The SFA and HFA analyses present similar findings. The SFA report includes more detail, so it is the focus of the discussion below.
The SFA analysis assumes that the MPSERS defined-benefit plan would be closed to new hires, and that these new hires would be placed in a defined-contribution plan for public school employees similar to the Michigan State Employees’ Retirement System’s defined-contribution plan. As noted above, the MSERS defined-contribution system caps the employer’s annual retirement contributions at 7 percent of the employee’s payroll — an automatic contribution equivalent to 4 percent of payroll, with an employer match of any employee contributions up to 3 percent of payroll.
In a defined-contribution plan, such as MSERS’, the employer’s contributions are commonly expressed as a percentage of payroll and can therefore be compared to a defined-benefit plan’s normal cost and its payments toward unfunded liabilities, both of which are also expressed as percentages of payroll. As explained above, the annual normal cost of the pension is calculated by state actuaries and represents an estimate of the amount of money required to prefund the retirement benefits earned by employees in a given year, so that on the whole, if all goes well, their pension benefits are fully funded at the time they retire. Amortization payments toward unfunded liabilities are likewise calculated by state actuaries according to yearly payment schedules determined by a number of assumptions.
The 2009 SFA paper, reflecting on the state’s funding policies and actuarial assumptions, observed that aside from the relatively small costs to develop and administer a new defined-contribution MPSERS retirement system, such a system would cost more than the current MPSERS defined-benefit system in two ways.
- Normal Cost. The public school system’s annual payments to a defined-contribution plan would be higher than the current normal cost of the MPSERS defined-benefit plan, the paper observed. Using the MSERS system as a basis of comparison, the SFA paper found that the normal cost of the existing MPSERS defined-benefit plan is lower: 4.21 percent of payroll, rather than the 6.55 percent of payroll paid by the state to the MSERS defined-contribution system.[*] After adding a supplemental piece for pension benefits offered to defined-contribution members in special cases,[†] a defined-contribution retirement system would cost the state an additional $7 million in the first year, and the extra costs would increase significantly as more members became participants in the new plan.
- Initial Payments on Unfunded
The initial annual payments toward the unfunded liability in the MPSERS defined-benefit pension plan would rise once the plan is closed to new members, the paper stated. The increase would be due to the shift in accounting treatment that occurs when closing a defined-benefit plan.
When paying down any existing unfunded liability in an open pension system — that is, a pension system accepting new entrants — government accounting rules are generally interpreted to mean that employers should calculate their contributions as a level percentage of the payroll.[‡] As a result, the amortization payments on the unfunded pension liability of an open system are “backloaded” — as payroll increases over time, payments also increase, since these are calculated as a fixed percentage of payroll. This dynamic allows the amortization cost to be a lower percentage of payroll in the early years than it would be if it were paid in equal annual dollar amounts. The payment dynamic is reminiscent of a variable rate mortgage with a rising interest rate, where payments increase in the later years.
When closing a defined-benefit pension system, however, government accounting rules are usually interpreted to require that employers pay for the unfunded liability as a level-dollar amount each year, rather than as a percentage of an eventually declining payroll.[§] In comparison to the level-percentage payment schedule, this level-dollar method is “frontloaded” (though it is technically flat), generating a higher cash payment schedule in the early years. The SFA paper indicates that this level-dollar payment method for a closed MPSERS defined-benefit system would cost $208 million more in payments during the first full year in which the MPSERS system was closed.
The second of these issues — the immediate increase in the calculated payments on the plan’s unfunded liability — is the primary concern over closing the MPSERS defined-benefit pension plan to new public school employees and placing them in a defined-contribution plan. Indeed, this issue was raised even during Michigan’s 1996 state employee pension reforms, when the state closed its state employee defined-benefit plan, but not its school employee defined-benefit plan. According to a Dec. 5, 1996, article from Gongwer News Service, “Public school employees were given a late-hour reprieve from a similar [defined-contribution] plan when administration officials agreed to a compromise proposal that allows [school employees] to remain under the defined benefits system until the state pays off a $6 billion unfunded liability.”
It should be noted that the SFA’s $208 million first-year estimate for the increase in unfunded liability payments is probably no longer accurate. MPSERS unfunded liability has risen substantially since the report was written — from $8.9 billion in fiscal 2008 to $17.6 billion in fiscal 2010. This hike has increased the amortization payments and the likely gap between level-dollar and level-percentage accounting treatments.
[*] The MSERS figure is not quite 7 percent because some state employees do not take full advantage of the state’s 3 percent match.
[†] MSERS defined-contribution members are also offered pension benefits in case of death or disability, and employers set aside some money to prefund this benefit. See Summers-Coty, “Examining a Change from Defined Benefit to Defined Contribution for the Michigan Public School Employees’ Retirement System,” (Michigan Senate Fiscal Agency, 2009), 3, http://goo.gl/jnzaB (accessed May 8, 2010); State Employees’ Retirement Act, MCL 38.21-38.25, 38.27, http://goo.gl/2QRzQ (accessed Feb. 13, 2012).
[‡] As a practical matter, the percentage never remains the same from year to year; rather, it changes as the plan’s actual performance diverges in various ways from the initial assumptions the actuaries used to calculate the percentage. For instance, in fiscal 2007, the percentage of payroll that school districts were instructed to set aside was 5.70 percent; now, in fiscal 2012, the figure is 12.49 percent. “Employer Contribution Rate,” (Michigan Office of Retirement Services, 2012), http://goo.gl/xDLlk (accessed March 4, 2012).
[§] GASB rules on the method of amortizing the unfunded liability appear to be less clear than the common interpretation might suggest. See the discussion at “2) Freeze and Close: Maximize the Results.”