San Diego’s $1.1 billion pension fund deficit has been blamed on deliberate underfunding of the city employees’ pension system, compounded by costly benefit enhancements for city retirees. But San Diego is hardly the only government employer with a big pension headache these days.

The much larger San Diego County retirement fund is underfunded to the tune of $1.4 billion. The state of California has seen its annual pension funding obligation rise from $200 million to $2.6 billion since 2000. And further afield, New York City’s annual pension cost has risen $1.3 billion in the last three years.

What all these places have in common is their reliance on a costly, complex and outdated defined-benefit pension model that provides government workers with guaranteed post-retirement incomes (plus health insurance) far exceeding what’s available to most private sector employees in similar occupations.

When San Diego’s Pension Reform Committee presents its options for digging out of the city’s pension mess, its recommendations should include a switch from the defined-benefit model to a defined-contribution retirement plan.

As its name indicates, the existing defined-benefit plan promises employees a set retirement benefit based on years of service and final average salary. To make good on this promise, the city must maintain a large pension fund heavily reliant on investments whose value can fluctuate with market cycles. If there’s any shortfall in this fund, the taxpayers are on the hook.

In a defined-contribution plan, by contrast, an employer promises only to annually deposit a specific sum, usually a percentage of salary, matching worker contributions to individual employee retirement accounts. The money in each worker’s account is managed by private firms and invested in a combination of stocks and bonds. The size of the ultimate retirement benefit generated by a defined contribution plan, such as the popular 401(k) account, depends on the amount of savings and investment returns a worker is able to accumulate. The downside risk of investment losses and the upside potential for investment gains are both shifted from the employer to the employee.

For decades now, a defined-contribution plan has been the retirement vehicle of choice for most employees of public higher education systems throughout the country, including California. A 401(k) plan has been in effect since 1997 for all new state government employees in Michigan. A defined-contribution option has been offered to Florida’s state and local employees for the past four years.

Sticking with the existing defined-benefit pension structure leaves cash-strapped government officials with a limited range of options, all of them bad. For example, Gov. Arnold Schwarzenegger has proposed a reform package that would bond out nearly $1 billion in pension obligations. It also would increase slightly employee pension contributions and roll back recent benefit enhancements for new workers.

But the California Legislative Analyst’s Office pointed out recently that switching to a defined-contribution plan could generate up to one-third more in savings than the governor’s proposal, while also providing much more fiscal certainty and stability for the future.

Even a comparatively generous defined contribution retirement plan in San Diego would cap the average cost for new employees well below the nearly 16 percent of salary the city will owe for current workers by 2008. Although existing employees could stay in the old system, the city’s pension costs would begin to drop sharply over the next 10 years due to natural turnover as new employees are hired under the new retirement system.

A defined-contribution structure would be a much better deal for San Diego taxpayers. For the first time, the cost of city employee retirement benefits would be absolutely clear and predictable in the city budget. It no longer would be possible for elected officials to cut deals with unions to sweeten pension benefits while hiding the expense in actuarially complex, off-budget pension funds.

A 401(k)-style plan would offer significant new advantages to workers as well. Benefits for public employees would finally be portable from job to job, between different levels of governments and across different jurisdictions, from public to private sector or vice versa.

By acting now to reform government pensions in a way that protects the interests of both employers and employees, city officials can make real progress in bringing these costs permanently under control � before another generation of San Diego taxpayers must wrestle with the consequences.

About the Author

E.J. McMahon

Edmund J. McMahon is Empire Center's founder and a senior fellow.

Read more by E.J. McMahon

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