October 3, 2013
By Allison Schrager
State and local pension plans are underfunded, in many cases dramatically. Enough so that, in the next decade, many states will have to cut benefits or services, raise taxes, or receive some form of a bailout. Matt Taibbi’s latest in Rolling Stone blames the situation on a convenient villain — Wall Street. But it’s far more complicated than that. State and local plans are underfunded because of terrible accounting standards, local governments who underfunded their plans, and plan trustees who gave away sweeteners that robbed plans of their assets. That is the inherent problem with traditional pensions, or any type of compensation that is back-loaded (payments pledged for the future). It’s too easy to over-promise today and not set enough money aside, but either retirees or taxpayers eventually have to pay up. It’s tempting to blame Wall Street, but that does not solve the problem. It enables public employees to lobby against their own long-term interests.
Traditional pensions, called Defined Benefit (DB) plans, are supposed to protect workers. Workers are promised that a fraction of their highest salary will be paid to them upon retirement and for the remainder of their lives. Around their peak of popularity, in 1980, about 38 percent of private sector workers had a DB pension, but today fewer than 15 percent do. Nearly all public sector employees still have a DB pension. [EXPAND Read more]
By contrast, most people in the private sector finance their retirement with an account they manage themselves. They decide how much to contribute and bear the investment losses. If their account is up when they retire, they get a richer retirement. If it is down, they get a poorer one. The advantage of DB plans is that they spread investment risk across different cohorts. High-return cohorts subsidize the low-return ones. Everyone is protected from a poorer retirement by giving up the upside. If you adequately fund the plans it can be an efficient form of risk sharing.
The recent revelation of why Detroit’s plans ran into trouble is an example of how this can go wrong. When returns were very high retirees and workers were given bonus money. But this undermines the risk-sharing aspect of a DB plan. You can’t have certainty and upside without paying for it.
Giving away upside for free isn’t unusual in public DB plans. Wisconsin state employees and some Illinois teachers are offered two options when they retire. They can either take what they were promised, based on salary and tenure, or they can take what they would have earned if their contributions earned a market return (or in the Illinois case, the return plan trustees hoped to earn). According to pension economist Jeff Brown at the University of Illinois, when returns were high, many other plans increased the generosity of promised benefits. The problem is plans don’t cut benefits when the fund does poorly. This asymmetry undermines the health of the plan.
The pensions are also underfunded because states did not contribute enough to them. Each year public plans must make contributions to finance new obligations and part of their underfunded pre-existing promises. Even pre-crisis, just before May 2008, only about half of plans paid in what they were supposed to. About 44 percent of governments that underpaid did so because they faced legal constraints that kept them from contributing the full amount. It’s gotten worse since the financial crisis. When a municipality has more pressing concerns than paying pension benefits in ten years, the plans don’t get the money they need.
In spite of this, many plans claimed good financial health before the crisis. More recently, one-third of state plans claimed they have enough assets to pay 80 percent of their promises. But these estimates rely on the assumption that pension assets will earn at least 7 percent to 8 percent each and every year. All DB plans are supposed to smooth risk across retirees, but public DB plans are special because the taxpayer is on the hook if there’s not enough money. That extra guarantee has value. We pay insurance companies premiums to ensure we are paid no matter what happens. Taxpayers provide that same certainty, but the pension funds assume it’s free.
The guarantee from the taxpayer isn’t free because plans typically need money when the market is down. But it’s more expensive to raise capital or taxes in a bear market. If you account for the true cost of paying benefits in all states, the public plans’ underfunded liability may be as high as $3 trillion, three times what states currently estimate.
True, the finance industry had a major role in causing the financial crisis. Following the crisis, plans’ assets fell in value and the recession undermined the health of municipalities. But that’s precisely why it’s so important to put enough money aside when the economy is strong.
DB plans have the potential to be very valuable to workers. But in practice they create a number of bad incentives. Managing a successful pension requires long-term thinking, and an ability to both sacrifice for the future and account for risk. Many state and local plans try in good faith to do this, but others are tempted to offer up short-term gains and underfund. Private accounts have been demonized for exposing savers to more risk, but at least the assets are yours and the risk is transparent. For that reason they may be a better alternative for public employees. We learned from Enron that investing all your 401(k) assets in company stock is a terrible idea because the fate of your employer and your savings are tied together. But in some ways DB plans have the same problem. A well-structured individual account can offer better diversification and is always fully funded.
Public employees are counting on what they’ve been promised. Many of them don’t have Social Security to fall back on because workers in some states, often police and firemen, don’t pay payroll taxes and participate in the program. Their pension was presumed to provide adequate security. Blaming the financial industry instead of taking a hard look at what these plans really cost undermines the financial security of public workers. Because eventually some plans will run out of money and workers will face a poorer retirement. [/EXPAND]