Dealing With ‘Transition Costs’

Closing the Michigan Public School Employees’ Retirement System to new employees would prevent state legislators from passing retirement system costs on to future taxpayers through unfunded liabilities and questionable tinkering with abstract funding assumptions. There are also ways a defined-contribution reform can minimize or even eliminate the transition costs discussed above.

These dynamic approaches to transition costs appear immediately below. Nevertheless, three observations should be made to put the entire “transitions costs” argument into context, since “high transition cost” is not as definitive an objection as it sounds.

First, using the flat (or relatively “frontloaded”) level-dollar method for paying down unfunded liabilities is (at best) a guideline of the Governmental Accounting Standards Board, not of the Michigan Constitution.[*] The Michigan Legislature is free to amortize its unfunded liabilities as it sees fit, as long as it (or the various state employers) first makes sure to prefinance retirement benefits — that is, to pay the normal cost.[†]

Indeed, GASB rules address how to account for financial problems, not how to solve them. The rules are not meant to guide policy, nor are they meant to allow governments to play games with payment schedules. In fact, the board has emphasized that its rules should not be “about acceptable public policy with regard to an employer’s contributions to a pension plan.”35

Thus, while GASB’s methods of calculating an annual required contribution have been widely adopted by state and local governments, and they will continue to be used in the state’s financial reporting, there are no requirements that they guide funding policy. Indeed, as discussed later, Michigan has frequently chosen to make payments that diverge from them. This history makes the rigid insistence that funding be driven by a different GASB accounting treatment for a closed pension plan seem artificial. GASB’s rules for reporting financial activity should not be a barrier to implementing a defined-contribution policy that would ensure that retirement benefits for future members are affordable, predictable and current.  

Second, in an important sense, the phrase “transition costs” is misleading when applied to the amortization payments on the unfunded liability. If MPSERS pension system is closed, the frontloaded amortization payments recommended under GASB guidelines in order to catch up on unfunded pension liabilities do not represent increased total expenses, only increased immediate cash outlays. The larger upfront deposits are similar to making early payments on a mortgage. The payments do not change the underlying value of the home (though it would lower the total cash payments on the mortgage).

Third, the “transition costs” objection to changing MPSERS to a defined-contribution plan rests on the assumption that the normal cost and the amortization payments on the unfunded liability provide a proper accounting of the costs involved — an incorrect assumption that will be analyzed later in this paper.

[*]  Regarding GASB requirements for paying unfunded liabilities for a closed defined-benefit plan, see the discussion at “2) Freeze and Close: Maximize the Results.”

[†]  The Michigan Constitution states, “Financial benefits arising on account of service rendered in each fiscal year shall be funded during that year and such funding shall not be used for financing unfunded accrued liabilities.” “Michigan Constitution of 1963,” 1963), (accessed Jan. 23, 2012).