Last Friday, after Senate Republicans temporarily gained control of the state Senate to pass an alternative budget, they also managed to pass a pension reform bill that would finally set the state on a path toward more sustainable retirement plans for state employees.

There are things to like and dislike from a taxpayer’s perspective. With bipartisan sponsorship, SB 6378 would do three things:

1) Eliminate the early retirement subsidy for state employees that allows early retirement with no penalty or reduced penalty;
2) Close the old defined-benefit Plans 2 to new employees and instead automatically enroll them in a hybrid pension plan with elements of both defined-benefit and defined-contribution plans;
3) Skip the unfunded liability payment for Plans 1 and use the money to balance the general fund. Fiscal impact: $146.9 million general fund,  $394 million total employer short-term “savings” for FY 2013; $472 million cost of repayment with interest over 25 years.

Currently a state employee with 30 years of work can retire early at age 62 without a benefit reduction, and may retire earlier with minimal penalties. This early retirement option was an extra benefit granted to employees in 2007 when the legislature attempted to repeal gainsharing (giving employees a share of “extraordinary returns” above 10%). It was essentially a trade-off in hopes that state employee unions wouldn’t get too upset about the gainsharing repeal, which didn’t work. The unions sued to restore gainsharing, but also sought to keep the additional early retirement benefit when a Superior Court Judge overturned the gainsharing repeal. The gainsharing lawsuit is still ongoing, and how this bill would affect that remains unclear.

The second major piece of the bill would close the defined-benefit pension plan that has been offered since 1977 to new hires. The defined-benefit plan offers a guaranteed benefit upon retirement, and is therefore the most expensive for taxpayers. If the existing employer and employee contributions and market returns are not sufficient to reach the guaranteed benefit, taxpayers must pick up the difference in the form of an unfunded liability payment. This is what has occurred with the state’s Plans 1, which were closed in 1977 after legislators figured out they would bankrupt the state if they continued to be offered to new hires. For the past decade, most new employees have been able to choose between either the state’s Plan 2 defined-benefit only plan or Plan 3—a hybrid which splits the retirement benefit between a defined-benefit portion and a defined contribution portion.

Defined contribution plans are retirement plans that are offered by most private sector employers, where employees have control and ownership over their own individual retirement account and are responsible for the higher or lower investment returns. Private employers began switching from defined-benefit to defined-contribution plans when they figured out that promising an employee a specific outcome 30 or 40 years down the road was impractical, expensive and altogether uncertain.

For more information on why defined-benefit plans are so gimmick-laden, see our September 2011 report on pensions in Washington.

The state actuary estimates the savings for closing the Plans 2 and removing the early retirement benefit to be more than $1 billion over 25 years, with about $624 million in savings going to the state General Fund and the rest to local governments. Savings continue to accumulate beyond 25 years, as the cost for closing the Plans 2 disappears entirely.

Because the phase out of the Plans 2 would occur at a time when the state is recognizing investment losses, the state actuary warns that the Plans 2 funded status would initially drop as a result of the phase-out. Unions and majority Democrats who don’t want the defined benefit plans closed can use this to try to derail the bill. As a result, politically what is likely to happen is the closing of the Plans 2 would be delayed until the cost is revenue neutral or entirely positive to the state—something that would probably not occur for a few years. Regardless of when the phase out would be implemented, however, once the initial closing costs are absorbed, the impact to taxpayers and the state budget is entirely positive.

The third portion of the bill would delay the Plan 1 unfunded liability payment for FY 2013. This is a payment necessary to backfill the too-generous promises made to state employees in this plan. Skipping this payment will “save” the state $147 million initially, which will be made immediately available to balance the state budget, but will cost the general fund an extra $174 million over 25 years to pay off.

The net affect of all three components of the bill—ending early retirement subsidies, closing the Plans 2 and skipping the Plan 1 payment for 2013—is $490 million in general fund savings and $176 million in local government savings over 25 years. As I noted earlier, however, beyond 25 years the savings from closing the Plans 2 only increases.

Overall, this is the first substantive pension reform bill that has gained any real traction in at least a decade. Most of the pension bills that have passed the legislature in the last ten years have been sweeteners for state employees that proved to be boons for their sponsors and boondoggles for taxpayers and the state budget.

Though we at the Freedom Foundation would be the last to condone the skipping of a required pension payment, if that is the price for closing unrealistic, expensive and gimmick-prone defined-benefit plans, we’ll call it the price of admission.