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August 7, 2014

Of Pensions and 401(k)s

Before policymakers rush to reduce pensions for new employees or shift retirement plans from pensions to 401(k)-type accounts, they should take a crash course in “pensionomics.”

Replacing steady retirement income (a pension) with income susceptible to market downturns (a 401(k)) may create significant economic consequences, according to a report issued by the National Institute on Retirement Security.

That’s because traditional pensions have fewer costs than 401(k)-type plans and because spending by retirees with traditional pensions provides a steady, economically efficient boost to the economy even during economic downturns because the dollar amount of the benefit stays the same. In contrast, balances in 401(k)-type accounts can fluctuate with market conditions and may cause retiree spending to dip during economic downturns when the steadying impact of retiree spending may be most needed.

And pensions are an important part of supporting Virginia’s economy. Each dollar a pension retiree spends supports $1.18 in economic activity. Pension spending by state and local government retirees generates 40,838 Virginia jobs, which pay a total of $2 billion in wages and salaries. This doesn’t even include the large number of federal government and private pension benefits received by Virginia retirees.  

What’s more, state and local pension payments made to Virginia residents produced $927 million in tax revenue. This tax revenue is invested in our schools, roads, and communities.

Traditional pensions are also a highly cost-effective retirement solution because the retirement fund receives regular contributions over the course of a person’s career, providing many years of investment earnings. Finance 101 says that accumulation of investment earnings over a span of decades can be substantial. That means investment earnings make up the bulk of pension fund payments, not tax dollars. And for the small amount taxpayers do invest, there’s a big economic return. For every $1 invested over 30 years, they receive $3.30 in economic output.  

So why the interest by some policymakers in scaling back or ending traditional pensions for public employees? Because 401(k)-type plans shift the risk of underfunding the plan or lower-than-expected investment returns off of states and localities and onto their employees. But they do so at a high cost. Researchers have found pensions can deliver the same amount of retirement benefits at about half the cost of a 401(k) plan.

The Great Recession showed just how vulnerable our communities are to economic downturns. Now imagine if the thousands of state and local government retirees – teachers, police officers, and firefighters – also had their income subject to Wall Street’s nosedive. Surely the impact to Virginia’s economy would have been even worse. Let’s preserve the pension system that for decades has been providing stability to our retired workers and communities.

–Emily Uselton, Research Intern

The Commonwealth Institute

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