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There is a story that an engineer determined that, based on the size of the bumblebee’s wings, the insect should not be able to fly. The bumblebee flew anyway. In the same way, actuaries working for the Kentucky Teachers Retirement System claim that Gov. Matt Bevin’s plan to switch newly hired public employees to 401(k)-type retirement accounts would cost billions more than simply keeping them in their traditional “defined benefit” pension plan. This conclusion flies in the face of a worldwide movement toward 401(k)s that was designed to reduce costs. And it has.
Kentucky, like states around the country, faces dramatically rising pension costs. The government’s required contribution to the Kentucky Employees Retirement System (ERS) rose from 4.8 percent of employee wages in 2001 to 31.2 percent of pay in 2016. The Teacher’s Retirement System (TRS) has seen similar cost increases. Gov. Bevin’s proposal would shift newly hired employees to 401(k)-type accounts, to which the government would contribute up to 6 percent of employees’ pay. Current employees would remain in their traditional pension plans but would receive reduced cost of living adjustments and other cost-saving changes.
However, actuaries for the Kentucky Teachers Retirement System, the firm Cavanaugh-McDonald, claim that the traditional pensions would need to shift to safer, lower-returning investments once new hires were switched to 401(k)-type plans. The logic of the actuaries’ argument is fairly simple. Just as a worker with a 401(k) shifts from stocks to bonds as he nears retirement, so a traditional pension will wish to hold a more conservative portfolio as its participants grow older. Closing a traditional pension plan to new hires speeds this aging process because there are no young new participants entering the plan.
The Teachers Retirement System actuaries claim that once the plan was closed to new hires, it must immediately shift from a riskier portfolio with an expected return of 7.5 percent to a safer portfolio returning only 6 percent. To make up for these lower investment returns, contributions for the TRS would need to rise by $4.4 billion over the next two decades before savings started to kick in.
It’s a compelling argument at first glance. But there are three problems. First, the Kentucky retirement plans don’t currently adjust the risk of their investments to the age of the participants. From 2001 through 2016, the average age of ERS participants increased by about 5 years. Yet over that same period, the ERS went from holding 55 percent of its portfolio in risky assets to 69 percent. The teachers plan went from 56 percent risky assets in 2001 to 73 percent in 2016. It’s strange to insist on changes now.
Second, the actuarial study overstates how quickly the reformed Kentucky pensions would need to adjust their investments. A 2011 analysis by the California Public Employees Retirement System concluded that a pension plan with only retirees should hold an investment portfolio of 60 percent bonds and 40 percent stocks. Using the investment returns that the TRS assumes for different asset types, such a portfolio would return about 6 percent per year. So far, so good.
However, because public employees hired up through 2017 would remain in the traditional pension plans, it would take 30 years or more before these plans consisted only of retirees. In the meantime, the ERS and TRS could remain invested in riskier, but higher-returning, assets.
The third reason is perhaps the most compelling: Around the world, corporations and governments have closed defined benefit pensions and shifted employees to 401(k)-type retirement accounts, as a way to reduce costs and financial risk. Even the federal government did this in the mid-1980s, shifting new hires to a smaller traditional pension and a 401(k)-like account. Like the bumblebee who was told he could not fly, these employers would be surprised to hear that they actually increased their costs by moving from traditional pensions to 401(k)s.
If the TRS actuarial study were correct, no defined benefit plan would ever be closed. In reality, practically every private sector defined benefit is being closed. The reason is that the Kentucky actuaries’ analysis is wrong. There are pros and cons to closing even an underfunded and expensive traditional pension plan, and policymakers should debate them. But the claim that closing a pension plan increases costs is false.
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