We have long known that the one of the biggest problems we face in the United States is the long-term debt we have racked up in public employee retirement systems.
The National Bureau of Economic Research suggests that the unfunded liability in systems all over the country is more than $1 trillion. Aside from incredible returns in the stock market and a lot of lucky guesses, only three things that can be done to fix this problem: Increase contributions by people in the system; reduce payouts to retirees; and shift people to private defined contribution plans.
The most important component of this in the long run is to move public employees to private defined benefit plans. This is the surest way to limit the long-term exposure of state governments to the bad management often inherent in bloated public employee retirement systems.
Apparently, doing this is really hard. Ohio is a perfect example.
In 1997, the state passed legislation that allowed a set of public employees to shift out of the defined benefit plan, and into a defined contribution plan. These public employees would be set loose to manage their own retirement investments, like private 401(k) plans. Those who shift out bear more individual risk, but for many people the risks are worth it because they gain portability — or the ability to take their retirement savings with them if they leave state employment.
Since 1997, only 3.1 percent of employees have shifted to this defined contribution plan. Why is this? Perhaps the most important reason is that the benefits paid to retirees who stay in the defined benefit plan are still really generous. When cost-of-living adjustments are included, they are greater than the payments a private citizen is likely to get from saving the same amount of money over their career and investing in a stock index fund tied to the Standard & Poor’s 500.
One reason for this is the state of Ohio allows the public retirement systems to tax people who opt out of the defined benefit plan and into the alternative system. The legislature called this the mitigating rate, allowing the public system to take some of the payment employers would ordinarily make to the retirement of their employees and use that money to make up for any resulting shortfalls in the traditional State Teachers Retirement System defined benefit plan.
The idea of making up for financial shortfalls that are created if too many people opted out sounds good, but it is a false premise. A retirement “plan” (whether self-managed or public defined benefit plan) should take someone’s money over their lifetime, invest it wisely, and deliver it back to them in retirement. In principle, it should deliver back the market returns. If someone opts out of the system, or does not join it, that should not harm a well-designed system.
Consider a different example, if you invest in a stock fund over time and then withdraw your investment, do you harm the other investors? You do not because there are assets (stocks) backing up the investment.
What the mitigation rate imposed in Ohio actually does is reduce the incentive for people to voluntarily opt out of the defined benefit plan and into the defined contribution alternatives. The problem for taxpayers is that this continues to create future liabilities, at the rate of about $200,000 per person for those who remain in the defined benefit system. Anyone who opts out of the system creates no future liability. Allowing the public systems to tax public employee retirement benefits leads to additional, large unfunded liabilities for the state in the future.
The mitigation tax imposed in Ohio also provides public systems with a failsafe: If they make bad investment decisions and spend too much money on management, they can be bailed out in part by increasing the mitigating rate. Most of us cannot make up for some failed investments by taxing someone else to recoup our losses, but the system in Ohio, which has nearly a $30 billion deficit, is planning to double down and increase this mitigation tax by 22 percent over the next year.
There is no easy solution to the problems created by old defined benefit plans. But in the long run, states like Ohio will be much better off if they can move more people off the defined benefit plans of old and onto defined contribution plans. Eliminating the taxes like the mitigating rate tax in Ohio would be a good start.
