When pension plans are struggling with solvency, a common proposal is to close the pension plan. However, only a few large public sector pension plans have ever been closed to new hires, leading to a mixture of mistaken ideas about both the positives and negatives related to switching from the status quo to a new kind of benefit design. Closing a pension fund does not solve the problem of existing unfunded liabilities; but at the same time new members are not needed to keep a pension plan solvent. The case studies linked to below explore why Michigan closed its pension plan for state employees in 1997, and what the outcome has been.
In short, closing the Michigan State Employees Retirement System (MSERS) in the late 1990s has allowed the state to avoid at least $1 billion in unfunded liabilities that would have accumulated due to underperforming investment returns since then. But the mismanagement of funding policy has allowed for pension debt to accrue that never should have happened in the first place.
Mishandled Funding Policy
Michigan maintained an 8% assumed rate of return until 2017, which proved to be overly optimistic. Payments into MSERS were predicated on that investment return assumption and thus had been less than necessary. To make matters worse, over the past two decades the state has sometimes skipped payments, used the amortization schedule to backload costs, and was very slow to update other actuarial assumptions too, such as the payroll growth assumption (which ignored the state’s declining population).
As a result, the 100% funded pension fund in 1997 has developed several billion in pension debt on its existing members, even though it is closed. This is a warning to any state considering a similar choice — closing a pension fund does not eliminate the need for sound funding policy.
Closing Plan Has Helped Avoid Even Larger Debt
However, Michigan is actually still in a better place than if they hadn’t closed the pension fund for state workers. A common misconception is that pension plans need new members to finance the benefits of the retirees, but because pension funds are supposed to be pre-funded, this is not true. New members do mean additional contributions, but they also mean additional liabilities.
Had new members been allowed to join MSERS, those additional promised benefits (accrued liabilities) would have accumulated pension debt (unfunded liabilities).
The story of Michigan mishandling the closure of MSERS highlights the real pros and cons related to switching from an existing pension plan to some other retirement benefit structure:
- Closing a pension plan does not eliminate any existing debt nor prevent the possibility of future debt from accruing. All promises made have to be honored and funding policy must be maintained in a way that allows for those promises to be kept. Closing a pension plan is not on its own a silver bullet to solve sustainability concerns.
- At the same time, the problem for MSERS has not been a lack of new members. MSERS has seen its solvency slip because of a lack of state contributions along with leaving the assumed rate of return too high for too long. New members would have meant additional promised benefits that would have meant today’s unfunded liability for MSERS being higher.
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