Recommended Research: Transition Costs as an Impediment to Pension Reform

Robert Costrell and the Arnold Foundation have recently put out an interesting policy paper on legislative obstacles to transitioning from Defined Benefit plans to Defined Contribution, Cash Balance, and Hybrid plans:

This paper examines the most common of these claims, that structural pension reform requires an acceleration of payments to amortize the old plan’s unfunded liability. The claim has three components:

(i) A rule set by the Government Accounting Standards Board (GASB) requires an accelerated amortization schedule for the Annual Required Contribution (ARC) if the old DB plan is closed to new members;

(ii) GASB rules for the ARC determine state funding policy, thereby driving actual contributions; and

(iii) The GASB rule for closed DB plans is sound policy, since covered payroll shrinks, ending the basis for a rising schedule of amortization payments.

The paper finds that:

    • The first claim is true. GASB accounting standards unambiguously require a shift in amortization methods from “level percent of payroll” – a back-loaded method – to “level dollar” if the old DB plan is closed to new members. This shift in amortization methods accelerates the amortization schedule for the ARC calculation.
    • The second claim is false. GASB sets standards for financial reporting; it does not determine funding policy and does not claim to. Pension plans are required to report the ARC for comparison with the actual contribution, but the actual contribution is set by each state’s statutory authority – either the legislature or the pension board, if that authority has been delegated. These authorities are not bound by GASB accounting standards in setting funding policy, and actual contributions often differ from the ARC.
    • The third claim is false. GASB’s rule assumes that amortization payments must be based on the payroll of DB members alone, a base that shrinks after closing the plan. However, states can and do levy these payments on total payroll – old and new plans alike – and with sound justification. Total payroll growth is unaffected by closing the DB plan, so there is no policy reason to change amortization methods. The rationale put forth by GASB for “level percent” amortization, based on a growing payroll, continues to be satisfied by total payroll. The GASB rule for closed plans, based on payroll of DB members alone, does not seem to anticipate the total payroll approach.

The paper can be found here. Keith Brainard of NASRA provides commentary on the paper here.

 

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