The Trillion Dollar Pension Problem

In the United States, there are two major forms of retirement plans. First, defined contribution plans and second, defined benefit plans. Most employees had private companies save for their retirement into defined contribution plan like a 401k plan. While the majority of state and local government employees, like teachers or policemen, have a defined benefit pension plan.

For the latter, city and state governments guaranteed a promised pension payment. Historically, insufficient contribution and a volatile stock market created a large shortfall between the promised pension benefit and what those governments had saved for it. Under some measures, the total unfunded pension liability has reached over $6.5 trillion, or approximately one quarter of the US GDP.

This raises the question of whether there are other retirement plans available. Concretely, are there retirement plans that are both desirable from the employee perspective and financially sustainable for the employer? Along with my co author Josh Rao, we surveyed over 7600 public employees across 16 states to address these questions.

Specifically, we asked under what terms employees would switch to a defined contribution retirement plan like a 401k plan. We found that 89% of them would accept the switch from their defined benefit pension plan to a defined contribution plan as long as their employer would contribute to their new retirement account.

Overall, most senior employees said they would require larger employer contributions relative to younger workers. We also found that employees who perceived their pension plans financial stability to be weak were more likely to accept a DC plan. In fact, for close to 80% of respondents, we find that the required contribution that employees demand is below the employer service cost for the existing plan.

That means that state and local governments could potentially save a lot of money by offering a DC retirement account. Separately from the financial aspect defined contribution plans provide employees more flexibility. They allow people to relocate and change jobs more easily. More than that, they give employees the ability to pick their preferred investments, and they dont settle state and local governments with large unfunded obligations far into the future.

So why don't more employees offer their employees a choice? Economic and political constraints have often prevented the supply of a broader menu of retirement options. Employee representatives that negotiate the retirement terms are often the most senior and have a vested interest in maintaining the current plan. However, recent examples, such as the state of North Dakota, the state of Kansas, and the city of Baltimore have shown that the transition to a defined contribution is possible if well designed.

They either mandate a switch to a DC plan or provided new employees the option to choose between a DC or hybrid plan. As a result, they put their state or city onto a fiscally sound path. As the liability associated with defined benefit plans continue to grow, state and local governments are looking for alternatives to lower their future liabilities.

Our survey demonstrates that there are alternative pension plans that are both desirable and fiscally sustainable. These options are particularly well received by young employees. Not only do these options preserve the satisfaction of employees with the expected retirement benefits, they also offer the ability to save taxpayers trillions of dollars.