Investment-Based Transition Costs Associated with Closing a Public Defined Benefit Pension Plan

Abstract

Defined benefit retirement plans for state and local government employees are underfunded in most jurisdictions. Policymakers and analysts have proposed closing these traditional pensions and enrolling public-sector workers in defined contribution plans similar to 401(k) retirement plans. One objection to such a change is that once a pension plan is closed to new entrants it must adopt a more conservative, lower-yielding investment portfolio that will require higher taxpayer contributions. These higher contributions are referred to as transition costs and increase the cost of pension reforms. I analyze optimal investment portfolios for open and closed pension plans, showing that portfolio allocations differ only slightly and that these differences appear only over long periods. Thus, the actual transition costs associated with pension reforms are likely to be far smaller than has been claimed.