Mention pensions and until recently most people pictured a secure income in old age, leisurely trips and visits from grandchildren. That assumes they were lucky enough to have a pension.
But their eyes would quickly glaze over if the conversation steered toward years-of-service formulas, funding ratios and other arcane workings of retirement funds.
No more. The deteriorating condition of many state and local government pension funds has grown into an impassioned topic for cable talk shows. The financial meltdown and recession made apparent what many experts have long known: Too many municipalities routinely underfunded their pension plans while the future cost of their retirement payout promises swelled.
Take Illinois. It has funded only 54 percent of its public pension liability, according to the Pew Center on the States. The financing gap of $54.4 billion bill is more than three times the payroll for current workers in the state’s retirement plan.
The generosity of many public pensions is an incendiary topic, with taxpayers potentially on the hook for billions in unfunded promises.
“These are structural issues and not just a reflection of where we are at in the economic cycle,” says Joshua Rauh, a professor of finance at Northwestern University’s Kellogg School of Management. Adds Robert Clark, an economics professor at North Carolina State University: “The next decade will be one of fundamental reform in public sector pensions.”
Reform won’t be easy. In most cases state and city pension obligations can’t be changed for existing workers. Those employees will continue to earn their promised benefits throughout their government careers, although some states are trying to tinker at the margin, such as by changing cost-of-living payments. Municipalities can renegotiate pensions in Chapter 9 bankruptcy. (In contrast, companies can freeze promised benefits and modify retirement plans.)
Public pension reform will mostly impact new hires. According to current political discussions, if the 401(k) is good enough for private sector employees, it’s fine for the public workers. Yet three decades after their launch, the drawbacks of 401(k)s are increasingly apparent.
“There is certainly ‘pension envy’ and the answer is, let’s go to the lowest common denominator,” says Alicia Munnell, director of the Center for Retirement Research at Boston College. “That doesn’t make sense.”
The pressure for change offers a real chance at designing a better 401(k)-type plan.
‘Ripe for Reform’
Pension experts agree that unlike private-sector 401(k) plans, public-sector programs should offer a very limited menu of broad, low-fee investment choices; mandatory worker participation; a required employer match; and low-cost inflation-hedged annuity options to guarantee a fixed income in retirement. It’s an approach private employers may eventually want to follow.
“I have grown increasingly frustrated that this is boiling down to a debate of taxpayer versus government workers,” says Jeffrey Brown, finance professor at the University of Illinois at Urbana-Champaign. “Public pensions are ripe for reform and it’s a real opportunity for everyone.”
A majority of government workers are covered by “defined benefit” plans. These are the blue-chip pensions from days past, where the employer bears all the investment risk and commits to a fixed payout based on compensation and years of service. A dwindling number of private employers offer defined-benefit plans, which are costly to run and entail onerous obligations to retirees.
Companies instead are embracing comparatively cheaper defined-contribution plans, especially the 401(k). In these, employees decide how much money to invest and where to invest it, depending on the limits established by law and the choices offered by the employer. Companies may kick in a matching contribution, but employees bear all the investment risk.
Among the 100 largest U.S. corporations, 58 offer new employees only a defined contribution pension, compared with 10 in 1998, according to a 2010 survey by consultants Tower Watson. Only 17 of the companies surveyed offered a defined-benefit plan, down from 67 in 1998.
To be sure, most public employees have the option of participating in a defined-contribution plan, but it’s usually supplementary to a defined-benefit pension. The 401(k) is the bedrock savings plan in the private sector and increasingly it’s the only option available through employers.
The realization is dawning that the future tab for state and local defined-benefit pensions is even bigger than expected. That’s because most public plans assume 7 percent to 8.5 percent earnings on investments while finance economists convincingly argue that returns of 3 percent to 5 percent are more realistic.
The lower estimate swells the amount state and local governments may have to kick in to pay retirees. Assuming all state pension liabilities were frozen as of June 2009, unfunded liabilities would increase to $3 trillion at a more conservative rate, almost double the $1.8 trillion shortfall under standard public pension practice, according to Northwestern’s Rauh and Robert Novy-Marx, a finance professor at the University of Rochester.
“It isn’t a viable funding model,” says Olivia Mitchell, a professor of insurance and risk management at the University of Pennsylvania’s Wharton School.
One complication of replacing pensions with 401(k)-type plans for new government employees is that many state and local workers aren’t part of Social Security. They weren’t included in the federal retirement program when it was created in 1935 and, while growing numbers have been brought into the system since then, about a third still aren’t participants.
“If you have Social Security you have a floor, and the private sector would have had a much more difficult time making the shift from defined benefit to defined contribution without Social Security,” Rauh says. “If the only thing workers have is a 401(k) plan they have a great deal of risk.”
The solution seems to be either bringing all new state and local workers into Social Security or keeping defined-benefit plans for those workers while slashing the payout until it mirrors the income replacement ratios of Social Security.
With Social Security or a shrunken, fully funded pension plan as the base, the improved 401(k)-like portion could be modeled after the U.S. government’s Thrift Savings Plan. It’s a voluntary 401(k)-type program open to all federal employees. Fees are a razor thin .028 percent, or 28 cents per $1,000 of investment. However, any state and local government version would require participation and an employer contribution.
Another widely admired model is TIAA-CREF, which manages retirement plans for higher education. It offers plans that require contributions from employers and employees. Some or all of the money may be converted into a low-cost guaranteed annuity with a 3 percent minimum annual interest rate.
The annuity-like option with the inflation hedge may combine the best of defined-contribution and defined-benefit plans, says Zvi Bodie, a professor of finance and economics at Boston University.
Right now, the prospects for a reasoned overhaul of public pensions seems remote. Yet public officials have an opportunity to create a better retirement savings plan. Done right, the private sector could well follow the public sector’s lead.
(Chris Farrell is a Businessweek.com columnist. A version of this column appears on Businessweek.com. The opinions expressed are his own.)
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