A New Way to Tame the Public-Pension Beast?

Adjustable pension plans could help governments control both risk and their out-of-control retiree-benefit costs.
by | May 8, 2013
 

It's certainly not news that public workers' pensions pose dizzying fiscal challenges for state and local governments. One study estimated states' combined unfunded pension liabilities at $1.38 trillion as of 2010, and many local governments also are staring down the pension-funding abyss.

But as the pension crisis grows, so does public-employee-union opposition to switching from traditional defined-benefit plans, which guarantee set payments to retirees, to defined-contribution plans, which guarantee only that government employers will contribute a certain amount toward employees' retirement.

Defined-benefit plans place the risk on employers, and defined-contribution plans shift it to employees. But risk would be shared under a new approach that seems to offer something for everyone.

Adjustable pension plans (APPs) guarantee lifetime payments to employees. But unlike traditional defined-benefit systems, the size of the benefit would be adjusted based on the pension fund's investment performance during the previous year. For employees, it means that while payments would often be less than under traditional defined-benefit plans, they would be secure.

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Adjustable pensions are similar to cash-balance plans, which guarantee an annual interest rate on employee contributions and the employer's match. But instead of tying benefits to a benchmark such as the rate of return on 10-year Treasury bills, APP payouts are tied to actual investment returns.

The APP approach allows governments to control risk far more than with traditional plans. Under defined benefit, public officials face a grim choice when pension-fund investment performance is poor (which usually corresponds with an economic downturn): Either let unfunded liability increase or ask taxpayers to kick in more at a time when they can least afford it.

California's experience offers a stark example. During fiscal 2001, years of strong returns meant taxpayers had to contribute only about $160 million to fund public workers' pensions. Less than a decade later, that number was nearly $3 billion.

With their emphasis on low volatility, APPs also assume lower rates of return on pension-fund investments than do most public-sector funds. Unrealistic assumptions about investment performance are another path to increased contributions and/or more unfunded liability.

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The New York Times and Consumers Union, which publishes Consumer Reports, are among the private employers that have switched to adjustable pension plans, and Maine is the first state to consider the approach. A legislative task force has drafted a bill that would include APPs as part of a plan to supplement Social Security for new state employees.

Politically, adjustable pension plans are more palatable than switching to defined-contribution plans because APPs preserve guaranteed lifetime payments. APPs have been adopted by at least one private-sector union pension fund, so the ground has at least been broken among organized labor.

It's unrealistic to expect any one approach to solve governments' massive pension woes. But adjustable pensions, together with defined-contribution and cash-balance plans, could be part of a menu of options that would offer public employees the chance to choose the approach that best fits their priorities at the same time as they help governments control risk.

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