Americans today exist amid the tension between hope for better times and the scars of the worst financial crisis since the Great Depression. Among the fiscal challenges we face are states and cities that are struggling to keep up with their promise to set aside enough money to fund public employees ‘defined benefit pension plans as those governments also struggle to recover from the longest economic downturn since the 1930s.
As difficult as it will be to live up to their pension promises, governments must avoid the temptation to increase their contributions to pension systems by raising taxes on average Americans. This would only deepen the wounds of those hit hardest by the 2008 financial crisis and subsequent Great Recession.
While corporate America has shifted to defined contribution retirement plans, most state and local government employees still participate in defined benefit plans. There is plenty of evidence that these plans lack the funds to make good on the promises made to public employees, but little evidence that structural reforms are being implemented.
Defined benefit plans promise a set monthly payment during retirement. Major challenges of managing these plans include estimating future retiree obligations and making accurate assumptions about variables such as length of service, future salary levels, retiree mortality and expected return on pension fund assets
Investment returns are critical, since investment earnings account for the majority of public pension financing. Any shortfall must be made up by increasing contributions or reducing benefits. One common flaw in pension plan management is undervaluing liabilities by assuming unrealistic rates of returns on pension assets.
Even small changes in rates of return can have a significant effect on assets. A Congressional Budget Office study found that with an 8 percent projected rate of return, unfunded liabilities amounted to $700 billion for state and local pension plans. If the projected rate of return dropped to 5 percent, the unfunded liability more than tripled to $2.2 trillion.
Public pension funds generally assume a high rate of return. For example, many base pension contributions on an assumed 7.75 percent annual return on fund investments, which is difficult to achieve in a near-zero interest rate environment.
Since actual returns have been less than the assumed rates, unfunded liabilities have increased.
There is no consensus on how best to deal with this crisis and preserve the sustainability of public pension plans. Since the 2008 financial crisis, nearly all states have enacted changes to make their defined benefit pension plans more solvent. Common options for overhauling the plans range from increasing employee contributions to benefit reductions, including cost of living adjustments and increases in eligibility requirements such as increasing the retirement age for new employees.
A handful of states have passed reforms that replace defined benefit plans with some version of defined contribution plans for new employees. Others have borrowed money through the issuance of pension obligation bonds, floating tax-exempt bonds at low interest rates in the hope of investing the money in securities with higher yields.
Still other states have changed their asset allocation mix to generate higher returns, investing in alternative investments such as private equity, real estate, hedge funds, commodities and derivatives. But along with higher expected returns, these investment vehicles also bring greater risk.
As part of the struggle to deliver promised benefits, some pension plans have begun to focus on investment management fees. For example, the California Public Employees’ Retirement System, the country’s biggest state pension fund with about $300 billion of assets, announced plans earlier this year to cut back on the $1.6 billion in management fees it paid to Wall Street firms last year.
Tough choices are needed to get public pension funds plans back on track. But in the current economic environment, increasing governments’ contributions to the plans by raising taxes on average taxpayers who have already taken a beating in recent years should be avoided at all costs.
originally published: June 27, 2015