Public Sector Pensions in Nebraska: Are Cash-Balance Plans

Platte Institute Public Sector Pensions in Nebraska Are Cash Balance Plans the Answer? By Andrew G. Biggs Resident Scholar American Enterprise Institute policy October 2011 STUDY Public Sector Pensions in Nebraska | Platte Institute Policy Study 2 Table of Contents Section Page Summary 2 Introduction 3 Background on the Nebraska NPERS Cash Balance Plan 3 Employee Attractions and Retention 4 Rate of Return Subsidy 5 Implications for Plan Funding 6 Transparency 7 Pure Defined Contribution Pensions 8 Summary and Conclusions 9 Endnotes 9 Summary Nebraska presents what could be a model for public sector pension reform, the so-called “cash balance” plan that offers some of the better aspects of both traditional defined benefit pensions and the defined contribution, 401(k)-type plans

that dominate in the private sector. In this study we examine the factors that make cash balance plans attractive as well as examining some of their potential shortfalls. Cash balance plans offer far greater portability than defined benefit pensions, allowing public employers to attract young mobile employees and removing current disincentives for mid-career employees to leave. However, cash balance plans share with defined benefit pensions a set of accounting rules that economists almost universally believe to understate pension liabilities and hide the investment risks that are borne by taxpayers. In the case of Nebraska's cash balance plans, this arises through the government’s guarantee of a 5 percent annual return on account balances regardless of the returns available in the market. Such a guarantee, which resembles a financial product known as a “put option,” is easily priced and shows the true costs of the Nebraska cash balance plan to be far greater than currently understood. While the cash balance plan claims to be 95 percent funded, when the market value of the rate of return guarantee is included the plan is only around 50 percent funded. Claims by pension managers that market values do not apply to government plans are not supported by the vast majority of economists. A pure defined contribution plan in which participants bear the investment risk would be more transparent in terms of the costs imposed on government budgets and the taxpayer. Platte Institute Policy Study | Public Sector Pensions in Nebraska 3 Introduction Pension plans for state and local government employees are in a state of flux. Traditional defined benefit pensions, which are quickly disappearing for private sector workers, remain in place for the vast majority of full-time public employees. But costs are rising for DB pensions due to a combination of benefit increases in flush times, chronic underfunding by sponsoring governments, and investment returns over the past decade that have fallen well below projected levels. 1 As a result, some have proposed shifting public employees to the defined contribution, 401(k) model that reigns in the private sector. DC pensions are by definition fully funded so long as the employer makes his required contribution, and market risk is borne and managed by employees. This has direct benefits for government budgets and taxpayers, but there are indirect benefits as well: the transparency of DC pensions makes government obligations easier for policymakers and taxpayers to monitor and manage...

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