The Reforms That Public Pensions Really Need

As two experts demonstrate, there's more to the problems faced by state and local retirement systems than mere political shenanigans.
by | January 21, 2014

A new report out of the Rockefeller Institute of Government paints the darkest picture of issues surrounding public-employee pensions I have ever read. But unlike so many reports brimming with dire warnings about pensions, Strengthening the Security of Public Sector Defined Benefit Plans isn't anti-government-employee or anti-union and, as its title suggests, it isn't yet another call for converting all defined benefit plans to defined contribution. Authors Donald Boyd and Peter Kiernan argue forcefully that public pensions are a societal value that must be preserved.

This powerful paper demolishes several major tenets of the conventional wisdom. For example, many pension experts will tell you that pensions have become a hot-button political issue as the result of the failures of a few bad actors. Detroit comes up in almost every discussion of public-employee pensions, and Illinois, Kentucky and New Jersey are infamous for not making the actuarially required contributions and for all sorts of fiscal gimmicks regarding their pension funds. In her 2012 book, State and Local Pensions: What Now?, Alicia Munnell, director of the Center for Retirement Research at Boston College, called these "shenanigans" the result of "politicians behaving irresponsibly."

Munnell's assertion is a fair one. But Boyd and Kiernan make effective use of data and compelling graphics to argue that the problems are more widespread and the causes more fundamental, starting with their compelling assertion that pension funds' liabilities are mismeasured.

This is the clearest version of the ongoing argument over the proper rate for pension funds to discount their liabilities by their expected return on assets that I have seen. Pension funds typically have used a discount rate that they believe reflects future earnings, but Boyd and Kiernan make a strong case for valuing the liabilities by the risk that they will not be paid.

Supporters of defined benefit plans have tended to argue for using estimated investment returns to discount liabilities because doing so makes the liability seem smaller and lowers the contributions that government must make. This is politically convenient but pushes a reckoning off to the future when the fund finds that it hasn't the money to pay beneficiaries and the required contribution has ballooned to a politically unsupportable number. The problem with pushing things to the future is that, as the authors note, "the future arrives."

Using the anticipated earnings rate to discount liabilities also encourages fund managers to engage in ever-riskier investments since, under the current system, the more risk the fund takes on, the larger the rate of return it can forecast and the lower the liabilities it can report. Munnell wrote that public-pension plans were chasing each other up "the ladder of risk," holding too large a share of their assets in riskier investments. Boyd and Kiernan amplify that point, noting that for the weakest funds "asset allocations to alternative investments grew to about 25 percent of assets in 2011 from virtually zero in 2001, translating into a larger asset-liability mismatch and exposing them to greater volatility and liquidity risks."

Pension funds are taking these risks at a time when the financial capacity of the governments that backstop the retirement systems is severely diminished. Further, Boyd and Kiernan note that "those most at risk -- stakeholders in government services and investments such as education, the courts, care for the needy, and infrastructure, and the taxpayers and fee payers who foot the bill as well as future government hires will not have a say in the risk they are bearing."

Boyd and Kiernan note that while the flaws in public-pension plans have existed for decades, they are creating much more risk than in the past because of changing demographics and the relative increases in the size of the funds relative to the rest of the economy. The number of active employees per beneficiary has steadily declined since the mid-1950s from more than 7 to 1 to less than 2 to 1. Pension-fund assets were about 7 percent of the economy in 1980; today that figure is more than 20 percent of GDP. And in 1980 about 23 percent of pension-fund assets were in equities; by 2012, that figure had ballooned to 67 percent.

A report like this from a major institution like the Rockefeller Institute that challenges so much of the conventional wisdom is bound to generate a real pushback from the established players in the pension arena. Many of them are going to seize on the authors' assertion that there is a national interest and a possible federal role in strengthening public-pension funds if "states and standards-setting bodies do not go far enough on their own." What I read here, however, is a wake-up call for states and localities to take seriously the issues being raised and deal with them forthrightly and effectively.

The motives of many of the critics of public sector defined benefit plans are questionable. Many of them are anti-government and anti-union, and it seems clear that they'd like public pensions to disappear the way private pensions largely have. Those who disagree with these critics should read this important and illuminating study and take careful heed of its warnings and recommendations.

Mark Funkhouser  |  Director, GOVERNING Institute
mfunkhouser@governing.com  | 

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