Alleged ‘Transition Costs’ Avoidable In Detroit

Shouldn't be used as a roadblock to pension reform

State legislators are discussing which strings to attach to a $194 million partial Detroit bailout.

One of those strings — a requirement that the city close its pension systems to new members — is being met with opposition over alleged "transition costs" from the move. But these costs are completely optional and easily avoidable, as other governments that have reformed their pension systems show.

Transition costs allegedly are mandatory increased up-front cash requirements to catch up on underfunded pensions. Detroit does not have enough money saved in its pension system to pay for the benefits that members have earned. According to an esoteric rule by the Governmental Accounting Standards Board, governments should switch from a back loaded payment policy to a more front loaded policy, requiring more short-term cash but saving money over the long-term. "Thus, the claim goes," as Andrew Biggs of the American Enterprise Institute remarked, "[I]f you stop digging, the hole actually gets deeper."

However, GASB has clearly stated that it does not dictate funding policy, just accounting treatment. If officials believe that their payment policies are prudent, they can keep that policy.

Moreover, other governments have made pension reforms without making this accounting switch.

A 2012 paper from Robert Costrell of the University of Arkansas looked at how state governments avoided even changing their accounting policies. Utah's pension reform avoided this switch by giving employees the option of a defined contribution plan or a pension plan that shifts underfunding risk onto employees. They did shift their accounting treatment of existing unfunded liabilities. Alaska gave new employees of one of its retirement plans a defined contribution plan but still kept its back loaded payment accounting after making a one-year switch.

In both cases, these governments limited their ability to rack up unfunded liabilities while avoiding transition costs.

The important issue regarding pension funding is not how to catch up on the problems, but how to prevent them. By closing the pension system, Detroit will stop its policy of promising to provide a benefit and paying for it later.

If the city had set adequate money aside to pay for pensions, it would not be in bankruptcy asking retirees to make concessions.