How to Fix Government Employee Pensions

Across the United States, a large number of public employee pension funds face the serious risk of running into insolvency because politicians have promised millions of state and local bureaucrats far more generous retirement benefits than they are capable of paying.

Many of these politicians are more than willing to negotiate incredibly favorable contracts with the public employee unions that demand lavish pension benefits for their members in return for their political support. However, when it comes time to pay the bills associated with the deals they’ve made, these policymakers often turn to smoke-and-mirrors accounting tricks to hide just how far short they are in covering the costs of their largesse with taxpayer money. Some of their tricks include:

  • Exempting government employees from contributing a reasonable portion of their pay toward their public employee pension plans from which they will benefit.
  • Reducing the amount of money their governments pay into public employee pension plans by assuming the plans will regularly deliver higher rates of return than relatively safe investments provide.
  • Chasing after the high rates of return they need to make the pension solvent by compelling pension fund managers to invest in risky investments, some of which fail and create losses that they then try to recoup by investing in even riskier investments.

Half the states’ pension funds for state and local government employees today are less than 70 percent funded to pay the lavish retirement benefits they’ve promised, including several that are now so deep in the holes they’ve dug for themselves that several state and local politicians are seeking to be bailed out at the expense of taxpayers.

But not every public employee pension fund in America has been so badly mismanaged by state and local government politicians. Politicians in states as politically diverse as New York, South Dakota, Tennessee, and Wisconsin have demonstrated that it is possible to maintain a solvent pension fund for their public employees.

What’s their secret? Writing in National Affairs, Josh B. McGee explains:

Plans in each of these states are better than 90% funded at this point because policymakers have been proactive in adjusting important assumptions, closing funding gaps quickly, and developing risk-sharing mechanisms that can fairly adjust contributions or benefits as needed. These states demonstrate that it is possible to sustainably manage a defined-benefit pension plan.

McGee then gets to the bottom line of what it would take to fix the pension funds that have been subjected to both chronic overpromising of benefits and chronic underfunding by state and local politicians:

Fixing public-pension funding is not technically difficult, but in most jurisdictions, fully funding pensions at this point would require significantly higher contributions or reduced benefits (or both), making a solution politically challenging to achieve. However, failing to take meaningful action to close the funding gap will only make the problem more challenging and painful to fix in the future. No matter the scale of the problem, governments that work with their plans to craft workable solutions and begin down the path to full funding will be better positioned to weather the next downturn.

The recommendations of the Society of Actuaries Blue Ribbon Panel on Public Pension Plan Funding (SOA BRP) make a great starting point for policymakers who wish to tackle the challenge of pension reform. The SOA BRP’s most important recommendations involve investment-return assumptions and pension-debt amortization. The assumption plays a critical role in calculating the current value of promised benefit payments, and thus the adequacy of annual contributions to cover the cost of those benefits. The amortization schedule determines how quickly pension debt is paid off. Together with mortality estimates, the investment-return assumption and amortization policy are the most important elements of pension funding policy. Tightening rules around these three elements would dramatically improve the accuracy of public-pension cost estimates and help ensure the adequacy of annual contributions….

Given the importance of these assumptions in calculating plan cost, policymakers should remove as much subjectivity as possible from the choice of the investment-return assumption by explicitly linking it, in statute or ordinance, to the yield on United States Treasury bonds (i.e., the risk-free rate) plus some pre-specified risk premium, as recommended by the SOA BRP. Tightly constraining plans’ investment-return assumptions to more closely track economic conditions would eliminate the most significant source of cost underestimation, mirroring improvements that were put in place for private-sector pension plans with the passage of the Pension Protection Act in 2006.

Making public employee pensions work more like private-sector pension plans is essential for their rescue. It’s a lesson that was recently demonstrated in Houston, Texas, which took action in 2016 to reform its underwater public pension plans by reducing its pension promises to a more sustainable level while boosting contributions to its pension funds with taxpayer support.

Houston’s template is one that ought to be followed in every jurisdiction with public employee pension plans that have no realistic path to becoming solvent as they are currently managed. Unlike the bailout path preferred by irresponsible policymakers, reforming public employee pensions to incorporate more realistic assumptions for how their pension funds should be managed is the only approach that protects the interests of the taxpayers who are ultimately the ones who pay to compensate their community’s public employees.

Craig Eyermann is a Research Fellow at the Independent Institute.
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