How Big Are Transition Costs Associated with Closing a Public Defined Benefit Pension Plan?
In the wake of massive underfunded pension liabilities, state and local policymakers have considered switching to alternative retirement plans. Some retirement stakeholders, however, oppose switching plans, citing transition costs. The “transition cost” argument has two prongs: First, opponents state that Government Accounting Standards Board (GASB) requires plans to pay off the old plan’s unfunded liabilities more quickly once it's closed. Second, opponents argue that switching new hires to a new plan requires the old plan to invest in safer, more liquid assets with lower returns that will eventually result in higher liabilities and employer contributions.
In this working paper, Andrew Biggs examines the soundness of these arguments. He states that GASB standards are guidelines, not requirements, and they don’t have the force of law. Funding is a policy decision for governments to make. GASB itself states that accounting and financial reporting is separate from funding. In response to the investment argument, Biggs estimates that closing a plan to new entrants will have a negligible effect on investment returns over the first several decades, a difference of 0.5 percentage point for CalPERS using one economic model. While plans might use less risky investments in their portfolio (not necessarily a bad thing), the lower investment assumptions would also be applied to the smaller liabilities of the closed plan. Although prior liabilities from the old plan wouldn’t disappear, they also would not get larger after switching.
Biggs concludes that transition costs should not prevent state or local governments from switching to a defined contribution, cash balance, or other hybrid plan.