Part IV: Public pension plans in crisis: Share the risk or fail
When public pensions get to the point where they only have about 60¢ or less to cover $1.00 worth of obligations, the solutions are going to be painful for taxpayers and beneficiaries alike. That’s the reality of a pension plan that has been allowed to fall so far short of its proper funding. However, solutions exist that preserve a high proportion of the promises governments have made to their employees and retirees while creating incentives to keep the plans solvent once they’ve undergone reform. States with deeply troubled plans should look to New Brunswick in Canada and to the Netherlands to find pension plans that have achieved sustainable reforms. They might also reach out to Pro Bono Public Pensions. Gordon Hamlin, whose story I told in the first post of this series, has developed a road map that might just put troubled pension plans on the road to recovery. Recently Gordon described the path forward on Kentucky Educational Television.
As I discussed in part three of this series, solutions that put the entire burden on taxpayers or beneficiaries aren’t solutions. In most instances, the deficit remains and/or government becomes incapable of funding its other vital obligations.
If deeply troubled pensions are to be saved and existing deficits addressed, three perspectives are going to have to change.
Beneficiaries have to agree to more realistic and sustainable pension benefits. To be clear, I am saying that pensions will have to be somewhat less generous in the future.
Taxpayers and their political representatives have to accept more realistic assumptions about investment returns and the liability being funded. Again, so there’s no misunderstanding, taxpayers will be asked to make somewhat higher and more consistent contributions.
Shared risk has to become imbedded in public pension plans. In other words, both taxpayers and beneficiaries have to bear responsibility when pension plans face challenges and enjoy rewards when they do well. Without shared risk, pension plans will remain prone to insufficient funding and/or unrealistic benefits, which are the twin causes of instability.
When all the constituencies finally decide to solve the problem, public employees and retirees are going to have to accept some combination of longer working careers and more realistic retirement ages before drawing benefits. In many public pension systems, beneficiaries can retire long before traditional retirement age. Moreover, they have been living longer and therefore drawing substantially more benefits.
All too many public plans have automatic COLAs, which have continued to escalate the liability in deeply troubled pension plans. COLAs do not have to disappear entirely, but they should be paid if and only if pension plans can afford the payments.
The traditional back-end loaded salary formula that drives retirement benefits will have to be modified to a formula that creates a more realistic average salary. This is especially important for the highest paid positions in public pension systems.
The discount rate, which drives the assumed rate of return and discounts the pension’s liability, needs to be calculated at a more realistic level of 4.5% to 5.0%. Most pension plans use discount rates that encourage excessive risk taking with the assets while grossly understating the liabilities. This change will necessitate higher contributions by taxpayers, offset by the reforms already described in the previous paragraphs.
Politicians, beneficiaries, and trustees need to agree to a set of risk-sharing rules by which employer and employee contribution rates as well as benefits are adjusted depending on the financial condition of the pension plan. If the plan’s funding falls below specified levels, contributions must increase and in certain cases benefits may have to be pared (with a guaranteed floor). If benefits are reduced, priority should be given to restoring benefits before contributions are reduced. Conversely if a plan performs well the same sorts of formulae should allow contributions to be reduced and/or COLAs to be paid.
To achieve a workable model all the stakeholders have to have a seat at the negotiating table. Any one party trying to dictate a solution will probably be stymied by legislative intransigence or court challenges. The stakeholders will have to jointly hire lawyers and actuaries to advise them. If each side relies exclusively on its own experts it will be near impossible for the parties to agree on the financial impact of the reforms or the legal strategy for implementing those reforms.
The stakeholders will have to agree on a series of transition steps that bring about reforms over time. Whether it’s raising the retirement age or changing the discount rate, change will have to be implemented in steps. Public pension plans didn’t get in trouble in one or two years, and they won’t be restored to health quickly either.
If politicians, employees, retirees, and trustees can’t reach a sustainable solution for deeply troubled pension plans, states, municipalities, school districts, and all the other public entities with pension obligations will inflict major damage on their economies and the people they serve. Shared risk or fail: those are the choices.