States all over the country are grappling with ever increasing unfunded pension liabilities. My home state of Connecticut trails such pension liability behemoths like Illinois and New Jersey but still ranks high on the danger list. In June 2010 the Connecticut public pension fund had $9.3 Billion in assets but its actuaries calculated that the State still needed an additional $21.1 Billion to meet all its pension obligations. It was only 44% funded.
By June 2016, six years later, State pension assets grew to $11.9 Billion, a 28% increase, largely because of the increase in the stock market. Nevertheless, despite Governor Malloy’s tax increases and commitment to funding pensions, the pension liability had grown to $32.3 Billion, a whopping 53% increase. After six years under Governor Malloy, the pension system was only 37% funded. What caused the increase?
The Governor, who will not seek re-election this year after serving two terms, has placed the blame for rising pension liabilities on his predecessors in office, as well as on the Legislature which has been controlled by fellow Democrats throughout his tenure. His complaint is a common one. If only previous politicians had had the guts to face up to reality and popular pressure, pension liabilities would be manageable. Instead, politicians just pushed the day of reckoning down the road.
There is a degree of truth in Malloy’s assessment but actually there was no way that any of these state public pension plans could ever have been adequately or fully funded. They are “defined benefit” plans that require actuaries to determine the potential costs of benefits that are promised to future beneficiaries. A key factor in the calculations will be the “assumed rate of return” on both assets in the plan.
Despite the increase in Connecticut pension assets during Governor Malloy’s tenure, the pension liability has grown largely because of the low interest rate environment during those years. If the expected rate of return is reduced, actuaries must indicate that pension liability is growing. A drop of even one percentage point in the assumed rate of return will add millions to pension liability.
Politicians have no control over interest rates. Lack of control is one of the reasons why most business corporations dropped their defined benefit pension plans over the past few decades. A business could be thriving but its pension actuary could kill its balance sheet by claiming that it had to put billions more into the pension plan because of a decline in expected rate of return due to circumstances entirely beyond control. In a defined contribution or 401k type plan, a corporation’s contribution is a manageable percentage of payroll.
The very definition of the benefit in a defined benefit pension plan presents another problem for actuaries trying to assess pension funding. The retirement benefit is usually a percentage of an employee’s final average pay over the highest three years of service. How is it possible to calculate pension liability when salaries can change dramatically especially during the last years of employment? For example, during his tenure Governor Malloy has appointed a number of Democrat legislators to high paying positions in his administration or on the judicial bench.
While those politicians served in the legislature, actuaries would determine their pension liability as a percentage of their $35000 part-time salary. But they need to serve only three years in their new positions to throw all pension calculations out the window. Instead of getting 60% or 70% of $35000, the actuaries will have to figure that they will receive the same percentage of some six figure salary. During his tenure the governor raised his long-time Stamford Democrat friend Andrew McDonald to a judgeship on the State Supreme Court. McDonald’s minimal contributions to the pension fund during his eight years in the legislature will come nowhere near providing a six-figure pension.
These political appointments are the tip of the iceberg. How is it possible to calculate the future pension liability for young teachers just starting their careers when no one knows what their final average pay will be? Step raises due to longevity, minimal cost of living increases, and future inflation will practically quadruple their salaries after 35 years of service.
Businesses changed their pension plans years ago because they lived in a very competitive environment, and they could not count on taxpayers to bail them out. States and municipalities were not in the same situation. Not only did public entities not worry about profits and losses, politicians had little incentive to strike hard bargains with public service unions. In business, management and labor sit across the negotiating table from one another. In government, the politicians negotiating with the unions are usually on the same side of the table. Not only do governors and legislators rely heavily on union votes and campaign contributions, but also they, their families, and friends often gain from benefits they grant to union members.
Why didn’t Governor Malloy change the pension system for non-union employees in his administration or in the state court system? They have no binding union contracts. In the last eight years he and the Democrat controlled legislature could have put them into a 401k type plan with the stroke of a pen. Alternatively, he could have easily changed the definition in the benefit formula for these non-union employees. Instead of basing their pension on the average of their highest three years of service, the Governor could have used the average of all the years of their public service.
Public service employees make up a small percentage of the population of Connecticut but a larger and larger share of the State’s budget is going to fund their generous pensions. The rest of Connecticut's population is covered under Social Security where the retirement benefit is based not on the highest three years pay but on average pay over practically an entire working career.
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