Who’s Afraid of the Defined Contribution Plan?

The city of Springfield can’t keep going with the police and fire pension system it has in place. The unfunded liability has reached at least $197 million, and discussions are under way about filling that gap. But those efforts don’t address an equally critical question: Should Springfield continue to offer the same pension plan, switch to a plan in which both the city and employees contribute to a retirement savings account, or provide some combination of the two?

Change is always a little frightening. For decades, police and firefighters have been able to put in service time and leave with a pension. It has become so commonplace that it is treated as an entitlement. The problem is the defined benefit plan, which provides monthly retiree payments that are not related to employee contributions. But there is opportunity for change. Indeed, it is necessary for Springfield and other cities to put everything on the table.

As a starting point, Springfield officials should consider a defined contribution plan, in which employees are responsible for funding and managing their retirement accounts.

Defined contribution plans frequently attract two criticisms:

First, people live for varying lengths of time. Some die right after retirement, while others survive much longer, which means they could outlive their retirement funds. This criticism is a red herring. After retiring, it is easy to convert your retirement savings account to an annuity that makes monthly payments for life.

Second, in a defined benefit plan, city government bears the risk when financial markets realize price declines. When asset prices fall, the city’s obligation to retirees is unchanged: The assets backing the pension have fallen. Put another way, when asset prices fall, the pension payment stream stays the same, but the asset value isn’t large enough to support that stream. That’s when the city government’s unfunded liability balloons. In contrast, retirees own their savings accounts under a defined contribution plan. Retirees bear the risk when asset prices fall. So, pensions provide income security to future retirees while defined contribution plans offer no such guarantees.

But risk-bearing differences are not the end of the story. Labor markets work much better than that. Higher wages can offset the additional risk associated with defined contribution plans. There is a wage level that will compensate future police and firefighters enough for them to bear the additional risk associated with a defined contribution plan.

It would take a more detailed analysis to quantify a wage increase adequate to hire the necessary number of police and firefighters. Such quantitative evidence is essential for comparing defined benefit plans and defined contribution plans. It may be cheaper, in expected value terms, for the city to bear the risk, but the work should be done.

One additional risk has been ignored, and arguably is the most costly. When governments offer pensions to workers, there is a disconnect between workers’ contributions to their retirement benefits and the size of the benefits. Elected officials find it politically easy — and a boon to their reelection efforts — to raise retirement benefits. Because the post-retirement benefits are deferred, policymakers get an immediate political gain without facing the cost. Of course, this simply widens the gap between workers’ contributions and their post-retirement benefits. Think of the problems associated with Social Security. Worried about upsetting voters, policymakers are loath to impose the costs necessary to make the national pension plan solvent.

Finally, some point out that employees are more likely to switch jobs under defined contribution plans. This poses a problem for cities that spend a lot of money training firefighters and police officers. Just when those employees learn their jobs, they move on to greener pastures. But job mobility is part of a free society. I understand the desire to ensure a stable, well-trained force that protects people and their property. However, it is critical to note that market forces are always operating. If there is a shortage of experienced people, basic economics tells us that higher wage offers are available to deal with such a shortage. A defined benefit package is not an essential feature for cities trying to operate an effective fire department and a professional police force.

I am a big fan of defined contribution plans. I like them precisely because they are portable. In addition, there is a sense of personal responsibility for my retirement standard of living that I like; with tongue planted firmly in cheek, there is no federal bailout for university professors who do not provide for their old-age spending.

More seriously, the political realities are such that a defined-contribution-only plan is off the table. If so, I think it is best to try some kind of hybrid approach for future hires. Some defined contribution combined with a defined benefit program would provide some risk sharing, and would give the city the best chance to achieve predictable expenses. I also would suggest adding Social Security to the city’s defined benefit program.

The existing approach got Springfield into this situation. Some reform is needed to avoid the same problems in the future.

Joseph Haslag is executive vice president of the Show-Me Institute, a Missouri-based think tank, and a professor in economics at the University of Missouri–Columbia.