The University of California (UC) is implementing major changes to their retirement system to address its $12.1 billion unfunded liability, which has been cited as the driving factor behind recent tuition hikes.
The proposed changes include a cap on pension benefits and the possibility of offering a 401(k) defined contribution plan to new hires.
Looking at how UC got here is instructive. In 1990, the plan enjoyed a healthy funded ratio of roughly 135%. The decision was then made to stop making any contributions – employee and employer – and rely on investment earnings to keep the fund afloat going forward.
This continued for two decades. UC only resumed contributions in 2010 when over $6 billion in unfunded liabilities had accumulated and the plan was heading towards ruin, should they fail to act.
The fiscal irresponsibility, first in suspending contributions, and then failing to reinstate them until the very last moment, is staggering. As Moody’s declared, “employee and employer contributions are the bedrock of any defined benefit pension plan.” The American Academy of Actuaries (AAA) concurs, noting that contributions “should actually be contributed to the plan by the sponsor on a consistent basis.”
It should be noted that the spectacular decline in the health of UC’s retirement system occurred despite UC realizing an average annual investment return of 9% over those same 20 years, significantly higher than their assumed 7.5% annual return. Clearly, Moody’s and the AAA understand what is needed to keep pension systems in sound financial shape, while public pensions’ emphasis on investment returns over annual contributions is fundamentally flawed.
So why did UC behave so recklessly? Quite simply, public institutions have the exact opposite incentives necessary to manage a defined benefit system appropriately. The decision makers who authorized the funding holiday in 1990 are all long gone, and none of them will bear any of the cost for their actions. In fact, they all directly benefited from their profound mistakes.
UC regents and plan trustees, all being members of the retirement plan themselves, all saw their take home pay immediately rise as a result of their contributions dropping to 0%. Further, UC administrators saw millions of dollars flow back into their general budget, no longer designated for funding the retirement system.
Pete Constant, Senior Fellow at the Reason Foundation, finds that public pension systems are “actually a perverse system in which there is a win for the entire membership when pension board trustees are wrong!”
He notes that, “The risk associated with not meeting actuarial assumptions is borne entirely by the taxpayers…unfunded liabilities are generally amortized over long periods of time, spreading the associated costs across generations.”
This point is driven home by looking at the several recent UC retirees who are collecting base pensions of over $300,000 a year for life. While these former UC employees were fortunate enough to pay nothing, for at least 20 years of their careers, for such lucrative pensions, the cost is now being borne by an entirely new generation of students and taxpayers.
Further, current UC employees have seen their annual contributions rise dramatically, and new hires will be under a substantially reduced pension system themselves. In short, virtually everyone but the employee who received the benefits, or those who received that employee’s services, are now paying the cost.
UC’s decision to consider shifting new hires to a defined contribution plan is long overdue. In addition to the perverse management incentives and issues of intergenerational inequity outlined above, a shift to defined contribution plans would eliminate the long term liability to taxpayers, while offering greater flexibility and portability to employees.
As UC President Janet Napolitano said, “Pension reform needs to happen. It’s the responsible thing to do.”
Robert Fellner is the Director of Transparency Research at the California Policy Center.