Recently, in an interview with Ira Glass on This American Life, Grover Norquist — the famed founder of Americans for Tax Reform, and organizer of the Taxpayer Protection Pledge, which asks political candidates across the United States to commit themselves in writing to oppose any and all increases in taxes — argued that one of the most fundamental reforms necessary to shrink the size of government is to move all state and local government employees from publically funded pension systems to 401(k) plans.
At this point, the problem with state and local government pensions is not a matter of partisan debate. All sides agree that pension liabilities are one of the most daunting issues facing state and local governments. Many states and cities underestimated how much money they would need to pay out in the coming decades and overestimated future tax revenues (municipal finances are heavily tied to the property tax) and the returns on pension fund investments. According the Pew Charitable Trusts, about 31 state pension plans are now under the 80 percent funding level that is generally recommended.
The move from defined benefit pension plans to defined contribution plans, however, is not as easy as Norquist suggests.
The catch: changing to a 401(k) system costs way more in the short term. Unless we expect current workers to take a significant cut in their take-home pay, their salaries would have to be increased so that they could afford to contribute to the new 401(k). In addition, the state or city would need to pay the employer contribution above and beyond the base salary (Norquist recommended 10 to 12 percent). And this doesn’t even take into account the fact that cities and states would still have to fund existing pensions of current and soon-to-be retirees.
There is no way to do a retroactive 401(k). Employees who were guaranteed a pension had no reason (and in many cases no additional funds) to save for retirement. They labored under contracts that promised an adequate income upon retirement, often in jobs that others would not want to do: picking up and sorting trash and recycling, or clerking at the DMV, for example.
Most governments finance pensions through a combination of special savings accounts and pay-as-you-go funding. Money is deposited each year by the city into investment accounts to ensure that sufficient funds are available when the workers retire. Pension experts generally recommend that governments fund their plans at a minimum of 80 percent of what they expect to have to pay. However, because benefit projections rely on assumptions about future wages, mortality rates, employee turnover, inflation, and other factors, full funding is, in the words of MIT pension researcher Olivia Mitchell, "a moving target." When returns fall short, like in many states and localities today, governments have to either make up the difference out of current revenues or “borrow” from the pension plan.
Without significant decreases to the plans of those who currently rely on their pension benefits, Norquist’s suggested change means spending more now to potentially save later. Shifting from pensions to 401(k)s would keep cities and states off the hook (at least directly) when markets drop drastically, but they also would require governments to produce more revenue immediately — in other words, raise taxes. While one way to decrease spending during the transition would be to cut the pensions and other benefits of current retirees, that may not be a viable approach. (Currently, many states and cities are waiting to see whether proposed modifications of current pension benefits, such as moving their workers from city provided health care to Medicare or decreasing promised cost of living increases, will even stand up in court, given that these changes are in effect a breach of contract).
The high price of transitioning from one system to another, according to the National Conference of State Legislators, is most likely the reason that states are reluctant to change their current pension systems. The costs of changing retirement plans — politically and actually — is simply too high. One study, done for the Minnesota legislature, suggested that changing to a defined contribution plan could cost the state almost $3 billion over the next decade.
It is often the case that investments in long-term financial security require an initial outlay of cash — and the cash in this case comes from taxes. Even if he won't say it, what Norquist is calling for is an increase in current taxes. This may be an idea worth considering, but unless we discuss the upfront costs honestly, we won't make any progress toward solving the pension crisis.