Converting from Defined Benefit to Defined Contribution: The “Free” Money Pays Down Unfunded Liabilities and Pays Dividends to Taxpayers

After a 15-year policy battle, Oklahoma in 2014 decided to implement a Defined Contribution (DC) plan for new state employees. Other than a few minor changes, the DC plan essentially mirrored the plan—a unique concept at the time— originally designed by me in 2000. Under this new DC plan, the state matches the employee’s contribution starting at 3 percent and increasing by 1 percent a year until it reaches a maximum of 7 percent in the fifth year.   This is better than many private sector 401(k) plans.

Under the prior OPERS defined benefit (DB) plan, annual retirement contribution costs totaled an incredible 16.5 of payroll. This translates into $6,600 on a salary of $40,000 in addition to health care, social security and Medicare costs. Ultimately, taxpayers bear this huge employment cost burden. This reduction in costs will benefit both taxpayers and future retirees.

Initially, the difference between the prior 16.5 percent OPERS payroll costs and the much lower cost of the DC match will be used to pay down the unfunded liability of the defined benefit plan. Using the aforementioned example of a $40,000 salary, the state can shore up the preexisting DB unfunded liability to the tune of $5,400 in the first year and gradually leveling off in the fifth year at $3,800. This use of the cost savings to resolve the unfunded liability ensures promises made will be promises kept.

Once these payroll cost savings resolve the unfunded liability from the prior DB system (in 10 to 30 years), these annual cost savings—equivalent to more than 9 percent of payroll—become available for tax cuts or core spending needs.  This sharply contrasts with the alternative scenario of constantly increasing employer contributions over 30 years to fund a DB plan. Oklahoma’s public pension plans funded ratio now ranks 17^th best in the nation, partially as a result of using these DC cost savings to pay down the DB plan’s unfunded liabilities. Once the DB system is 100 percent funded, more than $250 million in annual savings will become available for needed services or tax cuts.

Public pension plans in approximately half of all states will likely need no additional funding beyond the revenue stream created by this conversion mechanism in order to remain solvent. Of course, for plans relatively worse funded, these conversion savings will be diverted to shore up the plan for a relatively longer period of time before becoming available for other uses.  For some of the worst-funded DB systems, an infusion of funds at approximately 20 years after conversion may be required; but taxpayers still win big

Implementing a DC system delivers immediate payroll savings for the new plan’s participants. Using these savings to shore up the unfunded liabilities from the preexisting DB plans will ensure that past promises made are kept. At the same time, the new DC plan participants rest assured that each and every paycheck, funds are being deposited into an account belonging to them. Taxpayers win as the escalation in retirement overhead costs level off and eventually realize the full benefit of the savings.

Take heart. A way out of financially disastrous DB plans exists. A path to fiscal stability is available for even the poorest funded plans. In the next segment, we will discuss why the issuance of pension obligation bonds may be appropriate in a narrow set of circumstances—particularly as part of a broader pension reform strategy.