California should follow Michigan’s lead on pensions

By David Schwartzman
July 17, 2017

California’s previous attempts at pension reform have had a negligible impact. We should look to solutions from other states to tackle our growing pension problem. Last week, Michigan Governor Rick Snyder signed a landmark school pension reform bill that will cap the growth of pension liabilities. California legislators need to follow Michigan’s lead to save its pension funds from insolvency.

To lower future pension costs, the California Legislature passed the California Public Employees’ Pension Reform Act of 2013 (PERPA). PERPA slightly lowered pension benefits for some new employees, but did not make enough of a difference. According to the California Public Employees’ Retirement System (CalPERS), PERPA generated at most $15 billion in present value savings. This barely makes a dent. According to one of our previous reports, California has $713 billion to $1.02 trillion in unfunded pension liabilities.

Meanwhile, the Great Lakes State’s pension reform bill seems likely to save Michigan Public School Employees Retirement System (MPSERS). What’s new about Michigan’s law is the choice it offers to public employees. The state will auto-enroll new hires into a defined contribution plan with a 10% default contribution rate. The defined contribution plan will guarantee all employees retirement income, while currently, only half of school employees get a pension. Michigan’s defined contribution plan expands access to pensions without creating unfunded liabilities for taxpayers.

But Michigan doesn’t force employees into a 401(k) style plan. Employees have the ability to select a new “hybrid” plan, which is a defined benefit plan using a more realistic 6% targeted rate of return. The hybrid plan commits beneficiaries to split the costs of underfunding 50-50 with their employers. The retirement age in the hybrid plan could rise depending on life expectancy and levels of unfunded liability.

To keep the pension plans safe, the hybrid plan has a mechanism that triggers closure for new hires if the funded ratio goes below 85% for two consecutive years. The plan also helps teachers by increasing employer contributions to pensions. If teachers put 3% of their salary towards their pensions, their employer will put in 7%. Michigan’s plan allows choice, but both choices it offers new teachers ensure the health of the pension system.

Michigan is not alone. Florida and Pennsylvania have also moved towards defined contribution systems. South Carolina, Arizona and Kentucky have embraced pension reforms as well. But Michigan’s plan essentially eliminates the possibility of large unfunded pension liabilities for future employees. Michigan is taking steps to address previous liabilities as well. In Michigan’s budget is a $200 million contribution,  towards the school system’s existing pension obligations, covering about 0.7% of the $29.1 billion unfunded liability.

California has a difficult battle with pension liabilities ahead. Currently, CalPERS’ pensions are about 68% funded, down from 111% twenty years ago. Federal standards say that plans at 65% funding or below are in “critical status”.  But California is not the only state with pension issues. Michigan’s public school pension system is 60% funded. Pennsylvania’s system is 56% funded as of 2015. Kentucky’s pension system has $31.2 billion in unfunded liabilities and is only 37.4% funded. However, the difference between California and these other states is they have recognized the depth of their pension woes and have taken meaningful legislative action to address them. California should act now to avoid the fate of Illinois, which faces a rating downgrade to junk levels (its pension system has $119.1 billion in unfunded liabilities and is only 40.2% funded as of 2015 because of its refusal to institute reform). California legislators should move to minimize damage and protect pensions for future employees before their state ends up like Illinois.

California doesn’t necessarily have to move fully to a defined contribution system for successful pension reform, as Michigan shows. Michigan’s plan provides a long-term solution to the pension problem. Such a plan would allow California to concentrate on paying down current obligations without worrying about incurring them for future employees. Importantly, such reform would ensure that the current pension crisis would be the last one California faces. The solvency of the pension system wouldn’t be in doubt after every market downturn. If current pension problems are resolved, a Michigan-style plan ensures that there are few, if any, unfunded liabilities in the long run.

Other states have shown that pension reform is not some impossible dream––it is politically achievable. Defined contribution plans have a place in the public sphere just as they do in the private sector. Pension reform for California is not extreme, it is necessary, and as Michigan shows, it is possible.

David Schwartzman is a Policy Research Fellow at the California Policy Center. He is a rising senior studying economics, mathematics, and finance at Hillsdale College.

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