Tuesday, June 16, 2015

Beating the Drums for Defined Contribution Plans with the Unwarranted Assumption Fallacy

One of the most frustrating dynamic of the entire “defined benefit versus defined contribution” argument for public employee pensions is our opponents’ continuing use of unwarranted assumptions to make their points.

An unwarranted assumption makes a conclusion that is based on a premise which is false or unwarranted by the facts. The premises are typically “suppressed or vaguely written,” according to Wikipedia's explanation of unwarranted fallacies.

Let’s take as example “Commentary: Solving the debt in public employee retirement systems,” an opinion piece published recently by Brent Sohngen.

First, Sohngen is a “professor of environmental economics at Ohio State University… [who] conducts research on land use and climate change, carbon trading, and water quality trading.” It’s hard to understand how Sohngen is knowledgeable about pensions, especially in Texas.

Second, Sohngen displays the unwarranted assumption fallacy with his rather simplistic statement:
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. [emphasis added]
Really? Only those three things can fix the problem of unfunded liabilities?

We can think of at least one additional thing: employers should make the full actuarially required contribution (ARC) always and everywhere. When they don’t problems occur.

In Texas this year our legislators admirably owned up to their previous shortchanging of the state’s Employees Retirement System, passing HB 9 and adding $440 million to the program by raising state employee contributions to 9.5% of payroll. It was a situation that was brought on by years of underfunding. It need not have happened this way.

Next, Sohngen notes how a shift to defined contribution plans in Ohio was sold to employees:
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.

Did you notice that the most important reason for the failure of a shift away from the DB plans was that the defined benefits are still really generous. He ignores his own argument in the preceding paragraph, but apparently the ability to gain portability and being “set loose to manage their own retirement investments” weren’t good reasons for employees to switch either. 

If someone is let loose to manage their own investments it would seem that they would be confident they could beat the returns gained from the pensions’ investments. The truth is that few do and most people know they won’t. Who really wants to bear more risk? Moreover, why should they when they were told that they would have lower annual salaries in return for longer-term retirement benefits.

Sohngen steps in it further, noting how Ohio’s ‘tax’ of those who opt out is another disincentive. Of course it is. Converting public employees to defined contribution plans (which, remember, was one of only three possible options) is expensive to existing plans. Someone somewhere has to contribute ongoing increments to DB pensions to keep them viable. They were structured from the beginning to assume normal population, economic, and employee growth and the contributions that come with them. You can’t tinker with the foundations of the structure because the first contributions to the pension were so small. The government employers and taxpayers in that city benefited from those structures by being able to divert funds to other needs.

To be clear, Texas isn’t sticking its head in the sand and declaring that defined benefit or defined contribution plans are the only way to go. Several different organizations are studying the issue.

For example, upon finding that its teachers’ pension was struggling in 2011, the Texas Legislature asked the Teacher Retirement System of Texas to study whether defined contribution plans made sense. The answer was simply, “No.” Here are the key paragraphs from its study:

  • In conducting the Study, TRS modeled the alternative plans using two different approaches: the “Targeted Benefit Approach” and “Targeted Contribution Approach.” The TRS benefit, as currently designed, replaces roughly 68% of a career employee’s pre‐retirement income before a loss of purchasing power. Therefore, TRS modeled the plans in the “Targeted Benefit Approach,” to provide the same level of benefit as the current plan regardless of cost. As shown in Figure 2, TRS determined that the alternative plans would be 12% to 138% more expensive than the current plan (not including the cost to pay off any unfunded liability) to provide the same level of benefit.
  • Conversely, under the “Targeted Contribution Approach,” TRS modeled the alternative plans to cost the same as the current plan regardless of the benefit level provided. Under this approach, TRS determined that the alternative plans would replace 27.7% to 59.7% of pre‐retirement income for a career employee retiring at age 62.
The proponents of defined contribution plans also routinely ignore various warnings about how those with 401(k)s do not save enough or manage their retirement investments with a long-term growth perspective. These are recipes for disaster.

So, again, the unwarranted assumption fallacy provided by Sohngen and other DC-die-hards rarely measure up to a conclusion that they are only one of three options to dent the unfunded liabilities of pension funds. The unwarranted assumption fallacy runs throughout their argument.

We will have to continue to beat our drum for defined benefit plans as long as they beat theirs.