Memo: Switching to 401(k)-type Retirement Plans for New Employees Will Harm PA Taxpayers

Date of Press Release: 
June 12, 2013


To: Members of the Senate Finance Committee

From: Dr. Stephen Herzenberg, Executive Director, Keystone Research Center

Date: June 12, 2013

Re: Switching to 401(k)-type Retirement Plans for New Employees Will Harm PA Taxpayers

Cc: Members of the Pennsylvania General Assembly

The Senate Finance Committee may soon consider legislation that embodies some or all of Governor Corbett’s proposal to switch future teachers, emergency responders, nurses, and other school and state employees from the state’s current defined benefit pension system to 401(k)-type individual retirement accounts.

This memo highlights the impact of the Governor’s plan on Pennsylvania taxpayers. For more detail and references, see the Keystone Research Center’s series of pension primers at Attached to this memo is also a list of the “Top 10 Reasons Governor Corbett’s Proposal Will Cost Taxpayers More,” based on the research summarized in the pension primers.

There are three primary reasons that the Governor’s plan will cost taxpayers more.

First, the Governor’s proposal increases the employer (hence taxpayer) cost of retirement plans for new public employees. The 4% of payroll the state would contribute to new employees’ retirement plans is one-third higher than the average 3% of payroll cost for new employee pensions that was achieved by the Pension Reform Act of 2010. Fully phased in, pensions for new employees under the Governor’s plan would cost $179 million more annually, with $112 million of this falling on local school districts.

Second, the Governor’s plan shifts new hires into individual 401(k)-like accounts that are much less cost-effective than defined benefit pensions. Individual accounts have higher administrative costs and financial fees than defined benefit pensions, and lower investment returns because professionals do not manage the funds. The National Institute on Retirement Security estimates that, to achieve the same level of retirement security, it takes nearly twice the amount of contributions to 401(k)-type accounts as to defined benefit pensions. Echoing the research evidence, Forbes magazine last week published a story entitled “Pension Plans Beat 401(k) Savers Silly." Forbes notes that “Towers Watson, the global human resources consultant, found that pension-style plans beat 401(k)-style offerings by nearly 3 percentage points in 2011” and “76 basis points annually” since 1995. Switching employees to a less cost-effective 401(k)-type retirement plan without raising contributions will, of course, hurt employees and make it harder for schools and the state to retain great social workers, foresters, and other public servants. It will also hurt taxpayers because, to offer an attractive compensation package, salaries will have to increase to offset lower quality pensions or more employer contributions will be needed to employees’ individual retirement accounts.

Third, the Governor’s plan will increase the cost of the state’s current pension debt—in other words, it will dig a deeper pension hole. By closing SERS and PSERS to new employees, the Governor’s plan will gradually lower the investment returns on the pension assets held by the two plans (see reasons 2-4 in the attached top 10 list for more explanation). When investment returns pay for less of pension checks, taxpayers have to pay more. The costs of closing an existing defined benefit pension plan are buttressed by studies in a dozen states that rejected this option; by experience in states that closed defined benefit pensions (Alaska, West Virginia, and Michigan); and by pension experts across the political spectrum. Finally, the Governor’s plan increases the state’s pension debt by lowering employer contributions to SERS and PSERS in the next five years—“kicking the can down the road,” to use the Governor’s own phrase.

Managing Pennsylvania’s pension debt is an important challenge that warrants more action building on the progress of the Pension Reform Act of 2010. But the Governor’s proposal to switch new employees to 401(k) plans would worsen the problem of the pension debt, while also hurting taxpayers, employees, and public employers’ ability to attract and retain great public-sector workers.

Read Digging a Deeper Pension Hole: 10 Reasons Gov. Corbett’s Pension Plan Will Cost Taxpayers More