Now Is the Time for Pension Reform

Public pension retirement plans have been ornaments in state and local governments for over a century, yet the once popular and reliable benefit has become a liability to state and local employees and taxpayers alike. During the late 1990s, public pensions experienced funding shortfalls caused by market declines, funding holidays, and benefit increases. Today, these shortfalls have led to a $4.7 trillion unfunded liability.¹

This growing problem has not gone unnoticed. The Governmental Accounting Standards Board (GASB) sets accounting rules for states and municipalities, and in 2012 they made two significant changes to how the financial health of pensions is measured. The following year, the rating agency Moody’s changed the way it analyzes and adjusts pension liabilities as part of its credit analysis of governments. In 2014, GASB proposed new rules that would require governments to carry pensions on their balance sheets, which would ultimately make their overall financial position look worse.

While these two institutions are trying to incrementally shed light on the massive hole pensions have created in local and state governments, the courts are also weighing in on the discussion. In 2011, New Jersey passed legislation that would increase the state’s annual payments to its pension fund in exchange for higher employee contributions. A few short years later in 2015, the state experienced a budget shortfall, which triggered lawmakers to go back to their old ways and reduce contributions, as they had done in the past. The unions sued, arguing that legislation from years prior created a contractual obligation by the state to pay its required contribution into the pension fund. The suit ended up in the New Jersey Supreme Court, leading to a decision that the state does not have to put more money into the pension fund.

These well-established and once reliable aspects of state and local government employment are clearly in trouble, and have become the focus for many state and local lawmakers. The aforementioned events have brought public pensions into the limelight, but now it is time for states and local governments to act, protecting future taxpayers from bearing the burden of a broken pension system.

The Public Pension Predicament

There are approximately 90,000 state and local governments in the United States.² Most of these entities provide a defined benefit pension plan for public employees as part of their overall compensation. State governments employ 5.3 million people and local governments employ 13.8 million, with 14.2 million of those being full-time employees and eligible for a publicly-supported pension. According to a recent State Budget Solutions study, no state in the country is able to cover all of the pension payments it is obligated to make.²

Unfunded Pension Liabilities Nationwide

There are several ways to measure the severity of the problem, especially when making a national comparison among the states. While many look at the overall amounts of each state’s liability, those figures have limited relevance from a comparative perspective. The largest states with the largest government workforces will likely have the largest unfunded liabilities, as in fact California and Illinois do. A more useful gauge of financial health is the funded ratio, or the percentage of assets to liabilities. Evaluating states in terms of their funded ratios, Illinois, Connecticut, and Kentucky are revealed to be the most severely underfunded. Arguably the most alarming, however, is the total liability for every resident of the state. Since public pensions are the responsibility of all taxpayers, it is only fair to consider this metric when evaluating the states’ pension health relative to each other.

Accounting Methods Systematically Understate Pension Liabilities

Compounding the problem is how governments calculate their pensions. The most common way pensions are calculated is by a funding ratio – essentially, the investments held today relative to the benefits they must pay out in the future. This differs, however, because of the two types of accounting principles used when evaluating pensions. While the private sector uses Generally Accepted Accounting Principles, more commonly referred to as GAAP, the public sector uses the Governmental Accounting Standards Board, titled GASB.

When calculating pension valuation, the process is to assign a value today to employment benefit liabilities that will be paid years or decades in the future. Under the current GASB pension accounting rules, a public pension plan discounts its liabilities using the rate of return the plan assumes will be generated by the portfolio of assets it holds. Normally, the plan assumes a rate of return between 6 to 8 percent annually. However, during the 2008 Great Recession it became very clear that this was unrealistic. Even after the recovery, states cannot expect to meet these overly rosy expectations. Utah, for example, has calculated that it would have to commit 10 percent of its general fund budget for the next 25 years to pay for the effects of the Great Recession on its public pension plan.³

Because of this accounting discrepancy, economists and government officials alike have agreed that using the GASB accounting rules significantly underestimates the value of public pension plans. That is why State Budget Solutions and many other government watchdog groups calculate state pensions using a lower discount rate, or a lower rate of return than is assumed by the state governments. The logic is that the discount rate applied to a liability should be based on the risk of the liability itself, not of any assets used to fund the liability. Because public pension benefits are guaranteed by state constitutions and court precedents, they should be discounted using the interest rates that the markets pay on guaranteed investments, such as U.S. Treasury securities.

While some might feel that America’s public pension crisis only threatens retirees, it is in fact a problem that affects everyone. Taxpayers are on the hook for the legal obligation to cover the promised benefits of pension plans. State and local governments fund education, roads, health services, parks and recreation, and many other services that citizens use on a daily basis. Every dollar that is spent filling the gap in public pensions is a dollar taken away from other government services, and in some cases might also lead to tax increases. For example, states like Illinois and Connecticut have borrowed money to pay the required pension contributions, costing interest and lost investment gains.⁴ The current public pension system is truly broken, and that is why governments across the nation are starting to implement reforms.

Avoiding a Nationwide Pension Meltdown 

After the 2008 Great Recession, many states saw the likelihood of a default on their pension payments to current and future retirees alike. The discussion of reforming these plans has been at the forefront for many state and local governments.

The reform efforts that have been most politically palatable have generally consisted of amending retirement benefits for new employees.  Alaska started the trend in 2006 to implement a defined contribution plan for new employees, followed by Michigan in 2010, Utah in 2011, and Oklahoma just last year. Other states have been unable to reach this level of reform, but have been able to give new employees the option of a 401(k)-style plan, or they have enacted other measures, designed to lessen the risk of defaulting on pension payments.

Moving new employees to a defined contribution plan is a step in the right direction, but some states have not been as successful. Georgia, Nevada, Florida, New Jersey, Pennsylvania, and Illinois have seen legislation proposed this year to reform their public employee pension plans and none have been successful in their efforts.

It is clear that elected officials have their work cut out for them, but there it is not yet too late for states and municipalities to reform their current plans and avert what could very likely be a nationwide pension meltdown.

Moving to a Defined Contribution Plan

The most effective way to reform a state or local pension plan is to move all new and existing employees onto a defined contribution pension plan, which is similar to a 401(k) plan found in the private sector. For existing employees, the accruals from their defined benefit pension plan would be frozen and the amount placed into their new defined contribution account. If political pressures will not allow this move, then at a minimum, new employees should be enrolled in a defined contribution system.

From a budgeting perspective, moving employees into a defined contribution plan will allow governments more predictable contributions into the retirement accounts. Many governments know their total payroll and have projected these costs into the future. Switching to defined contribution plans would allow them to project retirement contributions the same as they do with payroll.

From a practical perspective, it is a good move as well because these plans are not subjected as many to accounting pressures or economic fluctuations. In times of budget shortfalls or when investment returns are not meeting expectations, employees do not have to rely on politicians to make payments into the plan. Contributions to employee retirement plans become routine and are essentially a fixed cost, such as it is with payroll. This depoliticizes employees’ retirement accounts, and therefore provides security for those public employees.

Other Reform Options

While the defined contribution system is far and away the most effective, other options are available for pension reform. If a state or local government wishes to keep its defined benefit pension plan, then the “Annual Required Contribution” must be paid in full each calendar year. Ideally, this would include triggers if the annual contribution is not paid, such as not paying for a discretionary budget item. When  determining their required contributions, states or localities could use more realistic rates, such as the treasury rate or the bond rate of the plan sponsor.

Closing loopholes is sometimes politically unpopular, but is another strategy for states and localities to consider if they are trying to limit their unfunded liabilities. For example, they could eliminate double dipping, or use base pay only when calculating the pension payout, negating overtime or longevity payments. Cost of Living Adjustments are frequently given to retirees and should also be ended. If a cost-of-living increase is necessary, then it should be tied to the consumer price index and not based upon legislative or political pressures.

Other incremental reforms would include raising the retirement age, increasing the vesting period, and capping the retirement benefits at no more than the final average salary.⁵

Hope Is Not Lost for Pension Reform

The future of public pension plans in America may seem bleak, but all hope is not lost. The problem is clear: promises made by legislators many decades are just not sustainable. Today politicians have the opportunity to change the trajectory of America’s pension crisis.

Now is the ideal time for lawmakers in cities and states nationwide to champion reforms that offer retirement security for current and future workers, while protecting taxpayers from crushing unfunded liabilities and ensuring that adequate funding exists for the many services upon which our communities depend.

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Notes and Sources

1. Joe Luppino-Esposito, “Promises Made, Promises Broken 2014: Unfunded Liabilities Hit $4.7 Trillion,” State Budget Solutions, November 12, 2014, https://www.alec.org/article/promises-made-promises-broken-2014-unfunded-liabilities-hit-4-7-trillion.
2. Robert Willhide, “Annual Survey of Public Employment & Payroll Summary Report: 2013,” United States Census Bureau, December 19, 2014, http://www2.census.gov/govs/apes/2013_summary_report.pdf.
3. The Economist, “American States’ Pension Funds: A Gold-Plated Burden,” October 14, 2010, http://www.economist.com/node/17248984.
4. Cory Eucalitto, “How to Prevent Future Pension Crises,” State Budget Solutions, November 1, 2012, https://www.alec.org/article/how-to-prevent-future-pension-crises.
5. Bob Williams, “Solutions to the Public Pension Crisis,” State Budget Solutions, August 1, 2012, https://www.alec.org/article/solutions-to-the-public-pension-crisis.