By the Editor
Introduction
There are hundreds of public pension plans across this country run by states and various local government entities covering a range of public employees. Many of these pension plans are in terrible shape. These problems have been brewing for a long time and the challenge is daunting. By one estimate, the unfunded liabilities related to these pension plans is over $12,000 for every man, woman, and child in the U.S. A multitude of factors are driving the current crisis in public pensions, but the core of the problem boils down to overly optimistic assumptions about future costs combined with a failure to adequately fund those pension obligations.
These issues are compounded by a lack of transparency and conflicts of interest in the political system. It is only a matter of time before these problems come home to roost, leading to a combination of massive tax increases, significant cuts in public services, or reductions in benefits. This challenge has been years in the making, so the solutions must include fundamental reforms.
Overly Optimistic Assumptions and Funding Shortfalls are the Main Problems
Pensions are by their nature very long-term programs, spanning the careers and retirements of their members. To quantify the cost of these long-term promises, the plans make a variety of assumptions ranging from the life expectancy of pensioners to cost of living adjustments. But the most important assumption is estimating the value of future payouts in today’s dollars and how those amounts relate to estimated investment returns on pension assets. In making these estimates, public pension plans are using assumptions that are far too aggressive.
This seriousness of this error is demonstrated by comparing these assumptions to those used by more highly-regulated private pension plans. State and local pension plans tend to make overly optimistic assumptions about their ability to earn investment returns on their invested assets, typically assuming around 7% per year in earnings, and also use these relatively high rates to discount the future value of pension payouts back to today’s dollars. The higher the discount rate used in the calculation, the lower the net present value of the liability. Because pensions are paid over such long periods of time, the selection of a discount rate can make a big difference in correctly calculating the amount of the future liability in current dollars.
Private pension plans tend to use much lower discount rates than public pensions. What is the right rate? Financial theory says future cash flow obligations should be discounted at a rate reflecting the creditworthiness of the entity making the payments. In the case of public pensions, the relevant government entity is obligated to pay the pension expenses. This indicates that a rate closer to the risk-free debt rate of 2-3% would be appropriate.
Over long periods of time, the difference between a 7% rate and a rate of 2.5% has a huge impact. The Hoover Institution recently analyzed 619 state and local pension plans and found that they reported unfunded liabilities of $1.7 trillion using a rate of about 7%. Using a more appropriate “market-based” discount rate of about 2.5% results in total unfunded liabilities of $4.1 trillion.
Exacerbating the problem of overly rosy assumptions is a failure to set aside enough funds to cover pension promises. The Hoover Institution looked at pension plans across the nation and found that these plans had set aside only about 48% of the current value of pension liabilities calculated using the appropriate “market rate” of about 2.5%. Even based on the more optimistic rate of about 7% used by public pension plans, pension assets were only 74% of the net present value of nationwide public pension liabilities.
The problem varies widely by state and locality. Illinois is the poster child for poor pension management. According to a recent calculation by The Hoover Institution using the more aggressive discount rate of about 7%, Illinois had set aside assets covering about 46% of the current value of its public pension liabilities. Using the “market rate” of around 2.5%, Illinois’ pension assets amounted to only 33% of the net present value of pension liabilities.
There are plenty of other states with pension plans in trouble. According to a recent analysis of public pensions from the American Legislative Exchange Council, 32 states have liability funding levels that fall below the 80% threshold that private plans must meet to avoid being considered “at risk” of defaulting on their pension obligations. And these calculations are based on the more aggressive discount rate assumptions of about 7% used by public plans.
Structural Issues Also Contribute to Pension Challenges
Structural factors, including a lack of transparency and conflicts of interest in the political system, are also important drivers of the current public pension crisis.
Politicians interested in getting re-elected have an incentive to defer tough decisions and funding requirements into the future. The complexity of pension accounting combined with the long-term nature of pension liabilities means it is relatively easy for politicians to obscure the real cost of future pension obligations. Because the assumptions play out over such a long period of time, even small adjustments to assumptions can make a huge difference in the calculation of the current value of future obligations.
There has been a lack of adequate disclosure of the true scope of pension liabilities, as well as the underlying assumptions used to value future pension promises. If taxpayers don’t clearly understand the status and cost of public pensions, it is difficult for them to hold politicians accountable for their management of these plans.
The political process itself creates a conflict of interest in pension negotiations with public sector unions. Politicians are supposed to represent the taxpayers in these discussions. However, politicians have very little motivation to take a firm stance over pension costs. After all, it’s not their money. At the same time, public sector unions and their lobbyists are large contributors to politicians who then have an incentive to accommodate union requests. In the resulting negative feedback loop, politicians receive contributions from public sector unions and, in return, work to increase their pension benefits.
The political influence of public sector unions has also contributed to another impediment to healthy public pension reforms: many of these plans now benefit from protections in state constitutions and other laws that inhibit changes to pension plans.
Proposals for Pension Reform
For pension reform to be effective, it should address these core issues, from overly aggressive assumptions and funding shortfalls to a lack of transparency and conflicts of interest.
Improved Assumptions and Funding Requirements
To correctly value long-term liabilities, it is very important to use appropriate assumptions. Getting this right is one of the most critical elements of pension reform. Private pensions provide a good model to follow. Prior to the 1970s, many private pensions were seriously underfunded and ran into significant trouble meeting their obligations. Starting in 1974, a series of reforms were implemented that significantly improved the health of private pensions. Public pensions would benefit from adopting some of these reforms.
For example, private pensions were required to calculate the present value of their pension obligations using discount rates that reflected the underlying credit risk of the companies making the pension promises. For public plans, adopting this standard would mean using a “market rate” of around 2.5%, reflecting the fact that public pensions plans are backed by governments and supported by broad taxing power. This would not change the payments due over time, but would increase the reported pension liability amount, providing a more accurate picture of the situation.
More accurately calculating the actual liability is a helpful step to the next logical reform: better funding of pension plans. Private sector pension plans implemented more stringent funding requirements and were able to significantly improve the funding status of their plans as a result.
Ideally, this reform would mean implementing requirements to set aside funding for the current value of future pension payouts as those benefits are earned, plus enough to pay down existing unfunded liabilities over a reasonable period of time. The result would be an increase in current taxpayer contributions, but a policy of funding benefits as they are earned is a fairer approach than deferring the cost of today’s promises to future taxpayers. Funding benefits as they are earned would also help taxpayers and politicians evaluate the real cost of pension compensation in the context of other budget priorities.
Fairer Risk Sharing Between Pensions and Taxpayers
The vast majority of public sector pension plans are defined benefit (DB) plans rather than defined contribution (DC) plans. Under DB plans, the state and local entities make promises to pay certain benefits to pensioners and bear the financial risk of finding investments to generate sufficient returns to fund those payments. This arrangement shifts all the investment risk to the taxpayers. In contrast, DC plans simply make a certain amount of contributions into their members’ accounts and the pension members bear the investment risk over time.
Because DB plans are inherently riskier for taxpayers and harder to manage and understand, public pension plans should be transitioned to DC plans to reduce these risks. Moving from DB plans to DC plans would also eliminate the problems of projecting the amount of future benefits and choosing the appropriate discount rate to calculate the present value of long-term pension liabilities. Once a contribution is made into a DC plan, the government’s obligation is satisfied.
Many private pension plans have transitioned to DC plans for these reasons. In the private sector, only 4% of employees are covered by pure DB plans, while an additional 13% of private sector workers have access to plans that are hybrids of DB and DC plans. On the other hand, 94% of public sector workers have access to DB plans where taxpayers bear all of the investment risk related to pension benefits. Transitioning public employees to DC plans would put public employees on a more equal footing with most private employees who must bear the investment risk related to their own retirement plans. Public sector workers should not get a better deal than the private workers whose taxes fund public pensions.
Finally, the simplification inherent in DC plans would mitigate the problem of politicians’ conflicts of interest as negotiators of pension benefits because DC plans would focus the negotiations on the amount of the annual contribution, a much easier process for taxpayers to understand. For pension participants who want more certainty in the amount of their future pension benefits, the plans could include options for pensioners to use their pension funds to buy fixed annuities at a market price.
Many participants in public pensions are protected by laws that restrict changes to their pension benefits. However, in most cases, changes are allowed for benefits related to new employees and adjustments in future benefits that have yet to be earned by existing employees. So, while a wholesale transition to DC plans may not be feasible for all plans, most plans would allow a partial transition for new hires and for future benefits that have not yet been earned by existing employees. Puerto Rico used this approach to reform its troubled pension plans as part of its recent debt restructuring.
Reforms to the Pension Negotiation Process
The process of negotiating public pension benefits is fundamentally flawed, with pernicious conflicts of interest affecting politicians who are charged with representing taxpayers but are often unduly influenced by the significant political contributions from public sector unions. To reduce these problems, state and local governments could insert independent third parties into the pension negotiations.
For example, an independent third party such as an insurer could be tasked with deciding the appropriate discount rate to use in valuing future pension obligations. Based on discussions with the pension plan negotiators, the government entity could provide all the other assumptions necessary to project future pension payouts, producing an “assumed annuity”. The private insurer would agree to assume a modest (e.g., 2%) pro rata tranche of the “assumed annuity” in exchange for a lump sum payment calculated using the suggested discount rate, plus a profit margin. This would be a way for the insurer to stand behind the validity of their discount rate assumption.
Similarly, government entities could use other third parties to provide market-based validation of certain pension assumptions, such as assumed inflation or mortality rates, by having the third party take on a small tranche of this risk in exchange for a price. Some critics may object that this approach would increase costs because the third parties would earn a profit margin on their small tranche of a pension’s plan’s risk. But the value of improving the accuracy of assumptions would likely more than offset this cost. The use of market validation would also be helpful in reducing the ability of politicians to manipulate assumptions to appease public sector unions.
Improved Transparency
It is hard to manage what you cannot see. In the case of public pensions, a lack of transparency has contributed to a misunderstanding of the scope of the problem. Enhanced disclosure requirements should be adopted to address this issue. Disclosures should include a clear explanation of all assumptions and projected cash flows used in the calculation of pension liabilities, the annual cost of future promises, and historical and projected investment returns. In addition, pensions should disclose the value of pension benefits for the average beneficiary and for beneficiaries grouped by quartile. This information should be publicly available and sent to taxpayers on an annual basis in an easy to understand format.
The federal government should work to move states in the direction of increased pension transparency. For example, one bill proposed by the House of Representatives in 2018 would have required increased pension disclosures in order for states and localities to qualify for the federal deductibility of interest on the bonds they issue.
Public Pension Reform Needs a Comprehensive Approach
Some factors are more important than others in driving the public pension crisis, but there is no single source of the current pension problems. Ideally, pension reform should be comprehensive to maximize its effectiveness. There is a long list of other changes that can be implemented to improve the health of public pensions including raising the retirement age for pension eligibility, capping salary levels that count toward pension benefits, prohibiting “double dipping” among different pension plans, and limiting cost of living adjustments.
Conclusion
All across our country, many public pension plans are in dire shape, laying the groundwork for a crisis in the future. Without fundamental reform, shortfalls in pension funds will result in a combination of cuts in essential public services, tax increases, or reductions in benefits. Eventually, this could lead to taxpayer flight, further weakening the tax base. Ignoring this problem is not fair to pension participants nor to future taxpayers. Due to the size and complexity of these problems, there is no quick fix. The solution requires serious fundament reform, the sooner the better. When considering this challenge, it is instructive to remember an old Chinese proverb: “The best time to plant a tree was 20 years ago. The second best time to plant a tree is now.” It is time to get started on public pension reform.