What America Can Learn from Washington State About Public Pensions
RCEd Commentary
State and local government pensions are reported to be underfunded by at least $1 trillion. With pension funds struggling to meet retirement funding obligations, there is a prospect of employees facing benefits cuts, current education spending being diverted to cover past promises, or taxpayers being asked for more revenue. Not surprisingly, reforming public retirement systems has recently emerged as a hot-button issue as policymakers consider options to prevent this type of situation from arising again in the future.
A second source of interest in reform stems from speculation that the type of pension plan predominant in the public sector, defined benefit (DB) plans, may be less desirable to today’s increasingly mobile workforce. DB plans pay an employee a monthly annuity in retirement (typically) based on his or her level of compensation and years of experience. The annuity is paid out of an investment fund managed by the plan provider and supported by contributions from the employer and/or employees. While DB plans isolate employees from investment risk, they tend to provide relatively little value to employees who do not stay with one employer for long periods.
Proposed reforms have tended to call for moving away from DB plans and toward defined contribution (DC) plans (such as 401(k)’s), where employers and/or employees contribute to an individual investment account and the employee’s retirement wealth depends on contribution levels and investment performance. A fundamental difference under DC plans, and a reason they are attractive to reformers, is that the employer’s pension-related financial liability ends with its present-term contributions to its’ employees individual accounts. Hence, the types of large unfunded liabilities that currently burden many states would be prevented from occurring in the future.
A concern with this type of reform is that it would shift the future risk associated with investment returns earned on pension assets from taxpayers to employees, potentially making teachers’ retirements less secure, a point raised in critiques of pension reform. But is it possible that reform could be beneficial to both states and their employees? This is precisely what we conclude from several studies of the teacher pension system in Washington State.
Washington is one of a handful of states that now has a hybrid pension system, part DB, and part DC. The shift from a traditional DB system occurred in 1996 when the state, motivated in part by a survey of employees and employers that suggested both saw benefits to the shift to a hybrid plan with a DB component half as generous as the prior DB-only system, and a new DC component allowing employees to select different contribution rates and asset investment options.
Teachers employed in Washington during the shift were given the opportunity to stay in the traditional DB system or opt into the hybrid plan. Newly hired teachers were mandated into the new plan between 1997 and 2006, but new hires were again able to choose between the old and new plans since 2007. We studied this shift of systems to assess three questions: 1) What types of teachers prefer each plan? 2) How does savings per teacher compare under the hybrid and traditional DB system? 3) What can we infer about the retirement security of those enrolled in the hybrid plan relative to those enrolled in the traditional DB system? The answers to these questions were surprising (details about these studies can be found HERE).
First, a clear majority of teachers who were given the choice over which system to enroll preferred the hybrid plan: about 75 percent of teachers who were initially in the traditional DB system switched to the hybrid plan in 1997, and when choice was reintroduced in 2007, about 60 percent enrolled in the hybrid plan. There are relatively few differences in the types of employees who choose one system over the other, but, if anything, those teachers opting into the hybrid system tend to be slightly more effective in improving the academic performance of students (based on a value-added measure of teacher performance – a statistical estimate of a teacher’s contribution to student achievement as measured by performance on standardized tests).
Second, many teachers in the hybrid plan elect to contribute more than the state requires into their DC accounts. As a consequence, when we compare the amount of money that is set aside for teacher retirement in each year under the hybrid and DB systems, it turns out that more money tends to be set aside for teacher retirement under the hybrid plan.
The fact that the system as a whole sets aside more under the hybrid plan does not necessarily mean that it provides greater retirement security since the benefits provided in retirement will depend in part on investment returns. This means that answering our third question about retirement security of each system is not straightforward. But, in calculating potential retirement wealth accumulations under the two systems, we find that under reasonable assumptions about investment returns on DC assets, Washington’s hybrid plan is likely to provide a level of retirement security that is comparable to or greater than that provided by the traditional DB plan.
As unfunded pension obligations compete for both current and future education dollars, there is likely to be increasing pressure to enact reforms that will prevent the recurrence of such problems in the future. Given the stakes involved, pension reform is inevitably a contentious process, but our findings suggest that the debate around pension reform, which tends to be centered on the suitability of DB and DC pension systems for the teacher workforce, may be misguided. Those on either side of the polarizing pension debate ought to look toward the Pacific Northwest. The Washington State experience demonstrates that pension reform can be done such that a new system is desirable to both teachers and states, lessening the risk that taxpayers will be on the hook for unfunded promises while helping guarantee teachers’ retirement security.