Transition Costs and Public Pension Reform

Andrew G. Biggs
Publication Date: 
February 2014

States and local systems across the U.S. are facing significant financial duress from unfunded pension liabilities. Some reformers have proposed replacing the traditional defined benefit that most public pension systems provide to a cash balance or defined contribution plan. In response, opponents argue that the shift in plan design would incur significant transition costs.

In this policy study, Andrew Biggs shows that transition costs are minor and should not stand in the way to pension reform. Biggs categorizes the perceived transition costs into two categories: accounting-based arguments and investment-based arguments.

In accounting-based arguments, opponents believe that the Government Accounting Standards Board (GASB) guidelines require closed defined benefit plans to accelerate the amortization of its unfunded liabilities, or speed up the time to repay unfunded liabilities, and in turn, increase pension costs. Biggs shows that GASB guidelines are not intended to dictate how pension liabilities should be funded. Rather, GASB guidelines are intended for disclosure only and are not meant to drive funding choices, and there is no economic or policy reason to alter amortization schedules.

In investment-based arguments, opponents claim that closing a defined plan would require shifting to more liquid, less risky assets as employees get older, and in consequence, lead to higher plan costs. Biggs demonstrates that transitioning to a more conservative investment portfolio carries both the benefit of less risk and the penalty of lower returns, but advocates of this argument often ignore the question of risk. Biggs argues that there is no evidence that U.S. public plans target their investment portfolios to the age of its participants, and believes that increasing liquidity of plan investments have only a small effect on expected returns.