Opinion: Hidden cost of pension reform: Freezing benefits is complex issue

The current controversy over public employee retirement benefits has produced calls for freezing traditional pensions for government workers and replacing them with a 401(k)-style retirement plan. The argument for scrapping traditional pensions for public employees is that it would be less expensive for taxpayers.

A closer analysis released by CalPERS – “The Impact of Closing the Defined Benefit Plan at CalPERS” – reveals the issue is much more complex, with higher initial and long-term conversion costs that may not produce the expected savings and may, in fact, result in higher costs for taxpayers. This means taxpayers may end up paying more for less – higher costs for lower worker benefits.

If a pension plan is frozen, whether just for new workers or for current and new workers, the pension plan must still be maintained for at least another 60 years or more until all current workers, some in the 20s, pass away and are no longer receiving benefits to which they are entitled under law. As long as some workers are still covered by the current pension plan, the plan must be actively managed.

Therefore, if a government employer freezes the current pension plan for existing workers and starts a new 401(k)-style plan for new workers, taxpayers would have to pay for the cost of administering two retirement plans simultaneously for the foreseeable future. Administering two plans costs more than one.

Also, as a frozen pension plan ages, it will likely require higher employer contributions over time than an active plan because as active workers in the frozen plan retire, plan administrators will have to investment more conservatively to increase liquidity to ensure adequate cash to pay pension benefits. More conservative investments result in lower investment returns, which will have to be made up with higher employer contributions to maintain adequate pension plan funding.

There is also the issue of getting the best bang for the buck. Studies have shown that dollar for dollar, traditional pensions are more cost effective than deferred compensation plans because the administrative costs for pension plans are much lower than for 401(k)s.

From 1997 to 2004, the average annual cost of administering the CalPERS pension fund was 0.25 percent of assets. The annual administrative cost for a defined contribution plan is typically between 1 to 2 percent. Higher administrative costs result in lower benefits. Taxpayers and retirees would receive less bang for their retirement buck.

Some pension reform proposals call for all public employees to participate in Social Security. Currently about one-third of CalPERS members do not participate in Social Security. Nearly all public safety workers such as police officers, firefighters, and prison guards do not participate in Social Security. All public school teachers covered by the California State Teachers’ Retirement System and about half of local government employees do not participate in Social Security. If all these workers were required to join Social Security, their employers – the state, cities, counties, and school districts – would be required to pay an additional 6.2 percent Social Security tax that they currently do not pay.

When you add up all of these additional costs, freezing traditional pension plans and replacing them with a 401(k) type plan may not produce the desired savings and could easily cost taxpayers more well into the future.

The topic of pensions and retirement benefits is complex.  If done wrong, pension changes could result in higher costs to taxpayers while providing lower benefits to employees.  If done right, pension changes could result in a system that better meets the needs of both taxpayers and employees.  Policymakers should conduct a thorough analysis before embarking on any changes.

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