The Pension-Reform Imperative

Overhauling public-sector retirement funds for sustainability is a political swamp. But failing to act now would be catastrophic.

In a 1962 speech, President John F. Kennedy recounted the story of a man who asked his gardener to plant a tree. The gardener objected, saying the tree was slow-growing and wouldn't reach maturity for 100 years. "In that case," the man replied, "there is no time to lose. Plant it this afternoon!"

The story could have been a parable about the need to overhaul public-employee pension systems. Since in most cases reforms apply only to new employees, they often won't save money until the reformers are long gone. Yet failure to enact them would be catastrophic.

For decades, the temptation to borrow from the future proved irresistible. States didn't make sufficient contributions to their pension funds. They passed early retirement incentives that saved money in the short term but drove up pension costs. And they never seemed to take the cost of health insurance for retirees into account.

The bill has come due. Last year a study from the Pew Center on the States found a $1 trillion shortfall between state retirement-fund assets run and the pension benefits promised to public retirees. The problem is only getting worse. In 2000, just over half the states had fully funded pension plans; by 2008, the number was down to four.

At least one expert thinks the actual unfunded liability may be more like $3 trillion since the calculation usually assumes that pension funds will earn about 8 percent annually while pension commitments remain regardless of actual returns.

The problem has gotten bad enough for some leaders to wade into this political swamp. Last week, New York Gov. Andrew Cuomo told the New York Times that pension reform is his top priority for 2012. In Rhode Island, General Treasurer Gina Raimondo, who chairs the state retirement board, says reform is needed to avert fiscal disaster.

When pension funds don't deliver expected returns, states have to make up the difference, sometimes imperiling their bond ratings. A falling stock market usually means state revenues are also on the decline, making it the worst time to ask taxpayers to plug funding gaps.

In part to avoid these fluctuations, Alaska, Michigan, Nebraska and Washington, D.C., have ditched traditional defined-benefit pension plans in favor of defined-contribution plans, like the 401(k)'s used by the vast majority of private businesses.

The traditional pushback has been that defined-contribution plans are unfair to public employees who earn lower salaries in return for good benefits and job security. But times have changed. According to the federal Bureau of Labor Statistics, the average hourly wage for nation's state- and local-government employees is more than 27 percent higher than for their private-sector counterparts.

Still, the fierce opposition in some quarters to defined-contribution plans is not likely to dissipate. Florida, Georgia, Indiana, Ohio, Oregon and Washington State, which have plans that are a blend of defined benefit and defined contribution, show there is a third way.

Cash-balance pension plans, under which employees are guaranteed an annual interest rate on their contributions and the employer's match, would also provide more predictability for states and stability for employees. The interest rate is often tied to the return on 10-year Treasury bills, which currently is around 3.25 percent and over the past 20 years has averaged closer to 5 percent.

Neither defined-contribution nor cash-balance plans can protect taxpayers from having to pick up the tab for years of kicking the pension can down the road. But they might just lead to a fair and sustainable future.