Did Pension Reform Improve the Sustainability of Pension Plans?

Can closing a defined benefit pension plan to new hires and replacing it with a defined contribution plan help improve the solvency and sustainability of a state’s retirement system finances? In 1996 the Michigan legislature voted to close its defined benefit plan for state employees, offering defined contribution retirement benefits for new hires. Alaska’s 2005 pension reform closed both their Public Employees’ Retirement System (APERS) and Teachers Retirement System (ATRS). Unfunded liabilities have grown in both cases.

We find that both Michigan and Alaska are better off specifically because they closed defined benefit plans compared to if they had made no changes. Unfunded liabilities have increased in both states since their reforms, but for reasons unrelated to the actual reforms: both states had underperforming investment returns, and both states failed to make 100% of their required employer contributions. Had Michigan and Alaska not closed their pension plans, unfunded liabilities would be even higher today than under actual experience. And had the states properly managed their pension reform projects they would be billions better off today. In effect, the states have ‘spent’ the savings from closing the defined benefit plans on other budgetary priorities.

Policymakers considering similar reforms to Michigan and Alaska should understand that closing a defined benefit plan and replacing it with a defined contribution plan can improve sustainability. They should also heed the warnings that Michigan and Alaska present in recognizing that responsibility managing plans after reform is just as important as getting the initial terms of the reform right.

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