Monday, June 17, 2013

Unfunded Pension Liabilities

Every day newspapers headlines complain of the huge deficits facing government at every level. At the same time, politicians and editorial writers warn that there is a serious problem with “underfunded” pensions. A great part of the debt load in states and municipalities across the country can be attributed to pension plan shortages. Even the troubles of the Federal Post Office are attributable to an enormous gap in pension funding.

Just recently it was reported that the pension plan of the State of Illinois was “underfunded” by a colossal 90 billion dollars. In tiny Connecticut the Governor and the State legislature had to play all kinds of tricks to at least balance on paper Connecticut’s projected two year budget. The City of Detroit is on the verge of bankruptcy largely due to enormous pension liabilities. Everywhere states and municipalities are cutting necessary services and raising taxes in attempts to fully fund pension and other public service employee retirement benefits. 

However, there is no way to adequately fund pensions without significant pension reform. Let me repeat. There is no way to adequately fund these pensions without significant reform. Most state and local pensions are “defined benefit” pension plans. In such plans, the benefit that an employee will receive in retirement is defined by a formula that gives employees a certain percentage of their “final average pay” for each year of service.

In other words, not matter what was earned in the early years of employment, a public service employee’s pension will be based on the much higher pay of the final years of employment. For example, a typical formula will guarantee an employee 2% of pay for each year of service. Thus, someone who reaches the normal retirement age after 35 years of service with a final average pay of $60000 will receive 70% of pay or a pension of $42000 per year for life. At 4% interest it would take a little over a million dollars to provide that annual benefit.

But how is it possible for a pension actuary to accurately predict how much money it would take to fully fund an employee’s pension? For a new employee it would take an annual payment of about $5400 earning 8% over 35 years to accumulate a million dollars. However, if the expected return is not achieved, then the actuary would have to report that the pension account is “underfunded,” and require that additional funds be added to it. So, merely a small reduction in expected rates of return would make a pension plan underfunded. In the last few years as interest rates have dropped dramatically, more and more pension plans have become “underfunded.”

Moreover, it is also very difficult for the pension actuary to predict what the employee’s salary will be in the final years of service. There is no way of knowing what inflation rates will do to salaries in the future, or where the employee’s career will lead. When a new Governor was elected in Connecticut three years ago he took more than six experienced legislators into his cabinet. As a result, their salaries more than tripled and so will their “final average pay” on which their pensions will be based. One was just appointed to the State Supreme court with a salary of $150000 per year, a figure that will soon be his final average pay instead of the $35000 he was making as a legislator. 

It’s hard to believe that “public service” employees don’t realize just how generous this formula is. Certainly, their union leaders understand. Just suggest that their membership shift into the Social Security system and you will send chills up their spine. Social Security benefits are based on average pay over 30 years of employment. In bankrupt Stockton, California a judge gave into union pressure and opted to screw the city’s bondholders rather than alter the generous pension formula. Detroit is about to go into bankruptcy and its public service unions have amassed a huge war just to resist any changes to their pension benefits.

Here is a suggestion for pension reform that will eliminate most of the existing pension liabilities without creating a Greek style revolt on the part of the public service employee unions. Gradually modify the benefit formula for all state employees so that Final Average Pay will be the average of 30 years of service instead of the highest 3 years. Phase in this modification for current employees in the following manner. Final Average Pay for employees who retire in the next 3 years would still be the average of their highest 3 years pay but for all other employees it would be the average of the number of years they have left to go before retirement.

For example, Final Average Pay for an employee retiring in 2017, 4 years from now, would be the average of their highest 4 years service. Final Average Pay for employees retiring in 2023 would be the average of their highest 10 years pay; those retiring in 2033 the average of their highest 20 years of pay; and those retiring in 2043 the average of 30 years pay.

Eventually, such a reform would enable actuaries to more accurately predict pension obligations and help to bring a degree of control and reality to government budgets at every level. It would also bring public service pensions more in line with what ordinary citizens can expect from Social Security. Has anyone ever wondered why politicians expend such time and effort dealing with public service employee pensions, and so little time in dealing with the terribly underfunded retirement plans of their constituents?


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