The Pension Time Bomb: Why Public-Sector Retiree Benefits Need to Change, and the Barriers to Meaningful Reform PDF Print E-mail
News/Features - Feature Stories
Written by Jeff Ignatius   
Thursday, 08 November 2012 05:00

[Note: Commentary from the Reader's editor, published on this topic, can be found here.]

A riddle: What do you get if you add $209 billion to $54 billion to $15 billion?

If you answered “a lot,” you’re correct and not particularly inclined toward math.

If you answered $278 billion, you’re adept at arithmetic and correct, if literal-minded.

If you answered the respective unfunded liabilities for Illinois’ state-run pension funds, its retiree health-care system, and its pension bonds, you’re correct and probably cheating.

And if you answered “a time bomb,” you’re probably most correct. Because while the numbers are important, they’re constantly changing and open to interpretation, and the most important aspect of them is their magnitude. Whether it’s cast as an $83-billion pension problem or a $278-billion benefits issue, the sheer size of it shows that it can’t be solved with tinkering.

“We’re getting close to the point where the choice is between making pension payments or paying for goods and services that we need today,” said Rae Ann McNeilly, director of outreach for Taxpayers United of America. “We are coming to the pinnacle of financial crisis where something has to be done.”

Ted Dabrowski, vice president for policy for the Illinois Policy Institute, said retiree health care is another unfunded liability that will soon reach a critical juncture for Illinois government: “We’ve promised all these things, but we haven’t set aside any money. ... The only way to pay them is to take money from the current budget. And the way it’s growing, that means you’re going to take away from education, from health care, from public safety ... .”

If that rhetoric sounds overheated, consider the 2010 paper “Are State Public Pensions Sustainable?” by Joshua D. Rauh of Northwestern University’s Kellogg School of Management. He concluded that using the typical state asset-growth forecast of 8 percent a year, the money in the pension funds for “Illinois would run out in 2018, followed by Connecticut, New Jersey, and Indiana in 2019.” Only “five states never run out” in this scenario. Iowa would run out of pension-fund cash in 2035.

A June analysis by the Pew Center on the States outlined a problem that has grown dramatically in the past decade: “Many experts say that a healthy pension system should be at least 80-percent funded. In 2000, more than half of the states were 100-percent funded, but by 2010 only Wisconsin was fully funded, and 34 were below the 80-percent threshold – up from 31 in 2009 and just 22 in 2008.” The funding ratio for the Iowa Public Employees’ Retirement System, for example, dropped from 97.2 percent in 2000 to 81.4 percent in 2010.

Pew calculated that Illinois in 2010 had a $76-billion unfunded liability (out of a $138.8-billion total liability) in its pension funds, and a nearly $44-billion unfunded liability for retiree health care – meaning a total unfunded liability for retiree benefits of $120 billion.

Iowa in 2010 had a $5-billion unfunded liability (out of a $27.1-billion total liability) in its pension funds, and a $538-million unfunded liability for retiree health care – for a total unfunded liability of close to $6 billion.

Those are big numbers, but they don’t tell the whole story. The unfunded liabilities represent, at a given point in time, how much additional money the states would need now to pay for retiree benefits already earned. Add current assets to the unfunded liability and you get the total liability – the amount of money today that should through investment be adequate to fully fund retiree benefits.

But that calculation is premised on a certain return on investment; if actual earnings are below expectations, the total and unfunded liabilities grow. Most states estimate their unfunded liabilities based on an anticipated asset-growth rate of roughly 8 percent a year – a historical number that many experts consider optimistic today, meaning that the actual retiree-benefit situation might be even more grim. Rauh’s paper figures that with 8-percent return, “states in aggregate will run out of funds in 2028.” However, “if average returns are only 6 percent, state funds in aggregate will run out in 2024.”

The Illinois Policy Institute notes that Illinois’ five pension funds assume a rate of return of between 7 and 8.5 percent a year in calculating unfunded liability. But their five-year average returns have ranged from 3.1 to 6.3 percent, and their 10-year average returns have been between 4.5 and 6.1 percent.

The institute calculated that the state pension system’s unfunded liability is actually $209.0 billion under new, more-realistic reporting requirements by Moody’s – instead of the current official estimate of $82.9 billion.

Pew said that one analysis of similar Governmental Accounting Standards Board reporting requirements and state and local pension systems found that “if the new rules had been in effect in 2010, those plans’ funding levels would have dropped from 77-percent funded to 53-percent.”

A $1.38-Trillion Bill for Taxpayers

The first thing to understand about the pension crisis is that states nearly universally give their workers defined-benefit pensions. In these plans, workers are promised a certain retirement income based on their salary and years of service, regardless of how much they or their employers contribute to the system, and regardless of how much money those contributions generate through investment.

Employer-provided defined-benefit plans in the United States originated, according to the federal Bureau of Labor Statistics, with the American Express Company in 1875 and spread to the railroad, banking, and public-utility sectors. As of March 2011, 84 percent of local- and state-government employees had access to a defined-benefit retirement plan, according to the Center for State & Local Government Excellence.

Taxpayers of course foot the bill for the required employer contribution, but they also end up paying for an additional portion of pensions under a variety of scenarios: if the initial contributions aren’t adequate, if the investments don’t perform up to expectations, if people live longer, and/or if contributions aren’t adjusted to account for market shortfalls and increased life expectancy.

Illinois has skipped or underfunded annual pension payments, but the current pension crisis across the country illustrates forcefully that the combination of employee and employer contributions and investment return is grossly inadequate to cover states’ pension obligations; simply put, what public-sector employees will draw from pension systems is far greater than the sum of contributions and earnings.

As of Fiscal Year 2010, taxpayers nationwide are holding a $757-billion bill for anticipated shortfalls in state retirement systems, the Pew Analysis shows. That unfunded liability has spurred discussion of both a federal bailout of state pension systems and federal legislation to allow states to declare bankruptcy.

The unfunded-liability problem extends to other retirement benefits, particularly health care: Inadequate money has been set aside to cover the costs of things promised to public-sector workers. The states’ estimated unfunded liability for retiree health care, according to Pew, was $627 billion in 2010.

That $1.38-trillion total unfunded liability represented a 9-percent increase from Fiscal Year 2009, Pew said. (The figures from Pew represent state-run pension systems, and each state is different. For example, Illinois’ figures don’t include the Illinois Municipal Retirement Fund. So Illinois’ unfunded liability does not include municipal employees, while Iowa’s does under the Iowa Public Employees’ Retirement System. Again, the specifics are less important than the magnitude and pervasiveness of the problem.)

Two recessions in the U.S. economy since 2000 have certainly exacerbated the situation by bringing down returns on investments. They’ve also put budget pressure on state and local governments, and because pensions and other retirement benefits are long-term obligations, funding for them has suffered in favor of short-term priorities.

Yet in a larger sense, pension underfunding over the past decade highlights the anachronism of defined-benefit public-sector pensions. The private sector has shifted to defined-contribution plans such as 410(k)s– in which retirement income is determined not by salary and tenure but purely by contributions plus investment return. Defined-contribution plans are attractive to employers and (with public-sector employees) taxpayers because there is, by nature, no unfunded liability.

As Businessweek noted last year: “In 1985, a total of 89 of the Fortune 100 companies offered their new hires a traditional defined-benefit pension plan, and just 10 of them offered only a defined-contribution plan. Today, only 13 of the Fortune 100 companies offer a traditional defined-benefit plan, and 70 offer only a defined-contribution plan.”

The public sector is now learning what the private sector learned over the past three decades: that defined-benefit programs are tremendously expensive in the long run if not properly funded up-front.

And even when enough money is put in at the outset, uncertainty is built in. As McNeilly of Taxpayers United of America said: “They are mathematically impossible to sustain. The whole system is predicated on the future growth of the current asset investment. That’s an unknown, and we treat it as a known when we’re calculating the value of the asset.” A defined-benefit system “puts the taxpayers at risk of catastrophic unfunded liabilities.”

Somebody will need to pay for those benefits, or the benefits will need to change, or both. As Pew summarized: “Though states have enough cash to cover retiree benefits in the short term, many of them – even with strong market returns – will not be able to keep up in the long term without some combination of higher contributions from taxpayers and employees, deep benefit cuts, and, in some cases, changes in how retirement plans are structured and benefits are distributed.”