Demystifying “Transaction Costs” When Reforming Public Pensions

By Greg Lawson

Meaningful public pension reform requires a transition from existing defined-­‐benefit (DB) pension systems to defined-­‐contribution (DC) or hybrid (a combina-­‐mandated accounting changes resulting from closing a DB plan that then end up as frontloaded costs have often been used as an argument against reform. But Ohio lawmakers should not view transition costs as an insurmountable impediment to comprehensive pension reform. As has been seen in other states, transition costs can be mitigated through smart reforms that correctly interpret several standards set by the Government Accounting Standards Board (GASB). The dominant belief until now has been that GASB accounting standards dictate that essentially, this would mean that more taxpayer money is needed upfront in order to the practice used by open DB plans which amortize liabilities more gradually over time. Frontloaded costs due to level dollar amortization can total billions of dollars above baseline spending in the short run; thus, reform can appear costly at a time of already strained state finances.

Chart 1 : Level Dollar vs. Level Percentage Accounting

Source: Laura and John Arnold Foundation

Chart 1 is an illustration of the difference between level dollar (closed DB plan) and level percentage accounting (open DB plan). While both practices amortize identical amounts of liabilities, level dollar practices frontload these payments, creating transitioncosts.

But as new research from the Laura and John Arnold Foundation shows, the supposedly mandated switch from level percentage to level dollar amortization is incorrect. While pension system actuaries claim that closing out a DB plan mandates accelerated costs, GASB Statements 25 and 27 do not mandate a change in funding policy, only a change in financial reporting. A number of reform minded states have made this distinction and have found success in aggressively reforming their pension plans without encountering the burden of high transition costs.

Rhode Island and Utah

In November 2011, Rhode Island converted its DB retirement systems into a DB/DC hybrid. Despite the reduction of the DB plan, GASB accounting standards did not trigger level dollar amortization. Basically, transition costs do not apply. Unfunded liabilities continue to be amortized on a gradual, level percentage basis.

This holds promise for states looking to accomplish similar reforms. Even though a DB plan may be dramatically reduced, keeping a remnant of the plan open allows for a continued usage of level percentage accounting practices.

To close the remaining unfunded liability of the existing DB system, amortization payments are calculated
according to total employee payroll (all members in both the existing DB plan and the newly created hybrid), not just the remaining employees in the DB plan. Utah implemented this strategy in its hybrid reform
package of 2010 and has experienced no accelerated amortization payments.

Full Defined Contribution Plans

While Rhode Island and Utah have shown that transition costs can be avoided through hybrid plans, it is still possible to alleviate transition costs in full DC systems.

This again is made possible by applying amortization payments to all employees participating in the existing DB plan and the new DC plan.

Just as is the case with hybrid systems, GASB provisions do not dictate state funding policy, only financial
disclosure requirements. In the case of DC plans, liability amortization of a closed defined benefit pension
plan must be reported on a level dollar scale to follow GASB reporting requirements, but liabilities can be
funded independently of GASB recommendations. The less frontloaded level percentage amortization schedule can still be utilized as long as all employees are included in calculating the amortization cost.

The entire question of defined benefit pension amortization should be resolved shortly as GASB is scheduled to eliminate provisions of Statements 25 and 27. GASB never was intended to dictate state funding policy and it is now preparing to remove itself from that arena.

Pension reform is a separate issue from liability amortization. Therefore, changes in one do not necessitate variances in the other. The falsely assumed barrier of level dollar accounting practices for closed DB plans has spawned the myth of transition costs and has only served as an impediment for true pension reform for over a decade. When reform is structured correctly with amortization based on total payroll, states can pay down their remaining liabilities at a fiscally sustainable rate and still address their long-­‐term fiscal
challenges with defined-­‐contribution solutions.

Greg R. Lawson is the Statehouse Liaison and Policy Analyst with the Buckeye Institute where his policy brief was first published.

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