New Rules Could Clear the Path to Pension Reform

For most states, the new government accountability rules eliminate the main substantive barrier to moving toward less costly defined-contribution plans.
by | March 2013
 

Illinois is the perennial -- and among states, the worst -- example of what happens when traditional public pension plans spin out of control. But as the state’s leaders struggle with their pension funding debacle, new government accounting rules may provide the route to a solution.

At the end of the last fiscal year, Illinois’ unfunded pension liability was nearly $100 billion, and the retirement fund had less than 40 percent of the money it needed to meet its responsibilities. Every day the problem goes unaddressed puts the state $17 million further in the hole.

More is at stake for Illinois than a comfortable retirement for its government workers. The ratings agency Standard & Poor’s downgraded Illinois’ bond rating last August and again in January, making it far more expensive for the state to borrow money. In addition to the downgrade, S&P said the outlook for Illinois is negative and that “lack of action on pension reform and upcoming budget challenges could result in further credit deterioration.” Only California’s bond rating is as bad, but unlike Illinois’, California’s outlook is positive.

Read the March issue of Governing magazine.

Many of the problems with state pension systems stem from their continued reliance on traditional defined-benefit retirement plans. Just 21 percent of private-sector employees were in defined-benefit plans as of 2009, down from 84 percent in 1980. But 84 percent of state and local government workers were still in the traditional systems.

Under a defined-contribution system, the employer makes set contributions to an employee’s retirement fund rather than guaranteeing a specific level of post-employment benefits. A defined-contribution plan more effectively ties employee benefits to contributions and better protects government budgets from short-term market fluctuations.

One reason for the continued dominance of defined-benefit plans in the public sector has been a fear that steep costs would accompany the transition to a defined-contribution system. Because most public pension systems are underfunded, the argument goes, their sustainability depends on higher contributions in the future from both employers and employees, and abandoning defined-benefit plans would leave taxpayers to pick up an enormous tab for current unfunded liabilities.

Those arguments almost invariably are paired with predictions that better investment returns are ahead that will help solve the pension mess. But with the first wave of baby boomers retiring as investment returns plummeted in the wake of the 2008 financial crisis, public pensions are starting to look a little like an officially sanctioned Ponzi scheme.

The simple response to the transition-cost argument is that we’ll be on the hook for unfunded liabilities whether or not a system switches from defined benefits to defined contributions. But things are never that simple.

In this case, the main complication has for nearly two decades been rules from the Government Accounting Standards Board (GASB) that some interpreted as requiring public pension systems to pay off more of their unfunded liabilities up front if a defined-benefit plan is closed to new members. Of course, higher short-run costs are rarely popular in government, particularly during times of fiscal stress.

That interpretation of GASB rules led to some strange results. Primary among them was that it made reform nearly impossible for the plans that need it most. Because their unfunded liability is so great, shifting more of the burden up front would be particularly painful. As one headline put it, “Virginia Retirement System too far in debt to reform.”

But last summer, GASB changed the rules, making it clear that its goal is to promote transparency in financial reporting, not to dictate how much governments contribute annually toward eventually retiring their unfunded pension liabilities.

For most states, including Illinois, the new rules eliminate the main substantive barrier to moving toward defined-contribution plans. But politics are just as responsible for the sorry state of government pension systems. Time will tell if the new GASB rules are the spark that ignites a transition for public pensions like the one we’ve seen in the private sector.

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