A Tale of Two Pensions, and the Compromise that Wins the Day:

In Support of the Collective-Defined Contribution Pension System

Joshua Wilson April 26, 2014

UNIV 225 Professors Doces & Wolaver

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The Problem On July 18, 2013, the city of Detroit filed for a Chapter 9 bankruptcy as a result of its

inability to manage its estimated $18 billion debt. The bankruptcy filing was followed by

Governor Rick Snyder's appointment of Kevyn Orr as Detroit's "emergency manager," and the

city of Detroit threatened to make compensation cuts of 6% and 26% for the Police and Fire

Retirement System and the General Retirement System, respectively (Halcom 2014). In light of

these events, Detroit has become "ground-zero" for the public pension crisis sweeping the nation.

The Commonwealth of Pennsylvania alone, with its two pension plans for state workers (the

State Employees' Retirement System, or SERS) and for teachers (the Public School Employees'

Retirement System, or PSERS), has a combined pension debt of $47 billion (Benefield 2014),

not to mention the estimated national funding gap of $2.7 trillion (Mahler et al. 2014, p.1). In

order to prevent the aforementioned benefit cuts or future tax hikes, such as the $900 annual tax

increase for the average Pennsylvania household (Benefield 2014), cities and states must

challenge the status quo and pass meaningful public pension reform. The best way to do this, I

believe, is to adopt a collective-defined contribution pension system.

Why Public Pension Reform Matters and Moral Concerns

As with any public policy proposal, it is important to ask why lawmakers and average

citizens should be concerned about the retirement security for public employees. Indeed,

pensions were first offered to veterans of the Revolutionary War and have since become part of

our national history (Lahey and Anenson 2007). As government bureaucracy grew and became

more consolidated, public-sector unions began to bargain for pensions with guaranteed,

continuous benefit payments upon retirement, manifesting nationally in the Civil Service

Retirement System and later disseminating to the states (Bogaert 2012). These pensions were a

manifestation of the tacit agreement that public-sector workers would accept lower-than-market-

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competitive wages in exchange for a generous, guaranteed pension plan. The defined benefit

pension could be considered to be an incentive to become a policeman, teacher, or firefighter,

without which, these individuals might not take those types of jobs. In essence, for years, public

employees were promised defined benefit pension plans in exchange for providing services on

which the public depends. Considering the previously outlined status quo, it would be immoral to

renege on that promise by cutting benefits.

Pension reform also matters because of the effects that inaction would have on state

budgets. Pension benefit payments, in most states, are actually contractually and constitutionally

mandated (Reinke 2011, p.1700). While legislation governs the structure of benefit payments, it

is the case that spending on pension plans increases automatically as employees enter retirement

or new employees join the public sector workforce. Much like non-discretionary spending in the

federal budget on Social Security and Medicare, increased pension funding obligations can strain

and crowd out available tax revenue, limiting spending on important programs, such as

transportation/infrastructure, education, or social welfare. This threat impacts all citizens, not just

pension plan beneficiaries.

Connected to moral arguments is the concept of positive liberty. Stone cites Isaiah

Berlin's concept of positive liberty, defined partly as requiring positive help from others and

society to ensure basic resources (Stone 2012, p. 115). Pension plans manifest a relationship

between an employer and an employee. Employers promise contributions to a pension plan if

employees work productively, and indeed are encouraged to do so until retirement, because net

benefits will be higher after a lengthy career (ORS 2014, p.23, Ragnes 2001, p.43). A complete

switch to DC pension plans may sever or reduce this promissory relationship, from fiduciary to

facilitator, because an employer is only responsible for a fixed contribution, and the employer's

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responsibility towards the employee ends once the contribution has been made, whereas the

employee is much more dependent on the employer under DB plans (Johnson 2013).

The central issue surrounding the public pension crisis is rooted in the fundamental flaws

inherent in defined benefit pension systems, which constitute the majority of pensions for public

employees across the 50 states. However, the majority of pensions in the private sector are

defined contribution plans. Many legislators and think tanks across the nation have proposed

eliminating the defined benefit system entirely, in favor of a complete switch to a defined

contribution system. Before engaging in debate, it is important to clearly define the differences

between defined benefit plans and defined contribution plans.

Pension Terminology Defined

The Congressional Research Service (CRS) defines a defined benefit (DB) plan as a

pension plan that specifies the benefits or the method of determining benefits, but not the

contribution. Benefits can be broken down into a specified amount per moth or each year of

service payable at retirement, a stated percentage of compensation, or a stated percentage of

compensation for each year of service. Employer contributions to a DB plan are determined

actuarially on the basis of benefits expected to become payable. The company bears the risk of

investment performance and must compensate the plan for any shortfalls in funding. DB plans

are not portable if an employee leaves his/her employment position (Purcell and Staman, 2009,

p.61).

The CRS defines a defined contribution (DC) plan as a pension plan in which the

contributions are specified, but not the benefits. Examples include money purchase plans, profit-

sharing plans, and most commonly, 401(k) salary deferral plans. This plan provides an individual

account for each participant that accrues benefits based solely on the amount contributed to the

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account, for which the employee bears the investment risk. 401(k) plans are portable if an

employee leaves his/her current employment position (61).

Goals/Intentions of Public Pensions

The choice between a DB or DC pension system could be considered to be a reflection of

the political ideology of policymakers, or perhaps the decision is based on a set of ideal qualities,

goals, or outcomes of a pension plan. The Brown Center on Education Policy at the Brookings

Institute cites three main goals of the ideal public pension system (Mahler et al. 2014). The first

is to provide adequate retirement security (5), particularly for those who are predisposed to

consume their income rather than save it (i.e. those with a high marginal propensity to consume).

The second is to ensure fiscal sustainability of pension funds/asset portfolios (9). The third is to

maintain or improve public-sector workforce productivity, meaning that pension systems should

be designed so as to encourage recent or mid-career employees to continue working (i.e. "pull

incentives"), and also encourage high-earning employees to retire (i.e. "push incentives").

Issues with DB Plans

In relation to the aforementioned goals of an ideal pension system, the Brown Center

argued that DB systems provided adequate retirement security, since generous pension benefits

are meant to be guaranteed to retirees, depending on their lifetime salary and length of tenure,

but they fail to ensure fiscal sustainability (9), since the time lag nature of DB plans allow plan

sponsors to underfund in the present and pass costs onto future generations1.

Part of this issue concerns the concept of moral hazard. Charles Wheelan defines moral

hazard as "a situation in which an individual/firm is protected against some kind of loss and,

therefore, acts with less caution than it otherwise would, thereby making a bad outcome more

likely" (2011, p. 558). In the case of public pensions, Maria O'Brien Hylton writes that

lawmakers spend taxpayer dollars to enhance benefits and decrease contributions during flush

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economic times in exchange for votes (2012, p.415). With the current electoral cycle of 2-4

years, it is in the interest of lawmakers to increase the benefits of their constituents or their voter

base in order to get reelected. In this scenario, the short-term goal of re-election trumps the long-

term necessity of pension plan solvency. DB pension plans, by their very nature, breed moral

hazard. If an employer views contributions to a pension plan as a future obligation, they may be

more likely to put off or underfund these obligations in favor of more pressing matters. To put it

simply, an employer may not fund their employees' pensions as well as they would fund their

own pensions, all else equal, hence the moral hazard.

Moral hazard in and of itself is difficult to measure without qualitative data, since

pension plan managers would not openly admit that they acted without caution, thereby making

public pensions worse off. However, the Upjohn Institute for Employment Research ran a

univariate regression analysis and found that there is a statistically significant effect, dubbed the

"union effect2," whereby higher union membership percentages and higher percentage of

employees covered by collective bargaining were associated with more risk-taking behavior and

lower credit ratings, as is evident in Figures 1 and 2, respectively (Mohan and Zhang 2012). One

can easily connect the dots between the union effect and the pension plan health of states with

high public employee unionization, such as California, Illinois, Pennsylvania, Michigan, and

New Jersey, as reported by the Bureau of Labor Statistics (BLS.gov 2014).

Both the Department of Labor and the BLS report that costs for DB plans are higher than

DC plans. This means that employers are spending more per employee hour worked for DB

plans than they would be spending on DC plans for equitable benefits (BLS.gov 2012).

Furthermore, DB plans require a great deal of administrative costs (as a percentage of payroll)

than do DB plans. In 1996, administrative costs rose to 1.66% of payroll from 0.32% in 1981

(DOL.gov 1997).

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One might also argue that there is an inherent government failure resulting from DB

plans, because public employees lack perfect information in terms of when their employers are

making pension contributions, how much they are, and how they are being invested. One of the

benefits of DC plans is that employer contribution are perfectly transparent, and employees can

make appropriate investment adjustments in response to market fluctuations. Those under DB

plans, however, are not at liberty to obtain information or have any influence regarding pension

asset investment, so they are unable to take retirement security into their own hands, as those

with DC plans are.

Issues with DC Plans

Defined contribution plans, conversely, do not provide adequate/guaranteed retirement

security, since 401(k) plans are highly susceptible to volatility in the market (Mahler et al. 204,

p.16). One study found that most people in their early 60s had only $60,000 in 401(k) savings

(Farmer 2013).

Furthermore, individuals with more financial and investment sophistication are more

likely to end up with higher retirement benefits under DC plans because they have a better

understanding of how much they should be contributing and how to best invest it. Whereas the

investment risk rested with the employer in DB plans, DC plans transfer the risk onto employees.

Research from the Center for Retirement Research at Boston College indicates that private

employees do not make the most rational choices, resulting in the market failure of diminished

retirement savings. Indeed, more than 90% of participants in DC plans don't contribute the

maximum amount as indicated by law and 40% don't diversify their 401(k) investments, perhaps

because of a lack of perfect information. Around 40% of individuals cash out of their plans when

they change jobs, and many don't contribute enough money to receive a company's matching

contribution, resulting in 401(k) balances that perform far below their potential (Munnell 2012).

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Pennsylvania's Deputy State Treasurer for fiscal operations Keith Welks stated that he didn't

necessarily believe that giving public workers more choice (vis-à-vis DC plans) was the right

thing to do, since many will withdraw retirement funds early, leaving them unprepared for actual

retirement (Farmer 2013). If given the opportunity, public employees will most likely behave

similarly to private employees in this regard.

The Solution: The Collective-Defined Contribution (CDC) Pension System

In the pursuit of ensuring retirement security for all public employees while maintaining

fiscal sustainability and preventing tax increases or benefit cuts, the Center for American

Progress introduced the Secure, Accessible, Flexible, and Efficient (SAFE) Retirement Plan.

Based on pension reform in the Netherlands, the collective-defined contribution (CDC) pension

system is a hybrid between DB and DC plans (Davis & Madland 2013). As analyzed by

Brookings's Brown Center (Mahler et al. 2014), the SAFE plan combines the best features of the

defined benefit and defined contribution systems. Similar to DC plans, employees receive

individual, portable, retirement savings account, but unlike DC plans, all accounts are managed

collectively by a professional, meaning that the pension sponsor chooses how assets are invested,

and how/when investment returns are divided among plan members (19). One benefit of the

professional management of accounts is that it reduces administrative costs, relative to DB plans.

Rather than having to spend time and resources assessing the performance of DB plans and

calculating expected benefits based on an algorithm of the number of years worked and salary

upon retirement, the CDC plan manager need only concentrate on the collective pool of

investments, since contributions are defined.

Similar to the Social Security payroll tax, members of the CDC plan would contribute

12% of their pay into collective fund, where an employee would contribute 9% and the employer

would contribute the other 3%. These percentages are based off of the standard recommendation

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of industry professionals. Once a plan participant retires, funds equal to their accumulated

account balance would be transferred into a separate annuity fund, which would include a 2%

annual cost-of-living adjustment, or COLA (Davis & Madland 2013, p.16).

The CDC plan capitalizes on risk pooling by spreading out and diversifying investment

portfolios over different stocks and bonds; specifically 65% in stocks and 35% in bonds (Davis

& Madland 2013, p.15). If a particular investment decreases in value, no one individual plan

participant would bear the full brunt of the loss, whereas taxpayers would have to make higher

contributions to DB plans, or an individual would bear the full loss in DC plan in the same

scenario.

It also accounts for market risk by pooling risk across time (Mahler et al. 2014, p.20),

protecting retirees from market volatility. During periods of robust economic growth, individual

accounts might not necessarily reflect the entirety of market gains, but the fruits of these gains

would be saved separately and credited to accounts in particularly lean economics times, or when

major assets are performing poorly (20). Essentially, a CDC plan capitalizes on risk pooling to

lessen the risk borne by individuals without increasing the risk borne by employers. Mahler et al.

indicate on Figure 3 that, as a result of market risk pooling, lower administrative costs and

professional management, the SAFE retirement plan guarantees a higher rate of retirement

replacement for the 95th percentile, which is higher than the 34% threshold for adequate saving,

and higher than rates associated with real-world 401(k)s3 and perfect/ideal 401(k)s4.

The Center for American Progress makes the compelling argument that the SAFE

Retirement Plan would have protected workers retiring during the Great Recession (see Figure

4). They claim that workers retiring with a SAFE CDC plan would have seen their replacement

rates fall by only 2.5% if they were assumed to receive no bonuses after 2012, compared to

workers retiring between 2007 and 2008 with real-world and perfect 401(k) plans These plan

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participants would've seen their retirement checks devalued by 9.3% and 28%, respectively

(Davis and Madland, 2013, p.24). If CDC plans could have borne such a blow with relative ease,

then imagine how much stronger the post-recession recovery could have been. Seniors could

have increased their consumption, fueling an increase in both tax revenue and income for firms,

allowing them to invest more, not to mention a potential increase in the money multiplier. This,

of course, is all hypothetical.

In terms of impacts on the labor force, CDC plans use vesting in order to retain valuable

and productive employees. The portability of the CDC plan increases the incentive for

employees to leave as compared to DB plans, but a vesting threshold of five years might cause

these workers to stay at their jobs long enough so as to cut down on turnover costs like

recruiting, training, and assimilating new employees (23). For the reasons stated above, CDC

plans provide adequate retirement security, ensure fiscal sustainability, and they maintain public

sector workforce productivity (25).

Criticisms

One might still ask questions about what would happen to an employee under a CDC

plan who decided to leave the public-sector for the private sector, since the SAFE plan only

facilitates highly-mobile employees within the public sector, not without it. If an employee

decides to leave the public sector all together, does the withdrawal of personal assets from the

pooled pension funds threaten the health of the CDC plan?

One objection that conservative critics of the CDC plan might offer is that it potentially

reintroduces the moral hazard issue that is eliminated by switching to a traditional DC plan. By

imparting the management of the pool of public employees' 401(k)s to an investment

professional, there is a potential for a plan sponsor to engage in "Socially Responsible" Investing

(SRI), which has been proven to cause portfolios to perform poorly, as compared to assets that

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are not invested in this way. In 2005, for example, SRI funds lost 2% of their value, while all

equity funds gained 0.3%, according to Jon Entine (2005, p. 2).

In a broader sense, the collective nature of CDC plans still insert government authority

into public employee's retirement planning. Conservative critics would say that this disrupts the

potential equality of retirement security between the public sector and the private sector, given

that the majority of private pensions are DC plans. According to the Employee Benefit Research

Institute, as of 2011, 69% of all private-sector wage and salary workers participate in solely DC

plans, whereas only 7% of these workers participated in DB plans (2011).

Private-sector workers and taxpayers might ask, "Why should their [public employees']

retirement be any different than ours [private employees']?" In this instance, the government

essentially withdraws an employee's right to decide whether or not he/she want to max out

his/her 401(k) contributions, and employees have no say in asset investments. While this is a

valid objection, I would refer critics to back to the studies cited earlier, indicating that the

average American, left to his/her own devices, behaves in ways that lead to the

underperformance of his/her 401(k) plan (Farmer 2013, Munnell 2012).

Furthermore, one might ask if it is simply enough to enroll only new public employees in

CDC plans, leaving existing DB plans untouched. Many state constitutions mandate that these

DB benefits be paid, but critics might argue that existing DB plan participants with limited

tenure may want to jump on the CDC bandwagon, instead of being ignored by this reform.

Potentially, plan sponsors could devise a dual-pension system, where the first is based on their

accrued DB rights as of the date the employee elected to make the transition from DB to CDC,

and the second would be based on final DC accumulations, as managed by the investment

professional (Fore 2001).

Conclusion

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It is unfortunate that the only real world application of this policy reform from which data

can be collected is the Netherlands. This should not detract from this policy's viability. Since the

vast majority of pensions in the US are DC plans, it is only logical that policy makers would

narrow the menu of policy alternatives to the status quo (i.e. nothing) or a complete switch from

DB plans to DC plans. Yet given the failed attempt in Pennsylvania in June 2013 to switch all

new state employees away from DB into DC plans, it would be wise to purse a more moderate

path. The SAFE Act is essentially a win-win situation: public-sector unions and state employees

maintain the sense guaranteed retirement security to which they have become accustomed, and

taxpayers and budget hawks ensure the fiscal sustainability associated with DB plans.

Legislative inaction [failure] leads to benefit cuts and tax increases, and a complete

overhaul to DC plans has been politically popular. Perhaps if one state such as Pennsylvania,

California, or Illinois (the states with the worst unfunded pension obligations) adopted a CDC

plan for all new public employees, then such success might boost morale nationally, causing a

spillover effect, and resulting in the end of the pension crisis.

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Notes

1. "In assessing the risk and return characteristics of future pension liabilities, a subtle issue is the extent to which future benefit accruals are offset by lower future base wages, since total compensation should always equal the marginal product of labor in a spot labor market. To the extent that the offset between benefits and base wages is incomplete, or total compensation is correlated with stock returns and benefits are a stable share of compensation, future liabilities will be sensitive to future base wages and the correlation between long-term wages and asset returns" (Lucas and Zeldes 2009, p.528). Also see Novy-Marx and Rauh 2008.

2. The "union effect" refers to the phenomenon in which fund managers pursue riskier investment allocation in order to provide larger retirement benefits for unionized public employees. Demand for more wages and benefits occurs at the expense of less funding. Investment policy shifts to cover the increased benefit expense. In California, the only requirement in terms of investment was "a degree of care expected of a prudent person, who is knowledgeable in investments" (Mohan and Zhang 2012, p.2, 10)

3. "Real-world" 401(k) plans are characteristic of a typical DC pension plan (Mahler et al. 2014, p.21). These reflect typical mistakes that individuals make, such as not maxing-out contributions, withdrawing retirement funds early, or making risky investments.

4. "Perfect" 401(k) plans are those that represent the best possible management of funds with very low fees (Mahler et al. 2014, p.21). Individuals with this plan have made all the correct choices, in terms of getting into the plan early, making continuous contributions, using a disciplined target-date fund for investments, and keeping all the funds in the plan with no early cash outs or loans (Davis et al. 2013 2013, p.18)

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Figures

Figure 1:

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Figure 2:

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Figure 3: Distribution Retirement Replacement Rates

Source: Davis, R. & Madland, D. (2013, August) American Retirement Savings Could Be Much Better, Center for American Progress. Figure 4:

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