Defined Benefit or Defined Contribution? Which is the Better Way to Structure Government Pensions?

Unfunded pension liabilities for government workers, which has been a visible issue for years, has received even more press now that Detroit has declared bankruptcy and the pensions of retired Detroit government workers are in jeopardy.

As businesses have increasingly shifted away from defined benefit pensions to defined contribution pensions, one of the big policy issues for government pensions is whether governments should make the same shift.

(A defined benefit plan gives retirees a pension payments of a guaranteed amount, often with a cost of living escalator so the pension will rise with inflation.  A defined contribution plan places a certain amount in the employee’s retirement account during the employee’s employment, and the amount of the pension depends on how much is in the account when the employee retires.)

As the policy debate has taken place in recent years, governments have tried to move their workers to defined contribution plans, whereas workers — and especially the unions that represent government workers — have pushed to keep the defined benefit plans.  Which way is better?

Looking at Detroit’s bankruptcy and its likely aftermath, defined contribution plans may be better for government workers than the defined benefit plans they have fought to keep.  Why?  Because once money is placed in an employee’s defined contribution plan, that money belongs to the employee, whereas the defined benefit pension may not pay as much as was initially promised, if the government behind the pension doesn’t have the money to pay.  Detroit is not alone in its fiscal predicament.  Regardless of what happens there, government retirees in other cities will increasingly find their pensions threatened.

The unions for government workers that are working to retain defined benefit pension plans are working against the best interests of their members.  As the Detroit case shows, defined benefit pensions can be reduced if the issuing government does not have the funds to pay them, whereas defined contribution plans are safer.

The best way for governments to run defined contribution pension plans is for them to get out of the pension business altogether.  This is what unions should demand.  There are many private firms that run pension plans, and if governments contribute to pension plans run by private firms, the pension money is completely out of the government’s hands and is the property of the worker regardless of the fiscal condition of the government.

Government pensions are now threatened because of the greedy behavior of government employee unions in the past.  It was often easier to bargain for higher pensions than for higher wages, because higher wages must be paid now but higher pensions push the cost into the future, when the government officials who promised them will likely be retired themselves.  Workers and their unions bargained for larger pensions, and governments gave in because the cost of giving in would only come due in the future.  Now, the future is here, and the retirees who bargained for pensions in excess of government’s ability to pay them are finding out that those defined benefit pensions may not have been such a good bargain after all.

Defined contribution pensions are a fiscally responsible way for governments to run their pension plans.  It is now becoming apparent that they are also better for the government workers who will draw them.

Randall G. Holcombe is Research Fellow at the Independent Institute and DeVoe Moore Professor of Economics at Florida State University. His Independent books include Housing America: Building Out of a Crisis (edited with Benjamin Powell); and Writing Off Ideas: Taxation, Foundations, and Philanthropy in America .
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