Public Pension Fixes Can Fill Gaps and Avoid a Big Ruckus

By the Editors - Mar 25, 2012 - BLOOMBERG

The hullabaloo over cutting public employee retirement benefits and collective bargaining rights has died down, but the pension funding crisis hasn’t. It has gotten worse.

Experts disagree over the numbers, but Joshua Rauh, a Northwestern University finance professor, calculates that public pensions may be underfunded by $4.4 trillion, up from $3.1 trillion in 2009. Bloomberg Rankings data show that states are also falling behind on retiree health care: Of the $627 billion they are projected to owe, almost 96 percent isn’t financed, up from 95 percent in 2009.

Health-care benefits aren’t usually guaranteed by contract, but public pensions are. Taxpayers must make good on those promises, or the promises must be reduced. Either way, the politics can be toxic, as a pair of Midwestern Republican governors have discovered. Wisconsin’s Scott Walker, who spent much of 2011 trying to limit public workers’ bargaining rights, could face a recall election in June. And Ohio’s John Kasich, who pushed through a similar measure, saw voters repeal it in November.

Pension plans are going broke because state and local governments assumed wildly optimistic investment returns, allowing them to promise rich retirement benefits without paying for them. The financial crisis, the recession and agonizingly slow recovery, and record-low interest rates have also depleted pension funds. And while it wouldn’t be correct to blame public employees, they and their unions have gone along for decades as government bosses found it easier to offer a dollar of future pension benefits than a dollar of wages.

Crowding Out

There are no pain-free solutions, but it’s possible to deal with public pensions without the Sturm und Drang of 2011. If the shortfalls aren’t addressed, cities, counties and states will have to dip into tax collections to pay for pensions, crowding out much-needed spending for public works, police and fire departments, schools and other things taxpayers need or want.

The National Conference of State Legislatures reported on March 14 that, since 2009, 43 states have enacted a soupcon of reforms, including increasing employee contributions, adding to the number of years of service before benefits begin, slightly increasing retirement ages and lengthening the final years of salaries on which payouts are calculated. Almost all of these changes affect only new hires.

That’s a relief to existing workers and retirees, considering that the average annual pension benefit is a not-so- princely $23,000, according to the Center for Retirement Research at Boston College. But it means the pile of unfunded liabilities remains. Ending abuses, including pension spiking (piling on overtime hours in the last year of employment to boost a pension payout) and double-dipping (retiring on a full pension one day and returning the next as a new hire at the same salary) helps, but saves only a modest sum. And revoking union collective bargaining rights is a political sideshow.

The best way the states can whittle down unfunded promises is by adopting a more accurate measure of inflation to calculate cost-of-living adjustments. The standard consumer price index overstates inflation because it fails to account for the product substitutions people make when prices rise. A better index, called the chained CPI, more closely models actual consumer behavior and, if applied to current retirees, would allow states to reap immediate savings.

To stop the growth in future obligations -- those made to new hires -- states should gradually raise the retirement age to 67 to keep up with advances in life expectancy, now averaging more than 78 years.

Hybrid Plans

One of the most promising solutions involves so-called hybrid pension plans, which encourage or require workers to save more on their own. Most state and local government workers belong to a traditional, defined-benefit plan that guarantees a monthly pension based on salary and years of service. By contrast, most private-sector employees have defined- contribution plans such as 401(k)s to which they contribute a portion of their salary and receive an employer match.

Hybrid plans combine a less-generous traditional pension with a 401(k)-style plan. Hybrids gradually move public employers away from traditional pensions, which cost state and local governments about $3 per hour worked. Private employers contribute only about 92 cents an hour.

Traditional pensions also lack the flexibility of 401(k)s, which can be tailored to different levels of salary, job types and employer matches. True, retirement security would depend more on how investments have performed, but employers can offset some of that risk by hiring professional money managers and educating workers on investment basics, as the private sector has done for decades.

Indiana has long had a hybrid plan. Since 2005, Alaska, Georgia, Michigan and Utah have adopted one for new hires. Rhode Island alone has a hybrid that requires existing and newly hired workers to participate in the 401(k)-style plan. Employees must contribute up to 5 percent of their earnings (depending on salary), or 9 percent if they are among the one-fourth of government workers nationally who don’t contribute to Social Security.

Other states are considering hybrids. California Governor Jerry Brown has recommended a plan, while Arizona, Kansas and Massachusetts are studying them.

Union Resistance

On March 15, New York Democratic Governor Andrew Cuomo won approval from the state legislature for a basket of pension reforms. But he scaled back the most contentious piece when unions put up fierce resistance: a hybrid plan giving new workers the option of forgoing the traditional pension for a 401(k). Instead, the option will be offered only to a small slice of new hires earning $75,000 or more and who don’t belong to a union. Cuomo should have stuck to his guns.

Raising retirement ages, adjusting COLAs and requiring workers to contribute more may still not be enough to shrink the mountain of unfunded liabilities. State and local governments will have to tap taxpayers for the rest. The good news is that governments have a couple of decades to make the numbers add up. But if they don’t start now, catching up will get harder and harder.

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