Michigan Pension Reform: A Model for the Nation

Americans have become accustomed to hearing about unfunded liabilities generated by the various federal entitlement programs, but many state and local governments have serious public finance problems looming as well. On the state and local level, public employee pension plans are underfunded by trillions of dollars. Underfunding has real consequences: essential public service may be crowded out by legacy costs for retired employees, politicians may turn to growth-harming tax increases, and retirees  stuck on fixed incomes may see the pension payments they are counting on slashed. A new American Legislative Exchange Council study titled Keeping the Promise: State Solutions for Government Pension Reform attempts to quantify the depth of the problem and chart a path forward towards fiscal solvency for states with underwater pension systems.

The first, and perhaps most significant, pension reform success story that states can learn from is the Michigan pension reform of the late 1990’s. Though Michigan is certainly not considered a one-party-controlled, conservative-Republican state, representatives of state government at the time had remarkable courage to recognize the problem and embrace bold solutions that dealt with the real issues facing the state, highlighting the fact that pension reform need not be partisan nor ideological.

In 1997, Michigan undertook pension reform that is truly a model for the nation. The state enrolled all new employees hired after March 31^st, 1997 in a defined-contribution retirement benefit plan. All employees hired before March 31^st and enrolled in the defined-benefit system would remain in the system under the original terms of the employment contract. Defined-contribution plans are similar to 401(k)s, where the state or local government and the public employee both deposit money in an account that relies on marketplace investment in order to generate a return. The employees retirement benefits is entirely defined by the level of contribution, the number of years of contribution, and the investment return of their contributions. This is in stark contrast to the plan type that is plaguing many states with unfunded pension liabilities: the defined-benefits plan. Defined-benefit plans guarantee a certain explicit payment detailed by contract, irrespective of the actual funding of the plan or any investment return.

Michigan’s government undertook this monumental reform in hopes of receiving 3 specific types of cost savings. Richard Dreyfuss, an actuary with vast expertise in public pensions, attempted to quantify each of the benefits in 2011, looking at state fiscal years 1997 through 2010. He found impressive cost savings associated with reform:

• The first area of savings that Michigan sought and achieved was lower annual “normal costs.” The annual normal cost is the expenditure necessary to prefund a pension plan during a given fiscal year. Dreyfuss found savings of $167 million for fiscal years 1997 through 2010 via lower annual normal costs.
• Another main driver of pension reform was the attempt to reduce the underfunding of the pension system. As of September 30, 2010, that unfunded liability line-item stood at $4.1 billion. It is estimated that absent reform, that line-item would have increased by another $2.3 billion to $4.3 billion.
• Finally, Michigan policymakers undertook pension reform because the status quo—a defined-benefit system—entails troubling incentives for policymakers. Policymakers are incentivized to underfund defined-benefit plans, thereby offer big benefits without the sting of high taxes necessary to fund those benefits. Moreover, this allows politicians to “kick the can down the road,” thereby giving future generations the responsibility to bear the financial burden of current policy. This same dynamic does not exist in defined-contribution plans, which must be funded each year. Dreyfuss finds that quantifying the savings generated by improved political incentives is essentially impossible, but acknowledges that these improved incentives are not trivial. It is likely that pension reform in Michigan yielded cost savings to taxpayers far beyond the explicit costs measured.

States and localities searching for options for stressed public pensions systems would do well to consider Michigan pension reform as a model. In our new pension publication, Keeping the Promise: State Solutions for Government Pension Reform, the nuts and bolts of public pensions are expressed in simple, common-sense terms. The publication, authored by Dan Liljenquist, a former state senator and pension reformer in Utah, sets a path towards pension reform by analyzing all of the options available to policymakers, offering tools for sound analysis, and sharing case studies in the successes and failures of public pensions.