The Issue

How Governments Successfully Manage Pension Integrity

Many states, counties, school districts, cities, and other governments do a good job managing their pension integrity. The money is there to match the promises made because the percentage of pension debt that has been set aside in the plans, the funding ratio. Despite some claims that these pension plans get inferior returns on their pension investments (in reality, all plans seem to get about the same returns), governments that successfully make their full contributions year after year are able to do so because they work to keep these payments at an affordable level.

There are several practices that these governments utilize to manage these pensions:

  • The government leaders who make the promises study the issue carefully and are deliberate and conservative in making commitments.
  • If the government finds it has made commitments to features of the pension promise that will be costly to keep, that government will make changes to the plans.
  • Like the Federal Government with Social Security, these local governments will reduce benefits and increase taxes or employee contributions in a timely fashion, so that changes are at necessary and reasonable levels.
Some Governments Have Lost Control of Pension Integrity

The Promises > The Money

Governments that do not follow the good practices of pension management sooner or later lose control of their pension obligations.
Often these governments start off with funding formulas that are based upon payroll dollars and not the values computed by their actuaries. If there is a shortfall, these governments depend on increasing payrolls to make up the difference. This practice of counting on the growth of the city or the workforce causes new workers to pay for the pensions of their seniors.

If governments do not study and understand what is going on with pensions at the time that plans are established or changed, they end up making reckless and uninformed decisions. Often, when finances are tight, governments give generous pension promises so they can save on current salary increases and often also do not fully fund their annual required contributions.
Eventually the pension beneficiaries, plan officials and union leaders see their pension security eroding and lobby for guarantees from government that their pensions will not be changed or diminished and seek to have the pension debt paid before other government debts.

Meanwhile, the underfunded plans continue to pay increasing benefits as the government struggles to find money to catch up funding, and so the assets in the plans decrease in value.
These pension plans are in trouble and a vicious cycle is cemented where the promise grows and the money dissipates. This is failed pension integrity.

When the government has lost control of its pension integrity, it is impossible to catch-up without crushing burdens on future generations. If pension plans cannot be changed and the liability reduced to help solve the problem, the only solution is for relief from a higher authority, either state government or the federal government.

The Original Sin: A Problem Created by the U.S. Federal Government

Many public employee pension plans were created in the early 1900s to provide former public employees with some sort of income during their retirement, keeping these valued employees out of poverty. Most of these plans were defined benefit plans, which means beneficiaries were promised a specific pension predetermined by a formula based on the employee’s earnings, age at retirement and years of employment. Although the government established required funding by employers that was a multiple of the employee’s required contributions, over time officials legislated plan changes that gave workers increased benefits, early retirement, and cost of living adjustments. But, they did not adjust their budgets to immediately pay for these benefits, creating a fiscally irresponsible situation.

The Social Security system offered by the U.S. government is a bit different. Social Security acts as an insurance plan that is funded on a pay-as-you-go basis. Funding comes from current employees and is redistributed to pay the benefits of those who are retired. Benefits are not guaranteed. The U.S. government can and regularly does raise taxes and reduce benefits to balance out the transfer of money. If public sector defined benefit plans had the same powers as our national Social Security system, there would not be an underfunded pension problem today.

What are Defined Benefit Plans?

Most pensions are defined benefit plans, which means that the benefit for retirees is fixed by a formula and can’t be increased or decreased.

Just because a benefit has been defined and fixed doesn’t mean that its cost to the employer is fixed and certain. For a variety of reasons, the annual costs by employers to maintain the integrity of the pension plan can fluctuate widely.

For example, pension plans hold assets to provide for retirement and invest these funds before they need to pay them out. The biggest source of instability in pension funding has to do with the rate of earnings on these investments. Fluctuation of investment returns affects the dollar amount of assets in the plan. Since the plans discount their pension debt by the returns they expect from their investments, actual returns – when different from expected – cause both the integrity of the plan to fluctuate as well as the annual cost to the employer.

Additionally, changes in benefit provisions as well as changes in life expectancies also have a big impact on plan integrity.

Defined benefit plans are inherently unstable not matter how hard the employer tries to maintain their integrity. To keep up, employers will experience wide fluctuation in the cost of pensions within their annual budgets and expenditures.

A Growing Problem

Our collective national debt for underfunded public pensions is approximated to be upwards of $3 trillion dollars.

Some public employee pensions have three built-in windfalls, that are not features of Social Security or typical in private sector plans, that contribute to this problem – early retirement age, automatic compounded cost of living adjustment (COLA) and no overall cap on benefits. As it stands now, a public-sector retiree who receives a pension starting at $75,000 with a three percent compounded COLA, not uncommon in Chicago, would receive total payments in excess of $3.4 million over 30 years. This level of promised compensation is much higher than what the average retiree receives relying on Social Security and other private retirement benefits.

Many funds are dealing with unfavorable circumstances: low funding ratios, imbalance between retirees and active contributing employees, plan provisions that drive escalating benefit payments, and a lack of adequate funding from the local governmental authority.

Despite attempts by state and local governments to solve this problem, it persists. In most cases unions and public employees have resisted any reduction in benefits. This has pitted retirees against active employees, and both groups against municipalities. In some cases, like Illinois, the state constitution prohibits the diminishment or impairment of benefits. In states where there is no such restriction, government has found it impossible to structure a real solution. Some enact trivial improvements. Elsewhere it has taken municipal bankruptcy to even open up plan benefits for consideration. But even in those cases, judges have been extremely reluctant to provide significant structural relief.

Where does this leave us?

With the exception of Rhode Island, no other state or unit of local government has been able to make any meaningful structural changes to their pension liabilities. Some localities have entered and exited bankruptcy, yet the pension liabilities were not restructured, persistently dragging on local economies.

Currently, state and local governments face tremendous roadblocks to solving their pension problems. Now is the time for federal action on this issue.

What is an Underfunded Pension?

Troubled public pension plans, and there are many of them, have a vicious financial dynamic. An imbalanced ratio of benefits to contributions pushes them to collapse as they enter a mathematical zone that requires increasing contributions to keep the percentage of underfunding from worsening. Not only do employees and the employer have to contribute regular amounts, they now also have to make up for an increasing imbalance between what comes into the fund and what continues to be paid out to retirees.

If local tax increases and other funding sources are inadequate to keep the percentage of funding constant, the plan will run out of money. It’s that simple, and not far down the road for many plans – in fact, within just a few years for some.

How did the plans get into this situation to begin with? A look at employment accounting is a good place to start in answering this question.

When a worker earns retirement benefits, the company, through its actuaries, calculates how much of that expected benefit the worker earns each year and how much must be set aside today to make sure the money is there to pay the pension at retirement.

Let’s look at a company with one employee who works for 30 years, retires and is replaced by another younger employee. Every year, the company must calculate how much of the total retirement pension the employee has earned so far and put that money in the company’s pension fund. When the older employee retires, all of the money should be there to cover future retirement benefits. When the new employee starts working, the company sets aside different, unique money for her eventual retirement. Just because the pension payment will be made in the future does not mean that the company can put off setting that money aside. A company is not supposed to skip contributions to an employee’s pension fund, or reallocate dollars from one person’s fund to another.

If an employer does not put money into a plan in the year it was earned, there is an unfunded pension liability – the employer is disconnecting the pension promise from the money. As this underfunding grows, it pushes the burden for prior employee costs into the future. It is a legacy cost, like paying your parents’ debts after they are dead. In the case of underfunded public pensions, if the unit of government decides to spread these costs over a period of 20 to 40 years, it is burdening the community’s children and future generations.