On Oct. 12, Dan Mitchell posted on the LERA-Dialog listserv an LA Times article on a May 23 ballot measure that would eliminate pensions and substitute 401(k)-style retirement plans for newly hired City Hall workers.
Faster than you can say "Social Security," LERA member and New School for Social Research economist and professor Teresa Ghilarducci had made a definitive and very educational post:
Conversion to 401(k)s is a bad idea from a public finance point of view.
The City’s rationale for converting the current plan to a 401(k)-type retirement account has two parts.
1. The defined-contribution plan design is cheaper and
2. 401(k)-type plans have predictable costs.
The City will have to pay more for the same benefit if it switches to a 401(k)-plan design. The 401(k)-type pension plans are more expensive than defined-benefit pension plans for three reasons:
1. Defined-benefit plans earn higher investment returns and pay lower investment-management fees (The Towers Watson consulting firm has been comparing the net of fees rates of return in defined- benefit versus defined-contribution plans for more than 30 years. Defined-benefit plans have consistently outperformed defined-contribution plans by an average of 1 percent per year, which redounds to a more than 30 percent difference in pension benefits over an employee’s career.) because managers of pooled funds have more bargaining power, and the investment functions are centralized and managed by professionals.
2. Defined-benefit plans reduce the overall cost of providing lifetime retirement benefits by pooling mortality risks over a relatively large number of participants. Switching to a defined-contribution plans require each individual to bear these risks alone, consequently requiring higher contributions than if the risks were pooled.
3. The vehicles in 401(k) plans are liquid mutual funds and are inappropriate for long-term savings because people pay a premium for liquidity they don’t need.
There are ways the city can get predictable contributions out of a defined-benefit plan.
For example, the state of Georgia has maintained their defined-benefit plan structure but stabilized the employer contributions by requiring the employer to contribute every year. Likewise, a municipality could fund the defined-benefit pension plan by always contributing to the fund, perhaps never letting contribution rates go beneath, say 2 percent.
If the annual required contribution (ARC) is higher because of investment losses and other experience changes, such as people living longer than expected, then the funds could use a surplus that has been built up in good times, this surplus will be used to make up for for low-return years.
Such a requirement will ensure that in good times the contribution never falls to zero.
One way that the stability is created is by creating corridors for annual changes in contributions that prevent a small municipality from experiencing enormous fluctuations in contributions from year to year. Instead, many sponsors e.g.., the state of California, took advantage of well-funded plans to stop making contributions, only to be dismayed when they were required to start making contributions again.