Unions for Underfunding

Claims of AFSCME aside, an underfunded pension plan benefits from closing it, not keeping it open

Nick Ciaramitaro of the American Federation of State, County and Municipal Employees union argued on a MIRS podcast that transitioning to a defined contribution plan would “cost a half billion” to “provide significantly less benefits” to employees. I guess he is proposing a paradox that the plan would both cost more and be less generous. He is mistaken. The proposed 401(k) plan would be more generous, but not trigger huge transition costs.

The 401(k) plan proposed last year was, on paper, more generous than the state’s plan. It would cost 10 percent if an employee maxed out contributions, with the employee putting in 3 percent and getting 7 percent from the employer. The current system for members costs 12.5 percent, with employees responsible for up to 8.4 percent and employers pitching in just 4.1 percent. So the 401(k) defined contribution plan costs slightly less, but employees receive more in employer contributions.

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Of course, if the state were good at estimating the costs of pension plans, they wouldn’t be underfunded by $29.1 billion.

There is an additional cost to employers for the increased generosity of a 401(k) plan. Last year, the state estimated it at $16 million for the first year of implementation. There would be savings to employees, however, of around $40 million.

But the extra employer contribution was not the cost Ciaramitaro was complaining about. The state’s pension fund managers have manipulated accounting rules to argue that offering new employees 401(k) benefits would trigger massive “transition costs” for the legacy plan. Yet the payments the state would make to shoulder these allegedly new costs would not make the legacy pension plan more expensive. Instead, they would simply bolster the health of the plan.

Nothing in the design of a 401(k) plan requires the state to make those payments for the transition costs. Lawmakers get to control how the state pays down the unfunded liabilities of the pension plan, regardless of when or whether they launch a 401(k) plan. Abstaining from the managers’ recommendation to make transition-cost payments would be as prudent as the current payment plan.

If lawmakers decide to put more cash into the retirement system, that’s great. Its debt increases at the state’s assumed rate of return of 7.5 percent, making it some of the highest-interest debt in the state, so decreasing the debt makes financial sense.

That’s why it seems odd that the union president is arguing against putting more money into the pension system. Doing so would secure more worker benefits and save money over the long term.

Ciaramitaro says that the state’s move to offer new employees 401(k)s, starting in 1997, caused underfunding of the legacy state employee retirement system. There were $0 in unfunded liabilities in 1997 and there are $5.8 billion of them now, he observes. Thus, closing the plan to new hires caused it to be underfunded.

But he is mistaken, and we can see that by comparing the closed pension plan for state employees to a pension plan that is still open. In 2004, Gov. Granholm and other policymakers put only 40 percent of the actuarially recommended amounts into the state employee plan. They put 71 percent of the recommended amount in the school retirement system. They repeated the pattern in 2007, when they put 48 percent of the recommended amount into the state plan but 91 percent in the school system.

So naturally you would expect the school plan to be better funded now. Even though the still-open plan for school employees received more cash than the closed plan for state employees, it is the latter plan that is in better shape today. So the key difference is whether the plan is closed or open. Closed is better.

When policymakers closed the state pension plan to new employees, they gave them a 401(k) plan. In raw numbers, that plan, which now covers the majority of state workers, cost state taxpayers $116 million in employer contributions in 2016. Meanwhile, the legacy pension plan cost $716 million, largely to pay down unfunded liabilities in the system. The costs of underfunding are the prime pension system costs, and they cannot be written off.

Ciaramitaro also says that the hybrid plan splits the risk between employees and employers. This is incorrect. The underfunding risk is exclusively borne by the employer, and thus the taxpayer. Employees do not share it.

He does make one agreeable point: “You don’t do something that specifically is known to not work.” Pension managers have promised benefits now and deferred costs to the future. The result is a broken system that has accidentally made school employees the state’s largest creditor. As Ciaramitaro’s actions demonstrate, unions have been poor watchdogs at ensuring that pensions are properly funded. Transitioning to a 401(k) plan is better and it’s good that lawmakers are interested in it.

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