Public Sector Pension Plans: Defined Benefit Versus Defined Contribution

Abstract

California faces large costs in funding its public sector pension plans, and its governor has proposed replacing its traditional defined-benefit plans with a 401(k)-type defined-contribution plan. This proposal, which will probably go directly to the voters in June 2006 and has generated nationwide interest, does not stand alone. Other states have adopted similar measures, and nonunion employers in the private sector have already shifted to defined-contribution and cashbalance pension plans. Other established industrial economies have also revised their retirement income programs in response to the increased competition from new entrants to the global economy. This article examines this development with attention to the arguments on both sides of the issue, what has already happened elsewhere, and the likely outcome of the current debate.

Complexity as a Barrier to Annuitization: Do Consumers Know How to Value Annuities?

“…To the extent that households are poorly-equipped to value the annuities offered by their public pensions, this can have implications for the political feasibility of reforms that change the benefit structure, particularly in cases where individuals are provided a choice to accept a lump sum in lieu of future annuity payments. The same, of course, is true with state and local public defined benefit plans (DB) in the U.S., which also face substantial underfunding problems (Novy-Marx and Rauh, 2011), and for which some reformers have called for a reduction in DB annuities in exchange for lump sum contributions to defined contribution accounts (e.g., Kilgour 2006).…”

Cognitive Constraints on Valuing Annuities

“…To the extent that households are poorly equipped to value the annuities offered by their public pensions, this has implications for the political feasibility of reforms changing the benefit structure, particularly if retirees were to be offered a choice between a lump sum and future annuity payments. The same point applies to state and local public defined benefit plans (DB) in the U.S., which also face substantial underfunding problems (Novy-Marx and Rauh 2011); indeed some reformers have called for a reduction in DB annuities in exchange for lump-sum contributions to defined contribution (DC) accounts (e.g., Kilgour 2006).…”

The Management of Defined Contribution Pension Plans in Local Government

“…The 401(k) is only used in governments that adopted it prior to 1986 (SigRist and Brown ). Section 403 (b) plans are used by educational institutions and nonprofits, and Section 457 plans are used by state and local governments (Kilgour ). Governments also may adopt a Section 401(a) money purchase plan (Kilgour ), in which sponsors make specified contributions (GAO ).…”