Why Municipal Pension Systems Are a Terrible Idea

Josh Barro is the lead writer for the Ticker, Bloomberg View's blog on economics, finance and politics. His primary areas of interest include tax and fiscal policy, state and local government, and planning and land use.
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(Corrects number of Rhode Island cities and towns in second paragraph.)

Scituate, Rhode Island, population 10,329, operates a pension plan for its police department. The plan is underfunded to the tune of $8.4 million, a liability that has quadrupled since 1999. That doesn't sound like a big shortfall until you realize that Scituate's pension plan has only 33 participants, meaning that it is short by more than a quarter million dollars per employee.

Worse, Scituate isn't alone. Rhode Island, with just 39 cities and towns, has 36 separate municipal pension systems, and their unfunded liabilities total more than $2.3 billion. Most, like Scituate's, are less than 50 percent funded. Cranston, Rhode Island's third-largest city, has funded just 17 percent of its $330 million pension liability. All but one of these plans have fewer than a thousand members.

Pension plans are underfunded all over the country, but Rhode Island and a handful of other states are in worse shape than usual because of a bad structural decision: letting municipalities of all sizes run pension plans independently. In most states, public employee pension systems are run either by the state government alone or by the state and a handful of the largest cities. For example, New York City is the only municipality in New York state with its own plans; all other cities and counties participate in two large statewide funds.

Pension systems are complicated, and overseeing them properly takes time and expertise. This is a heavy lift for municipalities overseeing small pension plans. In the case of Scituate, the board that was supposed to oversee the police pension plan met only once between 1999 and 2011. Until 2007, Scituate was using an investment return projection of 9 percent, far more aggressive than is typical.

This lack of attention has meant that local plans are much more likely than statewide plans to have become deeply underfunded. Of the 110 statewide pension systems covered by the Public Funds Survey, the worst-funded is the Illinois State Employees' Retirement System, with a funding ratio of 35.5 percent. Sixteen of Rhode Island's 36 local plans are worse funded than Illinois SERS.

Scituate, like many troubled Rhode Island municipalities, is trying to work out a restructuring of its pension plan (read: benefit cuts and higher employee contributions) that will help it close the funding gap. Providence has had some success with this approach. Cutting benefits saves taxpayers money, but it won't fix the structural problem: Municipal governments aren't suited to the job of operating their own pension systems.

The more promising long-term fix, floated by some Rhode Island lawmakers including State Treasurer Gina Raimondo, is to close municipal pension plans and have one pension system for municipal workers overseen by the state government. This would build on the progress Rhode Island has made in improving its statewide pension systems, which already cover some local employees. A 2011 reform improved the largest system's funding ratio from 48 percent to 61 percent. Benefits were restructured so that some of the risk of investment returns is shifted from taxpayers to employees.

The biggest challenge with closing local pension systems is one of fairness: making sure that it doesn't become an opportunity for irresponsible towns and cities that underfunded their pension plans for decades to dump their liabilities into a statewide pool. In some places, municipal officials and unions might also resist the loss of local autonomy, but in Rhode Island they would likely be grateful to have a problem off their hands.

Without structural reform, cities and towns are likely to repeat their mistakes: making generous promises and not funding them. Concentrating pension responsibilities in the state government's hands will reduce, though not eliminate, that risk.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.