In “How to Dig an Even Deeper Pension Hole,” published by the New Jersey Policy Perspective, Stephen Herzenberg, executive director of the Keystone Research Center, says phasing out the state’s traditional pension plans and replacing them with 401(k)-type accounts would burden taxpayers with transition costs currently estimated at $42 billion and fail to reduce the state’s unfunded pension liability. In addition, moving employees from defined benefit (DB) to defined contribution (DC) plans has failed in three states that have tried it and was rejected by 13 other states after research concluded that the change would hurt taxpayers and pension recipients, the report observes.

Herzenberg explains that numerous studies suggest such transitions reduce the rate of investment returns on the current pension plans’ assets, which increases the unfunded liabilities and can saddle taxpayers with billions in additional costs. He came up with the transition costs of closing the DB plan in New Jersey’s using studies conducted last year in Pennsylvania. “Actuaries in Pennsylvania estimated the cost of moving from a DB to a DC pension system at $42 billion. New Jersey could expect to incur similar costs, based on the similarities of the two states’ current plans,” he says.

According to Herzenberg, the reasons for high transition costs are straightforward. Pension fund managers rely on investment returns to pay for two-thirds of retirement benefits—twice the amount covered by employer and employee contributions combined. But, closing DB plans to new employees cuts off the flow of long-term investment funds from young workers, thus reducing the overall rate of return. Achieving less robust returns would drive up the amount public employers—hence taxpayers—must pay to cover current pension commitments.

Herzenberg further explains that most DB plans have a balanced mix of young, middle-age and retired members. Plans with multi-aged investors allow managers to diversify their portfolios over a long investment horizon, investing in some high-risk, high-return investments (such as stocks or private equities), as well as some low-risk investments that have lower returns (such as bonds). In DB plans that no longer accept new employees, existing plan participants gradually age and the plans’ investment horizons shorten. As a result, investment managers must shift plan assets from higher-return to safer assets—just as individual investors approaching retirement shift savings away from risky assets to protect themselves against market drops shortly before they start to withdraw money. The shift of pension funds to lower-return assets reduces investment earnings.

In addition, he says, without new employees entering the pension system, an increasing percentage of DB recipients will age out and retire. As this happens, more and more of the funds remaining in the plans must be removed from non-liquid assets, such as private equities, and invested in liquid assets that are easy to convert to pension checks for retirees. This shift to more liquid assets will also lower the rate of return.

Herzenberg notes that studies in 13 states that have considered a switch to DC plans have reached an actuarial consensus that closing a DB plan lowers investment returns and increases unfunded liabilities (see “Report for New Hampshire System Finds Switch to 401(k) May Be Costly”).

He also points out that 15 years after adopting a 401(k)-type plan, West Virginia reversed course in 2006, reopening its DB plan to all new hires and allowing the members of the 401(k)-type plan to switch into the DB plan. Michigan began enrolling all new state employees in a 401(k)-type plan in 1997. Since then, the system’s unfunded liabilities have skyrocketed from $697 million in 1997 to $4.1 billion in 2010. Alaska adopted a 401(k)-type plan for new state and public school employees effective in 2006. The unfunded liabilities associated with the closed DB plans have increased from $3.8 billion in 2006 to $7 billion in 2011 (the latest year for which data are available).

According to Herzenberg, beyond the transition costs of switching to DC plans, research and experience show that DC retirement systems are much less efficient and cost-effective than DB pensions because they deliver lower investment returns, experience higher administrative costs, assume higher financial management and trading fees, and incur higher costs because they do not pool “longevity risk.”

Herzenberg says there is no flaw in the basic design of New Jersey’s defined benefit pension plans, as long as these are managed well. Nor are the Garden State’s pensions—which average about $26,000 per year per retiree—overly generous. “New Jersey’s pension system is seriously underfunded primarily because the state has persistently failed to make required contributions,” he writes.

He admonishes the state to focus on improving how it manages its DB plans, starting with complying with the 2011 law requiring the state to phase-in full funding of these plans.

The report is here.