Cash Balance Pension Plan Could Hurt Public Employees and Taxpayers

Authors: 
Stephen Herzenberg
Publication Date: 
October 1, 2013

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Lawmakers Should Not Rush to Enact Poorly Understood Proposal

While the Pennsylvania Legislature did not enact the pension proposal introduced by Governor Corbett with his February 2013-14 budget, public-sector pensions remain a lively topic of debate in Harrisburg. One new option gaining attention is a so-called cash balance pension plan. This approach would eliminate for new public employees a guaranteed benefit tied to years of service. It would substitute an annual pension payment (or “annuity”) that depends, like a 401(k)-type defined contribution plan, on the level of contributions made by employer and employee, and on the rate of interest earned on those dollars.

This briefing paper provides basic information on how cash balance plans work and considers their implications for all who have a stake in Pennsylvania’s public pension system, including public employees, taxpayers, and the state and Pennsylvania schools as employers. (This briefing paper is not a comprehensive examination or critique of all aspects of Representative Grell’s pension plan, unveiled yesterday, but rather focuses on the least familiar part of that plan, the cash balance pension plan.)

The paper finds:

  • Cash balance plans could result in deep reductions in the pension benefits of future public employees. Actuarial studies of two cash balance proposals advanced by Representative Boyd in the 2011-12 legislative session (HB 1676 covering state employees and HB 1677 covered school employees) projected cuts in benefits averaging about 40%.
  • Representative Grell’s cash balance proposal, introduced yesterday, would provide better benefits but still cut benefits, by about 20% on average using the same range of career trajectories and assumptions made in the actuarial studies of the Boyd plan. Long-term career employees who retire from their government job would experience a higher level of benefit cuts, between about 35% and 60%. Employees who work in public jobs for 20 years and then take private jobs for 20 years would enjoy large increases in benefits.
  • In effect, some cash balance plans require new employees to pay for their own retirement benefits without any employer contributions. This was the case with the Boyd plan for state employees (HB 1676), which required employees to contribute 6.25% of their salaries to cover benefits that cost only 5%. In effect, this is a not very well disguised attempt to get new employees to pay for the state’s unfunded pension liability. It is not clear why new public employees have any responsibility for paying an unfunded pension liability they did nothing to create. Nor is it clear why they should forego (or virtually forego) any employer contribution to their pension so that employer contributions can all go to the unfunded liability.
  • Cash balance plans could erode the investment returns on pension plan assets below the current projected 7.5%, increasing the state’s unfunded liabilities. Pennsylvania’s pension funds may record lower investment returns if pension fund managers treat the minimum guarantee to workers as their rate-of-return target (rather than the current 7.5%), and invest in more conservative ways once the share of all pension fund members in the cash balance plan becomes substantial.
  • Since they reduce pensions most for long-term career employees, cash balance plans could make it more difficult for state agencies and public schools to retain experienced employees. Public employers may need to provide offsetting wage increases to retain mid-career workers, another potential cost for taxpayers.
  • While cash balance plans do require employees to share financial market risk with their employer (and hence with taxpayers), Pennsylvania’s pensions already include a shared risk feature because employees covered by Act 120 of 2010 can be required to make larger contributions if financial markets underperform. From the point of view of retirement security, the Act 120 approach is superior because it requires higher contributions while shared risk under cash balance plans translates into lower benefits.

Cash balance plans are also poorly understood by many policymakers and the public, and have not been subject to the scrutiny and discussion of defined contribution plans. Rather than rush to approve a radical pension overhaul without fully weighing the implications, we recommend that Pennsylvania build on the progress already made in a 2010 pension reform law (Act 120) in the following ways:

  • Explore the potential of bonds as a way for the state to buy down the current unfunded liability and potentially reduce the spike in pension contributions for school districts and the state.
  • Strengthen requirements for the state to make the contributions needed each year to maintain the pension funds on a gradual path to full funding.
  • Conduct an actuarial study of the Act 120 risk-sharing provisions to estimate how much higher Pennsylvania’s pension funding levels would be today if those provisions had been in place since 2000. This study could be the basis for considering whether a stronger risk-sharing provision.
  • Assess whether the State Employees’ Retirement System (SERS) and the Public School Employees’ Retirement System (PSERS) could save significant funds without lowering projected investment returns if they relied less on outside firms and relied more on their own professional staff to manage pension fund assets.
  • Increase state revenues available to meet all state needs and dedicate a small portion of these funds to pay down the unfunded liability. 

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