Missouri’s Public Pension Plans Need to Be Reformed to Maintain Solvency

Public pension systems across the country are falling apart before our eyes. The California Public Employees Retirement Security System (CalPERS), the largest pension system in the country, lost 20 percent of its value during three particularly bad months in 2008. That same year, the city of Vallejo declared bankruptcy after spending 75 percent of its annual budget on pensions for its employees. It might be comforting to think of these problems as limited to California, but that is far from the truth. Citing an analysis from PricewaterhouseCoopers, a late 2009 Washington Post article reported that within 15 years, the average public pension will not possess even half the money required to pay the benefits that they owe. If these systems go bankrupt, either public employees will see dramatic cuts to their retirement benefits — which is a remote possibility, given the strength of public employee unions — or taxpayers will be forced to make up the shortfall.

Although Missouri does not have nearly the range of problems that fiscal basket cases like California have, our state is far from immune to pension woes. The Columbia Daily Tribune reports that its city’s pensions for police and firefighters are underfunded to the tune of $55 million. Earlier this year, budget pressures forced the legislature to enact reforms to Missouri’s pension system, including raising the retirement age to 67 and forcing workers to contribute to their pensions for the first time starting in January. These reforms are positive steps, but we must consider fundamental changes to our system if we want to avoid similar problems down the road.

According to a new Show-Me Institute study written by University of Missouri–Columbia finance professor John Howe, shifting public pensions from defined benefit plans to defined contribution plans could generate higher returns for pensioners while limiting the risk to the public when pensions do not perform well. Defined benefit systems pay out a guaranteed amount of money to pensioners based on a formula that typically uses criteria like years of service and annual salary. On the other hand, defined contribution plans, like the 401(k) and Roth IRA, focus on the amount of money that employees pay in over the course of their careers and give employees more control over how that money is invested.

During the last 20 years, private companies have shifted towards defined contribution plans, but public pensions are still dominated by the defined benefit model. Missouri’s new reforms make the public pension system into a hybrid of defined benefit and defined contribution plans, which is an improvement over a pure defined benefit plan, but still subject to paying more in benefits than it receives in contributions.

The primary benefit to society of a greater reliance on defined contribution plans is that individuals would be more directly responsible for their own retirement funds, as opposed to relying on taxpayers for support. Furthermore, although it is difficult to make direct comparisons between the returns of defined contribution and defined benefit plans, because there are numerous variations of each, Howe cites evidence that defined contribution plans typically outperform defined benefit plans. This can be attributed to the fact that individual employees are generally willing to take on a somewhat higher level of risk than most companies or government agencies.

The downside to this risk is that a few people using defined contribution plans end up with less money for their retirement than they might otherwise have had. However, a system in which a relatively small percentage of pensioners becomes dependent on a social safety net is better than a system in which almost every beneficiary collects more than he contributes — with the difference made up by tax dollars.

All pension systems run the danger of failing to meet employee expectations, but we are less likely to encounter a complete systemic failure if we give greater control of pensions to the people who must live off of them in the future. Public employees are as capable as the rest of the working public to provide for their retirements.

John Payne is a research assistant for the Show-Me Institute, an independent think tank promoting free-market solutions for Missouri public policy.