In 1997, Michigan took the largest step among the states in public-sector pension reform by closing its state employees' retirement system to new members and instead offering new workers matching contributions for their own retirement accounts. A new analysis showed that this has mitigated the state's pension underfunding problems and provided annual cost savings to the state. But more importantly, it's changed the way politicians treat retirement funding. The state reforms are a model for the rest of the country.
The biggest problem in dealing with public-sector pensions has been that politicians can easily put off the costs for paying for them. But politicians in Michigan haven't missed a single payment to its defined-contribution plan, nor have they played around with its contributions since inception. While the state's pension plan was fully funded when it was closed in 1997, it developed an unfunded liability afterward. Thanks to the reform, the problem was much smaller than it would otherwise have been. The analysis found that the state's unfunded liability would have been $2.3 billion to $4.3 billion higher had Michigan not closed the defined-benefit system. That means that the system's current $4.1 billion unfunded liability could have been double without reform.
In addition, the plan was structured to be slightly less expensive. The costs (under the state's generous assumptions) to prefund pension benefits earned in a year averaged 8.1 percent of payroll, while the state's employer contributions were 6.2 percent of payroll. This saved the state $167 million since the switch -- not a trivial figure for a state that's been a national leader in tax hikes.
The political rate of return on a well-funded pension plan is pretty low. It's also been tempting for legislators to vote for permanent increases in pension benefits during good times: They can score points now while costs are borne by taxpayers years in the future. In addition, there are few political incentives for funding the defined-benefit plans conservatively: Any dollar saved for future pension costs is a dollar that can't be spent today. Michigan's defined-contribution plan, in contrast, has been essentially unadjusted since its introduction.
These reforms led Michigan to save billions in its pension system. Other states should follow its lead.