3. Political Incentives

Defined-benefit plans, by definition, permit retroactive increases in benefits, with the necessary funding often being deferred. For example, legislators may increase the benefit formula “multiplier” (the fraction of a worker’s salary) used to determine the pension benefit payments, or they may provide additional, ad hoc cost-of-living adjustments to the post-retirement annual pension payments. In the MSERS defined-benefit plan, the comprehensive annual financial report indicates that the following changes were made to the plan’s post-retirement cost-of-living adjustments:

One-time upward adjustments have been made in 1972, 1974, 1976, 1977 and 1987. Beginning in 1983, some benefit recipients share in a distribution of a portion of investment income earned in excess of 8% annually (supplemental payment). Beginning in 1988, all benefit recipients are eligible for automatic 3% annual (non-compounded) benefit increases, with a maximum $300 annual increase.[*]

In many cases, the cost of these benefits will be borne by taxpayers years after the officeholders who approved the increase have left office. Some of these taxpayers may have been too young to vote at the time the benefit increase was approved. Moreover, there are inherent political pressures to maintain or increase benefit levels, even when they are extremely expensive. Similar pressures exist to underfund these plans. Properly funding the plans requires immediate spending whose benefits will not be realized for years. It may also mean contributing more money, perhaps in a tight budget year, by reprioritizing spending, cutting other programs or reducing pension benefits prospectively — options that are often unappealing to legislators, especially when they are seeking re-election. In effect, properly funding these plans carries a low political rate-of-return.

In contrast, any improvements legislators make to the benefits of a defined-contribution plan, such as a larger employer match for any employee contribution, must, by their nature, be paid for in the same year they are made. Defined-contribution plans cannot be legally underfunded, as many defined-benefit plans are. Such factors reduce the uncertainty for taxpayers and the political pressure for unsustainable improvements in benefits. While this category of savings is the most subjective (no estimate is offered here), reducing politics in pension plans may be the most significant category of savings realized by switching employees from defined-benefit to defined-contribution plans.

[*] “Michigan State Employees’ Retirement System: Comprehensive Annual Financial Report for the Fiscal Year Ended Sept. 30, 2010,” (Michigan Office of Retirement Services, 2010), 77, http://www.michigan.gov/documents/ orsstatedb/SERS_2010_Published_1-10-11_342741_7.pdf (accessed March 17, 2011). According to the comprehensive annual financial report, a member’s eligibility for these benefits depended on the date of retirement: “Retired before October 1, 1987[:] Greater of supplemental payment or the combination of the 1987 one-time adjustment and the automatic increases. Retired on or after October 1, 1987[:] Automatic increases only.” Ibid., 77.