San Diego voters last week voted overwhelmingly to reduce pension benefits for the city’s workers. The pension reduction referendum among other things eliminated public pensions for newly hired city employees. Future San Diego municipal employees will no longer be able to enroll in the defined benefit pension plan that covers current employees and provides a modest lifetime pension benefit. Instead, new hires will be allowed to enroll only in a 401(k) type defined contribution savings plan.
Mayor Jerry Sanders promised voters that diverting new hires into a 401(k) type plan would save the city money by reducing the city’s long-term commitment to retirement security for its retired employees. As it turns out, the promise of savings was false advertising.
Fifteen years ago, the State of Michigan closed its defined benefit pension plan to new hires and diverted them into a defined contribution plan. State leaders made this change because they said that the long-term cost of the defined benefit plan was too unpredictable and the state could save money by diverting new hires into a defined contribution plan.
Those savings have not materialized. Today, Michigan spends nearly 50 percent more on its defined benefit pension plan than it did before it cut off enrollment to new hires. A recent study warns that those costs could rise sharply in the future.
When Michigan stopped enrolling new hires in its defined benefits pension, it allowed workers hired before 1997 to choose between staying in the defined benefits plan or enrolling in the defined contribution plan. Nearly 95 percent chose to stay in the defined benefits plan, and Michigan began administering two different retirement plans.
In 2011, the state’s contribution to the defined benefits plan was $424 million up from $288 million in 1997 when new hires were cut off from the plan. While state leaders thought that capping enrollment in the defined benefits plan would save money, it has actually caused it to be more expensive.
Because the defined benefits plan has no new members enrolling in the plan and its membership is not expanding, the benefits paid has become a greater percentage of the payroll of those remaining in the plan. In 1997, benefits paid were 20 percent of payroll; in 2011 that percentage increased to 56 percentl.
The higher percentage of payroll being paid in benefits has made the plan less solvent. In 1997, the plan’s funding ratio, the ratio of assets to liabilities was 109 percent, which means that the plan had 9 percent more assets than liabilities. In 2011, the funding ratio had dropped to 72.9 percent.
There are only two sources that provide funding for the plan: state contributions or return on investment. Unfortunately, the plan’s return on investment has been not been able to provide sufficient revenue. The average rate of return on investment over the last five years has been 2.1 percent, well below the 8 percent return that actuaries estimate is needed to fund the plan adequately.
This low rate of return on investment is also caused by closing enrollment to new hires. The precarious state of the fund that resulted from closing enrollment and the fact that it will be winding down over the next 25 to 35 years has meant that the plan cannot afford to absorb potentially big investment losses, which means that it must follow a more conservative, low-yield investment strategy.
As a result, the state has had to increase its contributions to the plan. A report by the state’s Employee Retirement System says that state contributions are likely to increase sharply as the plan’s phase-out draws closer.
A recent report by the Texas Public Pension Review Board finds that any governmental entity choosing to transition to a defined contribution plan by closing enrollment to new hires will face similar increased costs:
Michigan’s declining funding ratios and increasing contribution rates illustrate the challenges of funding a closed group plan, where active member payroll steadily decreases due to no new enrollment. Every plan choosing to transition from a defined benefit to a defined contribution structure will face these costs.