Reuters Money

Alicia H. Munnell is the Director of the Center for Retirement Research at Boston College and the Peter F. Drucker Professor of Management Sciences at Boston College’s Carroll School of Management. The opinions expressed here are her own.

In the wake of the financial crisis, policymakers have been chattering about moving to defined contribution (DC) plans in the public sector. Defined contribution plans may well have a role in the public sector, but not as an alternative to defined benefit (DB) plans. Defined benefit plans should remain as a secure base for the typical public employee and defined contribution plans could be “stacked on top” of them to provide additional retirement income for those at the higher end of the pay scale.

Before the financial crisis, ten states had introduced some kind of comprehensive DC plan.  Many of these states provide stand-alone DC plans, either as a requirement (Alaska and Michigan) or an option. Two states (Oregon and Indiana), however, recognizing the value of offering some secure benefit, provide a combined DB/DC plan.

In the wake of the financial crisis, three states (Michigan’s public schools, Georgia, and Utah) have introduced such combined DB/DC plans, where new employees will get some of their retirement income from each type of plan. And an additional six states are discussing DC options.

Why the enthusiasm for DC plans?  Some arguments are wrong; others hold water. Starting with wrong: Some supporters highlight the magnitude of the unfunded liabilities in public sector DB plans as justification for switching to a DC. The reality is that even with a new DC plan, states and localities are still left to deal with past underfunding. A new plan only addresses pension costs going forward, it does not help close the current gap between pension assets and liabilities.

Similarly, some contend that switching to a DC plan would save money in the future. But for any given level of benefits, DC plans have higher investment and administrative expenses than DB plans. Some proponents think that even if total costs increased, taxpayers could gain by shifting contributions from the government to the employee.

Transferring the burden to the employee provided a major economic incentive in the private sector to move from DB plans, where employees make no contributions, to 401(k) plans, where employees make the bulk of the contributions. But such a gain is difficult to achieve in the public sector where employees already make substantial contributions to their DB pensions.

A more legitimate argument is that shifting to a DC plan would eliminate risk for sponsoring governments and, thereby, taxpayers. A DC plan avoids the “moral hazard” of not funding benefits promises, as the plans are fully funded by design. And when things go wrong in financial markets, the taxpayer is not on the hook for covering any shortfall.

The flip side is that public employees must face the risk of poor investment returns, the risk that they might outlive their assets, and the risk that inflation will erode the value of their income in retirement. Private sector workers who are dependent on 401(k)s have accumulated only modest amounts ($78,000 for the median worker approaching retirement before the financial crisis according to the Federal Reserve’s Survey of Consumer Finances) and many will not be able to maintain their standard of living once they stop working.

Thus, the choice of plan type comes down to a question of who should bear how much risk. A strong argument can be made that public employees with modest salaries should not be forced to decide how much to contribute, how to invest their contributions, how to change that investment risk over time, and how to withdraw money at retirement. On the other hand, it does not seem reasonable for the typical taxpayer, earning $50,000, to be forced to pay higher taxes when the stock market tanks to cover benefits for public employees at the high end of the scale, such as university presidents.

Therefore, the compromise in the public sector should be a mix of DB and DC plans, but not of the “hybrid” form adopted to date. Instead, DB plans should serve as the base in the public sector, so that, say, school teachers do not face 401(k)-type risks and are assured a secure basic retirement income that will last their lifetime.

It seems reasonable to cap the earnings covered by public sector defined benefit plans at the income of the average taxpayer in the state. The public employer could then provide a DC plan on top of the DB plan to provide added retirement income for the higher paid. Such an approach would ensure a more equitable sharing of risks and would also avoid headlines generated by the occasional inflated public pension benefit.