Public Sector Pensions: 'Their Accounting Makes Enron Look Good'Published: September 26, 2012 in Knowledge@Wharton
The growing debt crisis in public sector pensions -- governments face a $757 billion shortfall in funding their retirement promises, according to one estimate -- is coming at a time when unprecedented numbers of baby boomers are reaching retirement age. About 10,000 members of that generation are turning 65 every day, according to the Pew Research Data Center.
In better-funded pension plans, the slew of retirements is a blip on the radar, a demographic shift that was foreseen decades earlier and properly funded. But in shakier systems, the retirements are being met with cuts to benefits across the board -- for new employees, current workers and retirees alike -- benefits that were once considered cast in stone. A generation of workers is now wondering if their pensions will still be able to pump out the funds they need to pay the bills in retirement.
"That's a very common worry, and it's wholly justified," says Olivia Mitchell, a professor of business economics and public policy, and executive director of Wharton's Pension Research Council. "I think the whole prospect of retirement has grown much riskier than for those in previous generations. Employer-provided retiree medical plans are being cut; Medicare as we know it is facing insolvency. People hoped to retire on their little bit of savings that now is paying no interest, and Social Security is in bad shape. Homes aren't worth what people thought they would be, so nest eggs are a lot tinier.... It's not a very pretty picture for a lot of people."
Distributing the Pain
In defined benefit pension plans, retirees are paid a fixed monthly amount every month until they die. Often the payments are subject to cost-of-living raises, and most plans include a survivor's benefit if the employee's spouse outlives him or her.
A defined contribution plan, like a 401(k), shifts the retirement risk to the employee. Employers allow workers to contribute a percentage of their salaries to the plan, and often match the contributions up to a certain threshold. The plans are more portable than pensions, allowing workers to move their investments as they switch jobs, but it is up to the workers to save, manage their investments and then make sure their nest eggs are sufficient for their retirement years.
Defined benefit pensions are generally confined to the government sector now, as most private sector employers long ago abandoned them for defined contribution plans. But many state governments are currently facing pension funding obligations that are forcing lawmakers to consider making changes. The rule -- sometimes unwritten and at other times constitutionally codified -- had been that pension plan changes are limited to those who have not been hired yet, or to employees who are early in their public sector tenures.
"You don't like to change the rules of the game for those who don't really have the ability to adjust. It's particularly painful to make changes to people who are in retirement already or approaching retirement," says Alicia Munnell, professor of management sciences at Boston College's Carroll School of Management and director of the school's Center for Retirement Research. "It is a worrisome thing to do."
But that's exactly what happened in Rhode Island. In 2011, the state created a defined contribution system similar to a 401(k) plan and forced all its current employees to enter into a system that blended the two plans together. Cost-of-living raises for retirees were also suspended for five years.
In other states, retiree costs are being managed by creating new, cheaper pension plans for new employees. In some cases, premiums are being driven up for retiree health care, which is generally not given the same protection as pensions.
But the Rhode Island reforms -- which are being challenged in court -- are seen as a template for other cash-strapped states to model, giving rise to more fears that pension systems may not be as unshakable as once thought. "Any change will hurt," Munnell says. "If you were counting on your pension and the value is reduced, it can be a painful adjustment."
Munnell also notes that the math in Rhode Island allowed for few options. By Pew Center estimates, the state had only 49 cents on hand for every dollar owed to its retirees in 2010. In some cities, the shortfall was even deeper. "The funding situation was so serious that if something wasn't done with pensions, all the money would go there," Munnell notes. "You wouldn't be able to have things like libraries or buses. When it gets that dire, you have to distribute the pain broadly. It's not fair in some sense to take away existing benefits, but when you're really suffering, you have to do things you wouldn't normally."
Worse than Enron?
The decisions that led to today's crossroads began decades ago.
For most plans, a secure funding model with relatively low risk was never adopted, according to Kent Smetters, professor of business economics and public policy at Wharton. Instead, politicians allowed the funds to broaden their investment policies beyond government-backed bonds and at first dabble, then fully immerse themselves in, the stock market and progressively riskier investment vehicles.
That allowed the plans to expand their retirement benefits while, at least on paper, requiring no more funding from the governments whose workers they served.
Smetters argues that the most grievous pension funding error over the years has been assuming an unrealistically high discount rate, or the rate at which funds can discount their future liabilities. Also referred to as a fund's annual rate of return on its investments, most funds assume a 7.5% return on the low end and 8.5% on the high end. Many economists argue the fund liabilities should be discounted at a rate closer to 3% or 4%.
Those assumptions open the funds up to higher levels of investment risk and dramatically understate the liabilities owed. According to the Center for Retirement Research at Boston College, public pension plans have on hand about 76 cents for every dollar they owe retirees. Under more conservative accounting standards proposed by the Government Accounting Standards Board -- an independent, seven-member nonprofit board that sets generally accepted accounting principles for the public sector -- that figure could drop to 57 cents on the dollar.
"State and local pensions are not covered under any reasonable accounting standards," Smetters says. "Their accounting makes Enron look pretty good."
Private pensions offered by corporations have their own shortfalls, too, estimated at around $500 billion, according to the Pension Research Council. Indeed, the defined benefit system may be trillions of dollars shy of what's needed to fund the retirement promises made to employees.
But does that mean retirement funding is at risk for baby boomers? As with most things economic, it depends on whom you ask.
Although private sector pensions are protected to some degree by the Pension Benefit Guaranty Corp., a government agency that financially guarantees corporate pension plans should the sponsoring company enter bankruptcy, the public sector equivalents have no government safety net. The federal bankruptcy code includes provisions for municipal bankruptcy, commonly called Chapter 9, but for years it has been assumed that it did not apply to states seeking protection from their creditors. That point of view is slowly changing in some legal circles, although there has been no court test of such an argument to date.
In many states, pensions are protected either by state law or the state constitution, making it harder, at least in theory, for states to simply throw up their figurative hands and declare that pensions can't be paid. "New employees don't have to be entered into the plan, but the states are going to have to come up with the money somehow," says Smetters. "That's going to be very hard for them to do."
Most financial estimates show even the most beleaguered pension plans are still decades away from insolvency, but a clue to how such a scenario might play out can be found in the small town of Pritchard, Ala. In 2009, Pritchard stopped sending retirement checks to its retirees after warning for years that its pension fund would run out of money. Retirees later struck a deal with the city to resume payments, but only for about a third of what they were originally owed. It is unclear if current employees enrolled in the system will ever collect a benefit.
A Slow Unraveling
Well before that pension cataclysm is reached in other, larger funds, the underfunding could still take a toll, Mitchell says. The worse the underfunding gets, she argues, the less likely new employees will be to jump into a system that seems destined for disaster. "If contributions continue to be inadequate, then we will see a slow unraveling. In some states and cities, if reform is successful, then they can stave off the unraveling for a little while. But just as we have seen in the corporate sector, where there has been a long downturn in defined benefit plans, that will continue in the public sector."
Munnell sees the future of government retirements as a blended system, one that will still reward long-time workers but allow for more portability than a pension plan. "My sense is that there will be some compromise, and states will end up with some mix of defined benefit and defined contribution plans. I view that as a desirable outcome -- it balances the financial risk between employer and taxpayer, and helps both long-term public employees and shorter-term workers who don't fare well under pensions."
Smetters, however, still sees a future for defined benefit programs in the public sector, which has been the last bastion for pensions. Only 30% of private sector workers participated in a defined benefit plan in 2010, according to data collected by the Employee Benefit Research Institute. In the public sector, on the other hand, 87% of workers contributed to a pension.
"I think any rational worker coming online today is going to want to be able to stay in an old-style pension plan. They are viewed as safer," Smetters notes. "Defined benefit plans did provide workers a lot of protection, and it's a pity to see them go. They are a good idea from the point of view of retirement security."