switches may be financially smart in the long run, as Carcieri insists. But states looking to make this particular move will have to overcome not only the objections invariably raised by public-sector unions but the reality that there will be some significant financial downsides in the early years.

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