A new Pew Center on the States report finds that state pension systems have a combined $1 trillion unfunded liability. According to the analysis, state pension funds had set aside $2.35 trillion to pay for an estimated $3.25 trillion in liabilities over the next 30 years. The $1 trillion public pension deficit amounts to more than $8,800 per U.S. household.
The gap is actually probably even worse, for, as the preface to the report notes, "Because most states assess their retirement plans on June 30, our calculation does not fully reflect severe investment declines in pension funds in the second half of 2008 before the modest recovery in 2009." Moreover, while the recession has contributed to public pension funding woes, it is not the principal cause of the underfunding:
While recent investment losses can account for a portion of the growing funding gap, many states fell behind on their payments to cover the cost of promised benefits even before the Great Recession. Our analysis found that many states shortchanged their pension plans in both good times and bad, and only a handful have set aside any meaningful funding for retiree health care and other non-pension benefits.
States with significantly underfunded pension systems have left taxpayers and policymakers with a legacy of "high annual costs that come with significant unfunded liabilities, lower bond ratings, less money available for services, higher taxes and the specter of worsening problems in the future."
As pressure to reform public pension systems has grown in recent years, 17 states reduced future benefits, increased employee contributions, or both in 2008 and 2009. While Michigan (beginning in 1997) and Alaska (2005) are currently the only states to require state employees to participate only in a 401(k)-like defined-contribution retirement system (several other states require participation in both a defined-benefit and defined-contribution plan, have a "cash-balance" plan that is a hybrid of defined-benefit and defined-contribution plans, or offer an optional defined-contribution plan in addition to the mandatory defined-benefit plan), the option of switching all new employees to a defined-contribution plan has been discussed in several other states, including Florida, Kansas, Louisiana, and Utah.
This is probably the ultimate solution to the public pension problem, as defined-contribution plans would: (a) place the risk of investment losses on employees (as it is with the 80% of private-sector employees with defined-contribution plans instead of defined-benefit plans), (b) make contributions by the government much more stable and less volatile (since they would simply be a fixed percentage of employees' salaries, plus perhaps a matching portion up to a certain percentage—note that there is no such thing as an "unfunded liability" or "pension deficit" with a defined-contribution plan), and (c) eliminate the need to make actuarial assumptions—which can be fudged to make plans look better funded than they really are or simply be incorrect—that attempt to estimate such things as what the average annual pension fund return will be, when employees will retire, and how long retirees will live, projecting these factors decades into the future.
Much of the Pew Center on the States report echoes concerns that I and my co-author, George Passantino, voiced in our June 2005 public pension study, The Gathering Pension Storm: the scope of growing pension deficits, the nature of public pension underfunding schemes, the incentives of politicians to not make the full actuarially "required" contributions, the risk of unfunded liabilities to taxpayers, unrealistic actuarial assumptions, excessive benefits, spiking final salaries with sick leave, overtime, or other benefits to increase pension payments.
In addition to switching new employees to a defined-contribution system, we recommended that state and local governments implement requirements that voters approve future government employee benefit increases (which has been the case in San Francisco for many years and has subsequently been adopted by the City of San Diego and Orange County, California, in recent years) and adopt budget reforms—such as outsourcing/privatization, selling off underutilized assets, and eliminating duplicative, low-priority, or poorly performing programs—to cope with liabilities that have already been racked up. Sadly, over the past five years, the public pension skies have only grown more ominous and these reforms are needed now more than ever.
Related Research and Commentary:
» Fixing the state's pension mess (published in the Orange County Register)