Pension Reform: Could Michigan Be A Model State?

Appalled by the $22.4 billion fiscal millstone that the public teacher pension fund (MPSERS) has become, Michigan lawmakers hope to make long-overdue structural reforms. In particular, the Michigan Senate is now considering a new “Hybrid” pension plan that would bring retirement benefits more in line with the defined-contribution plans so often utilized by the private sector. If Michigan — a state whose economic struggles are well documented — can achieve fiscal stability, the rest of America should take note.

While Hybrid systems cannot wreak any more havoc than defined-benefit plans do now, they still bear similar risks. If the “normal cost” of MPSERS — the amount needed to prefund a year’s worth of retirement benefits — is inaccurate, the state risks the possibility of a severe shortfall in the pension fund. In other words, Hybrid plans assume a certain rate of return on investment in order to work. As is true with defined-benefit plans (which promise a certain payoff upon retirement), both taxpayers and teachers suffer when those investment predictions prove overly-optimistic.

The good news is that, by offering a 401(k) option, a Hybrid system can lessen the chance of underfunding. The advantage of a 401(k) program, as noted by a June 26 editorial in The Detroit News, is that future taxpayers never pay for the overly optimistic promises made by politicians today. Unfunded liabilities simply do not occur in this sort of arrangement, otherwise known as a defined-contribution plan.

A Hybrid pension system can also create good outcomes for educators. The 401(k) is portable, meaning that teachers can take their savings with them when they leave the school district. By including the 401(k) option, the Hybrid plan offers flexibility for younger teachers who may not want to work as an educator for an entire career.

By way of contrast, defined-benefit programs often lock a teacher into a single district where they stay in order to avoid seeing their nest egg squashed. Many public school teachers throughout the U.S. risk losing up to 50 percent of their pension if they decide to transition into other careers.

As Chad Aldeman and Andrew J. Rotherham observe, DB plans also “back-load benefits so that teachers accrue substantial pension wealth in their last years in the classroom.” With such cash incentives, DB plans reward teachers financially for holding on even if they feel burned out. Reforming or eliminating defined-benefit plans would give teachers the flexibility to make career choices that suit them, rather than worrying about their longevity in a particular school district.

Unsurprisingly, the Michigan Education Association (MEA) stands by this structure of incentives. They argue that the new plan imposes a “hefty financial burden” on current and future workers. But the MEA seems bent on cleverly disguising what the Hybrid system actually does. It will remove pensions from the control of politicians (and their dangerously myopic actuaries) and place them firmly in the hands of individual teachers — where it should have been in the first place.

Some Democrats oppose the Hybrid system on the grounds that it breaks the political promises made to teachers. But they underestimate the moderate nature of the proposal. Teachers with old defined-benefit plans can hold on to them, while recently hired educators (and future hires) can choose from MIP or the 401(k) options. Other opponents of the bill assume that the presence of short term “transition costs” justify blocking long-term structural reforms, but these arguments do not hold water either.

Here is the biggest piece of evidence for adopting a Hybrid plan: every new Michigan state employee (excluding teachers) has already enrolled in a 401(k) program. Shockingly, the sky has not fallen. Michigan’s unfunded pension obligations have actually decreased by several billion dollars. Dare I say it — Michigan’s public sector is doing just fine. There is no good reason why the educational system cannot do the same.