Three problems, exemplified by the crises afflicting the public pension systems in Houston and Dallas, plague state and local pension systems across the country.
First, state and local governments have only contributed 88 percent of the required annual contributions into their public pension funds between 2001 and 2015.
In total, according to the Pew Charitable Trusts, public pension plans need an additional $1.1 trillion just to meet current expected obligations. This 28 percent funding gap understates the problem because it does not account for the unfunded repayment risks that taxpayers are bearing on behalf of public employees.
Second, public pension funds currently assume an unrealistic return on their investments.
Compared to their private sector counterparts who assume an annual return a bit over 4 percent, public sector funds are, on average, assuming they can annually earn around 7.5 percent. Assuming a better outcome does not make it so. Should the overly optimistic returns not come to fruition, then the dire financial state of the state and local public pension systems is even worse.
Third, public pension funds are carrying too much risk in their investment portfolios.
During the 1970s, public pensions used to invest one-quarter of their assets in riskier “equity-like” investments such as stocks, real estate, hedge funds and other assets subject to substantial investment risk. Today, public pension systems invest two-thirds of their assets into these types of riskier investments.
The Consequences of High Risk Pension Investments
Dallas knows all too well the consequences from assuming excessive risk. While several years ago Dallas’ public pension system appeared healthy, soured bets on nontraditional real estate investments, when coupled with questionable accounting practices by the fund, have precipitated the current crisis.
Dallas’ experience exemplifies that even seemingly sound public pension systems can quickly become unsound. The only sustainable, long-term, solution is to transition toward the defined contribution plans that are commonly used in the private sector.
Transition to a Defined Contribution Retirement System
To start the transition, all new employees should be ineligible for the current defined benefit programs, and should instead be enrolled in a defined contribution retirement system that meets the average standards of large company defined contribution plans. These standards should include no minimum length of service requirement for eligibility, immediate vesting on matching contributions, and the government’s matching and non-matching contributions equal to 6.5 percent of pay.
For current employees, the current defined benefit programs should be frozen, specifically a hard freeze. Under a hard freeze, no public employee would accrue any more benefits in the defined benefit program. All vested public employees should then be offered a choice: either receive a lump sum payment equal to the present value of their actuarially determined benefit that is currently funded, or remain in the defined benefit plan.
The assets that public employees want to cash-out would be, effectively, privatized and transferred into appropriate retirement accounts directly controlled by the public-sector employees.
Those employees that choose to remain in the frozen defined benefit plan would receive the benefits that they have accrued up to the date of the hard freeze, which will then need to be adjusted based on current funding levels and to appropriately account for the under-valued risks.
Of course, difficult, transition issues must be managed to the extent public sector workers value the cash-out option. However, ignoring the inherent unsustainability of the current defined benefit plans will not avert the coming public pension crisis. Facing these problems, head on, will.