Tackling the Public Pensions Problem

State and local public pension systems are in deep financial trouble. The latest comprehensive assessment by Joshua Rauh of the Hoover Institution, which captured 97 percent of public pension assets, found that the unfunded liabilities of public pensions are in the trillions of dollars. The public pensions problem is a reality nationwide.

Valuing the unfunded liabilities using the Government Accounting Standards Board procedures (GASB), Rauh found that the unfunded public pension liabilities in the U.S. are $1.2 trillion. However, the GASB regulations do not properly account for market risks.

Government public pensions (liabilities) are guaranteed regardless of the market’s performance – they are supposed to be riskless. Therefore, the required contributions into the pension systems should be based on the riskless profile of these liabilities, not the potential market returns that can be gained if investors bear market risks. Properly accounting for the riskless liabilities, Rauh estimates that state and local public pensions have unfunded liabilities nearly three times higher – $3.4 trillion.

Such MEGO (my eyes glaze over) numbers are hard to conceptualize. To put this burden into perspective, the $3.4 trillion unfunded liability is equal to an approximately $30,000 bill imposed on every household in the U.S. And, these costs do not even include the promised, but generally unfunded, health care benefits for retirees.

Clearly, public pensions are facing an enormous fiscal crisis and ignoring the crisis only makes it more difficult to resolve. The surest way to ensure state and local government workers have a secure pension in retirement is to acknowledge the scope of the problem, and implement policies that directly address them.

Tackling these problems will be challenging, especially because pension reform elicits strong opposition. But, without changes the national pension crisis will diminish the country’s economic vitality for the next generation. Ironically, it also poses a large risk to the retirement of public employees as the risks of there being insufficient assets to fund the promised retirement benefits grows.

As I document in a recent study for the Pacific Research Institute examining California’s pension crisis,California’s Pension Crowd-Out, closing California’s unfunded liabilities (valued at market rates) requires an annual $28.3 billion tax increase over the next 30 years. If such a tax increase were implemented, California’s economy would be 21 percent smaller over the next three decades compared to the baseline growth path.

Alternatively, if California chooses to forgo reforms and pay down the pension debt through an across the board reduction in the current levels of state funding, California would maintain its 6th highest state and local tax burden in the county while simultaneously cutting $8.3 billion from schools and higher education, $4.9 billion from income support programs and $1.9 billion from the state’s hospital systems. Under either scenario, the vitality of California will be significantly worsened in order to maintain current pension promises.

Reform efforts should start by switching all new employees into 401(k) retirement plans – the typical retirement plans that most private sector workers currently receive. The 401(k) plan benefits should be equivalent to those benefits offered by large private sector employers including employee participation upon hire, and employer contributions (both matching and non-matching) equal to 8 percent of pay.

However, a defined contribution model for new state workers is only part of the solution. To prevent either massive tax increases or massive budget cuts, reforms must also tackle the pension obligations of current employees.

The pension plans for all current public employees across all defined benefit programs should be frozen – or what is called a hard freeze. Public employees should earn all new retirement benefits through the newly established 401(k) plan with the same terms and benefits as new hires.

As for the frozen defined benefit plan, no public employee should be able to accrue any more benefits in the program. The transition of most private sector retirement programs from a defined benefit to defined contribution plans serves as an excellent road map for this transition.

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, or remain in the defined benefit plan. Employees that choose the lump-sum payment would transfer their share of the assets into an appropriate retirement account. Although there would be many transitional issues in a “cash-out” option that would need to be addressed, such as the impact these payments would have on pension program’s funded status, they pale in comparison to the difficult decision facing states if they fail to enact fundamental pension reforms.

It simply makes no sense for state and local governments to continue their current pension systems that will drive them into insolvency. Without the necessary reforms, the next generation will endure fewer economic opportunities and fewer public services.

With effective reforms, the economic costs from the unfunded liability crisis can be minimized while still ensuring that public sector workers receive a comfortable pension for their retirement.

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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