As of Sept. 30, 2010,
the defined-benefit pension plan in the Michigan Public School Employees’
Retirement System had an unfunded liability of $17.6 billion. This unfunded
liability and the large annual payments necessary to fund it suggest the plan’s
liabilities should be contained by closing the plan to new entrants, much as
the defined-benefit pension plan in the Michigan State Employees’ Retirement
System was closed in 1997. Future public school employees would be offered
participation in a 401(k)-style defined-contribution plan.
A concern repeatedly
raised about closing the MPSERS plan, however, is the so-called “transition
costs” involved. This paper discusses these “transition costs,” their validity
and ways to minimize or eliminate them if they are considered barriers to the
important and necessary reform of closing the MPSERS defined-benefit plan.
The Senate Fiscal
Agency, the House Fiscal Agency and the Office of Retirement Services have each
published estimates of the “transition costs” involved in closing the MPSERS
defined-benefit plan. The two material items discussed in the papers are
changes in the “normal cost” and the “amortization costs.”
Normal cost refers to
the annual cost of paying for employee pension benefits earned during that
particular year. According to the SFA, HFA and ORS analyses, these costs would
increase if the defined-benefit plan were closed and new entrants were placed
in a defined-contribution plan similar to MSERS’. This conclusion is questionable.
The stated normal cost for the MPSERS defined-benefit plan has almost certainly
been understated by a debatable assumption of 7 percent to 8 percent
annual pension asset growth. The failure of this assumption is clear from the
plan’s asset growth over the past 14 years and the plan’s large and growing
Even assuming the
normal costs are as currently stated, the transition cost could be eliminated
by simply tailoring a MPSERS defined-contribution plan differently than the
MSERS defined-contribution plan. This same MPSERS normal cost structure could
be maintained in a defined-contribution plan simply by requiring school
districts and other MPSERS employers to contribute approximately 71 cents for
each dollar of employee contributions up to 5.38 percent
of employee salary — a total employee and employer contribution similar to that
of the MSERS defined-contribution plan in fiscal 2010.
The larger “transition
cost” discussed in the three papers is the immediate increase purportedly required
in the size of MPSERS’ “amortization payments,” which are deposits made
annually by MPSERS employers to pay down the defined-benefit plan’s unfunded
liabilities. These amortization payments ensure the pension plan can meet its
future pension obligations.
The rules of the Governmental Accounting
Standards Board are frequently interpreted to mean that if the MPSERS
defined-benefit plan were closed to new entrants, the MPSERS amortization
payment schedule would need to change to a “level-dollar” treatment that would
calculate larger upfront amortization payments than those projected if the plan
were to remain open. The expected increase is large in the first year — the
Office of Retirement Services places it at $360 million — but would decline
over the next seven years and ultimately produce lower projected payments than
under MPSERS current “level-percentage” amortization schedule. In fact, if all
went as expected, there would be a projected net savings in total amortization
payments over time.
Three things should be noted about this immediate
“transition cost.” First, GASB rules govern how MPSERS and other government
entities report their expenditures; the rules do not
tell policymakers what expenditures they should make, as GASB itself has
confirmed. Thus, even if the state were to adopt a level-dollar amortization
payment schedule in reporting on a closed MPSERS plan, it would make increased
immediate payments only if it chose to.
Second, the phrase “transition cost” is misleading.
MPSERS’ cost is the underlying pension liability, which would not change; the
cost is not the amortization payments used to meet that liability. Hence, even
if MPSERS employers paid more at first, the plan’s cost would not increase any
more than a large first payment on a mortgage would affect the value of a home.
Third, the emphasis on normal and amortization
“transition costs” ignores a considerable additional cost: the potential that
unfunded liabilities in the MPSERS plan will become even more burdensome. In
fiscal 2010 (excluding the cost of an early retirement incentive), the unfunded
liability in the MPSERS defined-benefit plan increased by $4.3 billion — nearly
a tenth of the annual state budget. Since fiscal 2000, the unfunded liabilities
of the plan have increased by 6,500 percent, and the state has failed to
make GASB’s “required” annual payments eight times.
If policymakers nevertheless perceive “transition
costs” for amortization payments as a problem, they have alternatives. Five are
provided in the study, listed from most comprehensive to most limited.
First, since MPSERS pension liabilities must be met
under the Michigan Constitution, policymakers could scale back MPSERS’
extensive retiree medical care coverage, which is not protected under the
Michigan Constitution, and which cost MPSERS employers $795 million in
fiscal 2011. The retiree medical reduction need not be $360 million, given
that the “transition cost” would decrease in subsequent years, and given that
the Legislature could tap $133 million already slated for MPSERS reform.
Second, policymakers should consider making the most
of MPSERS reform. If there are upfront “transition costs,” the Legislature
could maximize the benefit of incurring those costs by not just closing MPSERS,
but also freezing it — that is, providing current defined-benefit plan members
with a defined-contribution plan in lieu of their current plan, so that they
would earn no additional benefits under the defined-benefit plan. This step
would considerably decrease the potential future unfunded liabilities of the
MPSERS pension plan. In addition, GASB appears to provide flexibility in
choosing an accounting treatment for the amortization payments on a closed and
frozen plan, making it even easier for the state to adopt a payment schedule that
minimizes immediate costs.
The state’s third-best course is simply to pay the
“transition costs.” MPSERS’ unfunded liabilities have built up over years, and
they must be made good at some point. Making larger amortization payments
sooner rather than later will not only ensure that retirement assets are
available as employees retire, but reduce the projected total burden of
amortization payments on taxpayers as well.
Policymakers have additional alternatives, however.
Legislators have frequently failed to make the “required” amortization payments
under GASB schedules, and they could continue this “business as usual” with a
closed plan by reporting under a level-dollar schedule, but making
Alternatively, legislators could also choose to spread
the amortization payments across the entire MPSERS payroll, including the
payroll not just of members of the defined-benefit plan, but of the new
defined-contribution plan as well — something the state is already doing with
MSERS. The state could then maintain a level-percentage accounting treatment
Each of these five approaches to amortization payments would
make it easier for policymakers to honor their constitutional obligation to pay
MPSERS pension benefits.