Study: Cost Increase When States Switch From Pensions to Individual Accounts

Alaska, Michigan, and West Virginia Experiences Offer Cautionary Examples to Policymakers

WASHINGTON, D.C., February 10, 2015- A series of new case studies finds that states that shifted retirement plans from defined benefit (DB) pension plans to defined contribution (DC) 401(k)-type individual accounts experienced higher costs. The case studies also indicate that the DB to DC switch exacerbated rather than solved any pension underfunding issues, and employees faced increased levels of retirement insecurity.

Case Studies of State Pension Plans that Switched to Defined Contribution Plans, by the National Institute on Retirement Security, presents summaries of changes in three states – Alaska, Michigan, and West Virginia – that made the switch from a DB pension to DC accounts.

The case studies examine key issues that impact pension plans, including demographic changes, the cost of providing benefits, actuarially required contributions (ARC), plan funding levels and retirement security for employees. The case studies indicate that the best way for a state to address any pension underfunding issue is to implement a responsible funding policy with full annual required contributions, and for states to evaluate assumptions and funding policies over time, making any appropriate adjustments.

Download the case studies here

Download a PowerPoint summary here.

"These case studies are important cautionary examples for policymakers examining retirement plans in their states," said Diane Oakley, National Institute on Retirement Security executive director. "It's clear that closing a pension plan to new employees doesn't fill overdue funding gaps or reduce the cost of providing employees' pensions, and in fact has had the exact opposite effect of increasing costs to taxpayers. Moreover, employees that moved to individual DC accounts found themselves with inadequate retirement account balances. We hope our research helps policymakers avoid the mistakes of these states. For example, West Virginia eventually moved back to the pension plan to shore up both plan funding and employees' retirement security," Oakley said.

In nearly all state and local pension plans, employees and employers share the responsibility for funding the pension plan. Investment returns also play an important role in funding retirement benefits. Nationally, employee contributions and investment returns cover about 75 percent of public pension retirement plan costs.

The case studies provide in-depth details for the following states:

  • In Alaska, legislation was enacted in 2005 that moved all employees hired after July 1, 2006 into DC accounts. At the time, the state faced a combined unfunded liability of $5.7 billion for its two DB pension plans and retiree health care trust. The unfunded liability was the result of the state's failure to adequately fund pensions over time, stock market declines and actuarial errors. Although the DC switch was sold as a way to slow down the increasing unfunded liability, the total unfunded liability more than doubled, ballooning to $12.4 billion by 2014. In 2014, the state made a $3 billion contribution to reduce the underfunding. Legislation has been introduced to move back to a DB pension plan.
  • In Michigan, the DB pension plan was overfunded at 109% in 1997. The state then closed the pension plan to new state employees who were offered DC accounts. The state thought it would save money with the switch, but the pension plan amassed a significant unfunded liability following the closure of the pension plan. By 2012, the funded status dropped to about 60% with $6.2 billion in unfunded liabilities. In recent years, the state has been more disciplined about funding the pension plan, making nearly 80% of the ARC from 2008-2013.
  • In West Virginia, the state closed the teacher retirement system in 1991 to new employees in the hopes it would address underfunding caused by the failure of the state and school boards to make adequate contributions to the pension. As the pension's funded status continued to deteriorate, retirement insecurity increased for teachers with the new DC accounts. Legislation was enacted to move back to the DB plan after a study found that providing equivalent benefits would be less expensive in the DB than in the DC plan. By 2008, new teachers were again covered by the pension, and most teachers who were moved to the DC plan opted to return to the pension. After reopening the DB pension, the state was disciplined about catching up on past contributions, and the plan funding level has increased by more than 100 percent since 2005. The teacher pension plan is expected to achieve full funding by 2034.