Underfunded Pensions: Tackling an ‘Invisible’ Crisis


As cities throughout the United States grapple with the lingering impact of the financial crisis, they are looking for real solutions that will help them achieve fiscal stability. With that goal in mind, the Penn Institute for Urban Research recently held a one-day conference on the financial health of cities, titled “Urban Fiscal Stability and Public Pensions: Sustainability Going Forward.” The center is co-directed by Wharton real estate professor Susan M. Wachter and University of Pennsylvania city and regional planning professor Eugenie L. Birch. Penn IUR is producing a book on this subject as part of its book series, the City in the 21st Century, with Penn Press.

The event brought together expert voices, including academics and practitioners from city governments and federal agencies, to focus on the complex fiscal issues facing cities and their pensions. The panel of academic specialists considered the hidden dimensions of the crisis, its impact on the American economy — both now and in the future — and the policy changes that could and should be taken to mitigate the risk of a deepening crisis over time.

Wharton finance professor Robert Inman provided this cautionary perspective: “This is a serious problem, and there is no running away from it Twitter . It has made the front pages of every financial newspaper in the world, and rightly so.” He noted that researchers who have studied this crisis have “corrected a fundamental flaw in the way that people were thinking about these unfunded liabilities.” The bottom line, Inman said, was that there were $3 trillion worth of unfunded pension liabilities at the state level, and $400 billion of unfunded liabilities at the large-city level. That turns out to be about $10,000 per American citizen. “That’s something that we really have to think about, and it has not gotten significantly better.”

Inman noted, for example, that Chicago’s unfunded liabilities are 10 times its revenues. “Just assume that they’re going to have to pay 5% of that [number annually]. That means you’re looking at 50% of their cash that will have go to pensions.” Philadelphia, Boston, New York, Houston and other major cities will face similar challenges. “What does it mean for cities to do this?” Inman asked. “If that number is 50%, then $1 has to get you back at least twice the benefits [you spend]. That’s a very high threshold for city services to have to meet.

“Chicago’s unfunded liabilities are 10 times its revenues. Just assume that they’re going to have to pay 5% of that [number annually]. That means you’re looking at 50% of their cash that will have go to pensions.” –Robert Inman

“Someone is going to have to bite the bullet here,” Inman warned. “It can be current resident taxpayers who wind up having to pay higher taxes and/or receive a lower level of services in return for their current contributions. Or it can come in the form of lower property values.” He added that the ultimate losers will be the people who own those properties whose value declines as a result. There is no way that funds and households “are going to move into a city unless they are absolutely certain that they will get dollars back for every dollar they spend..”

In those cases where an unfunded liability has been built up over time, taxpayers who move into a city in the future will have to shoulder a share of the bill for services they didn’t receive. “If they do know about [the unfunded liability], they don’t go into that city. Or if they go, they go to a less productive location [within that city], and as a consequence, society as a whole loses productivity,” said Inman. Shifting the bill to nonresident taxpayers — in other words, having the state or federal government bailout such indebted municipalities — is the option Inman said he’s least attracted to. Bailouts become “an invitation to repeat the process once again. It becomes important to send a signal that you are not in this game helping anybody who gets into trouble.”

Inman warned that, with the wrong incentives built into the system, a situation may be produced in which everyone agrees that “it’s in my best interest to underfund this pension system to protect myself.” What can be done to minimize the chances of that happening? “The economist’s answer is that the problem is the asymmetric nature of the information provided in this situation.” The solution is transparency, Inman concluded. “The important thing is to stress that information has to come from a wider, more credible source.” That source has to be independent, and provide the information to all concerned: current taxpayers, future taxpayers, public employees and investors, whether involved in bonds, real estate or other instruments. “Let’s get this information out there. Let’s be very clear.”

Too Much Optimism?

How are America’s cities still so far in the hole, years after the supposed end of the Great Recession? On the one hand, said Joshua Rauh, finance professor at Stanford Business School, the funds that these cities invested in declined substantially in value during the crisis. However, between 2009 and 2013, the stock market rebounded. “You might have thought that in a period when the [S&P 500] rose by 75%, that would have eroded much of the unfunded liabilities,” Rauh said. But his research showed that, measured by GASB standards, four out of 10 major cities (New York, Chicago, Jacksonville, Florida, and Philadelphia) have actually seen a rise in their unfunded liabilities recently. The other six saw only modest improvements; their unfunded liabilities fell by an average of 16%.

“Contributions have increased …but benefits have also increased; so the difference between the two [lines on the chart] has stayed about the same.” –Joshua Rauh

Rauh noted that liabilities have continued to grow, or shrunk only marginally, in part, because actuarial assumptions have proven to be too optimistic about such factors as employee longevity and about how many workers were going to take advantage of early retirement programs.

Contribution increases have kept up with benefit payout increases, but no more than that. “Reforms have not addressed the root of the problem…. Contributions have increased because a lot of cities have said, ‘We need to devote more resources to these funds,'” noted Rauh. “But benefits have also increased; so the difference between the two [lines on the chart] has stayed about the same.”

Rauh provided his own roadmap for managing reforms, categorizing them in terms of their long-term effects and their degree of political difficulty. Unfortunately, he noted, those structural changes that would have the greatest long-term effects — options such as deferred annuity plans, pooled defined contributions, and individual accounts — are the most politically challenging to implement. On the other end of the spectrum, it would be easier to build political support for the sorts of changes that would have smaller impacts, Rauh said. These kinds of changes would involve “contribution changes” for retirees, current employees, new employees and taxpayers. For example, employees might be required to pay in order to keep their current benefits (most already do). Or increases in employee benefits might be contingent on caps in government contributions. Or there might be increases in government contributions, which would ultimately lead to higher taxes.

Somewhere in the center of Rauh’s road map for improvement are “benefit parameter changes.” These kinds of changes — easier to build political support for than structural changes, but harder to gain support for than contribution changes — would include tweaking the formula for COLAs (cost of living adjustments), pushing back the age at which retirees could take their pension benefits and reducing early-retirement benefits.

“The only way we are going to be able to deal with this problem is by implementing structural changes,”Rauh said. That means changing the way that pension benefits are provided. Two models that would be useful to focus on, he suggested, are “pool-defined contribution plans,” and “deferred annuity plans.” In the first model, employees and employers pay into a special fund. When workers retire, they receive an annuity that is a function of how well the assets in their pension fund have performed. In the second, employer contributions would go to insurance companies, which would promise to pay deferred annuities.

“[Bailouts become] an invitation to repeat the process once again. It becomes important to send a signal that you are not in this game helping anybody who gets into trouble.”— Robert Inman

An Invisible Problem

In her presentation, Amy Monahan, a law professor at the University of Minnesota, noted that the “law has been ineffective in enforcing funding discipline against contrary legislative will,” and that there is “little evidence” that the law incorporates best practices in governance of pension funds. Thus, “even the strongest forms of benefit-guarantees are unclear in cases of fiscal distress.” Monahan said there is a need to put new laws in place that compel better behavior from governments, because political-economic forces “strongly favor underfunding.” Moreover, she said, there is “no obvious counter-pressure” because “workers have behaved consistently with the position that pension benefits are protected; negating the need to police fund planning.” As a result, the problem of underfunding “has been largely invisible to taxpayers,” or too far removed from them to care about it.

On a positive note, Monahan said taxpayers and officials are becoming more aware of the nature of the pension problems they face. Since 2008, at least 12 states have enacted benefit reductions or increased contribution requirements for their current employees or retirees, and then been challenged in court. “At least four cities have done so outside of bankruptcy.” Looking to the future, Monahan said that “growing awareness of the impact of pension underfunding may lead to change,” citing a lawsuit against a Detroit actuarial firm, as well as “political support for using law to better ensure public pension success.”

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