The Pension Time Bomb -- Part I

In April 2005, San Diego mayor Dick Murphy stepped before a hastily as­sembled crowd of news reporters and announced his resignation. Murphy, elected just five...
by | July 20, 2009 AT 3:00 AM

In April 2005, San Diego mayor Dick Murphy stepped before a hastily as­sembled crowd of news reporters and announced his resignation. Murphy, elected just five months earlier, had become the focal point of public backlash over a city pension deficit of nearly $2 billion. Not only were San Diego's pension troubles a key factor in Murphy's resignation, they also hin­dered the city's effort to complete capital projects. San Diego's credit rating fell in 2004, hobbling the city's ability to sell bonds to finance initiatives such as water and sewer improvements, according to the Los Angeles Times.

Murphy's resignation may be the most visible fallout yet from unfunded public pension liabilities. But he is far from the only public official confronting the massive problem of retiree pension and healthcare liabilities. Following the market meltdown of 2008, the outlook for public pension systems only grew worse.


The hole in which most states and municipalities find themselves in is massive. How massive? It is difficult to tell with any precision. First, where pension assets stand at any given moment depend largely on recent stock market performance, and in times of high volatility--times like these--the numbers shift rapidly. Second, collecting the status of thousands of independent public retirement systems is impossible. Third, determining the associated liability of future health care obligations requires looking into a murky crystal ball to foresee how medical costs might increase in the future.

There is no disputing, however, that the scope of unfunded pension and retirement health care obligations facing the public sector is enormous.

Accrding to an article by David Evans of in March 2009, "With stock market losses this year, public pensions in the U.S. are now underfunded by more than $1 trillion."

Anecdotally, we know that Vallejo, California, had to declare bankruptcy, largely because of an unsustainable burden on their budget caused by retirement obligations. In New York City, Mayor Bloomberg sees almost 10% of his budget go towards unfunded pension liabilities. Illinois, New Jersey, and other states face huge uphill climbs.


Cause #1 -- Lack of Prefunding Requirements

There are generally no requirements forcing public retirement plans to fund their pension liabilities. As a result, these plans are funded to varying de­grees, including some that are completely unfunded and operate on a "pay­-as-you-go" basis. Paying less than the actuarially determined contribution each year increases the unfunded liability.

In contrast, private sector organizations must comply with the Employ­ee Retirement Income Security Act of 1974 (ERISA), which sets minimum funding standards for company-sponsored retirement plans.

Cause #2 -- Benefit Expansions

Flush with earnings from a bull market that lasted through much of the 1990s, government retirement plans opted not only to expand bene?ts for retirees, but also to make those benefits easier to get. States and localities routinely added perks to public sector retirement plans, often justifying the increases as necessary to retain qualified workers.

Cause #3 -- Growth of Supplemental Benefits

Retirement plans also greatly expanded supplemental bene?ts over the past 10 years, which in turn signi?cantly increased pension costs

Cause #4 -- Smaller Employee Contribution Share

Most public retirement plans require participants and their employers to contribute to the plan. But as plan costs have risen, employee contributions generally have not kept pace.

Cause #5 -- Lucrative Early Retirement Packages

Not only were benefit amounts rising in the 1990s, but public retirement systems were paying out fatter pension amounts for longer periods of time. Lucrative "unreduced" early retirement bene?t provisions had the effect of actually encouraging many employees to retire in their early 50s. Such early retirement adds signi? cantly to the costs of these plans because earlier ben­efit commencement coupled with constant improvements in health care (re­sulting in retirees living longer) mean that retirees now draw bene?ts longer than ever before.

Second, special early retirement windows programs, implemented to re­duce the size of the workforce, are often designed without sufficient consid­eration given to how to provide the underlying services with a much smaller workforce or to the costs of the window. The result is that these programs often cost more money in the long run than they save.

Cause #6 -- Higher Risks of De?ned Bene?t Programs

All of the issues already discussed are magnified by the fact that gov­ernment retirement plans tend to be much more expensive to support than those offered by private employers. Unlike the private sector today, the vast majority of government retirement systems still offer defined benefit plans, which guarantee retirees a predetermined bene?t amount based on the number of years they work and their final or highest average compensa­tion amount.

Cause #7 -- Structural Weaknesses Masked by 1990s Stock Market Boom

The increasing cost of government pensions (and the failure of many public pension sponsors to fund their plans adequately) was masked by a booming stock market in the 1990s. Thanks to historic market gains during the dot­com era, pension fund investment revenue easily kept pace with expanding retirement perks.

Investment returns were so good, in fact, that many governments made no contribution at all to their retirement funds during that period. Before 2005 local governments in New Jersey had gone six years without pay­ing anything toward public employee retirement plans, the Star-Ledger re­ported.

Cause #8 -- Deferring Pension Contributions to Balance Budgets

Dwindling investment returns and growing pension costs would seem to demand bigger government contributions to prop up the ailing retirement funds. But, in fact, the opposite actually occurred over the past few years. The faltering economy crimped general government reve­nues, leading jurisdictions to divert retirement fund contributions to other priorities. States such as New Jersey and North Carolina reduced retire­ment fund payments to help balance their books.

Cause #9 -- Little Incentive or Urgency to Fix Problem

Public pension policy often suffers from an "It won't be my problem after I am out of office" mentality. Those in office shortchange the pension fund, and the bill for unfunded pension liabilities is left for future administrations and generations.

Cause #10 -- Dif?culty of Modifying Retirement Plans

Pension costs are outpacing contributions, but it is extremely difficult to increase the amount employees pay into their plans or reduce the benefit amounts they receive. Public pension rights, however, typically are considered part of a con­tract between the employer and employee. That makes it much harder to modify a public pension plan's terms.

From Causes to Cures

How can governments escape the fiscal black hole some already have entered and others are on the verge of falling into? Unfortunately, there is no silver bullet, no single strategy that ?ts all situations. Several options exist, and states and localities must choose approaches that best fits their fiscal situation, po­litical climate and future goals.

Part II of this series, "Fixing the Pension Mess", will look at short term and long term fixes for this vexing issue.

This article is adapted from "States of Transition: Tackling Government's Toughest Policy and Management Challenges," published by Deloitte, edited by William D. Eggers and Robert N. Campbell, Chapter 4" Fixing the Pension Crisis, by Lance Weiss, Tim Phoenix, William D. Eggers and Rick Davenport.