Unfunded State Pension Liabilities

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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Federal Budget Cuts

                                             Federal Budget Cuts

In a conversation with a friend recently he mentioned that all the employees at his company would have to take a 10% pay cut this year. He was naturally concerned but at the same time he realized that it was necessary in order for everyone to keep his or her jobs.

Companies, even major ones like the one he worked for, cannot necessarily raise their prices in order to achieve greater revenue. In a highly competitive environment, higher prices often mean less actual revenue as customers either flee to cheaper products, or just buy less.

Unfortunately, the Federal Government does not work this way. Facing a huge operating deficit, the President can only propose increasing prices or taxes without one cent of spending reduction.

Here is a modest proposal. Many years ago I read a letter to the editor of a major newspaper from the owner of an auto dealership that was trying to weather another economic recession like ours. He came up with what he called a 5-10-15 plan. In his company the top third of wage earners had to take a 15% pay cut. The middle third had their pay cut by 10%, and the bottom third only had to take a 5% cut.

In other words, if the CEO was making $150000 per year, his pay was cut by 15% or $22500. Someone making $75000 per year had to take a cut of 10% or $7500. An administrative assistant making $30000 per year had to take a cut of 5% or $1500. Given the circumstances, anyone would agree that these cuts were fair and equitable, but they also worked. The company was saved and weathered the storm until the economy recovered, but in the meantime not one employee lost their job.

How much would the Federal government save if every employee, including the President and Members of Congress, making over $150000, had to take a 15% pay cut? Substantially more would be saved if the great mass of Federal employees making between $50000 and $100000 had to take a $10% cut. Even greater savings would be realized if all those making less than $50000 per year had to take a 5% cut.

In this way, no one would lose their jobs and there would be no need to cut needed departments and services. Cutting jobs usually means that higher salaried government workers just bump lower salaried ones out of their jobs. To ease the pain the cuts could be phased in over two years.

This 5-10-15 plan would be an important first step in turning the massive ship of state around before it sinks under the massive load of debt and taxation. We are not too far from following Greece and Italy into a titanic disaster. ###

The New Aristocracy

                                            

Despite the economic hard times there is a large class of Americans for whom there is no retirement crisis, no health-care crisis, and no employment crisis. Federal, State, and Municipal employees have no reason to worry. They all have defined benefit retirement plans that are guaranteed against market loss by taxpayers. They all have excellent medical insurance at virtually no cost. After a short period of employment, their jobs are virtually guaranteed and it is only with great difficulty that they can be terminated or laid off.

This class constitutes a kind of aristocracy that is entirely supported by the rest of the population that has nowhere near the benefits enjoyed by its members. The Federal government is the largest employer in the Nation and its size gets bigger every day no matter which party is in office. State and Municipal employees include police officers, firefighters, teachers, as well as an army of civil servants.

Retirement benefits are the least understood part of the compensation of the government class but they provide a good example of the disparity between the two classes. Virtually everyone in the government class enjoys the benefits of what is known as a defined benefit pension plan. These plans, which have largely disappeared in the private sector, provide a guaranteed lifetime income at retirement.

For example, in my home state of Connecticut a teacher can retire after 35 years of service on 70% of their final average pay. Final average pay is important. In Connecticut it means the average of the highest three years earnings, not an average of lifetime annual earnings. Teachers whose final average pay is $90000/year could retire as early as age 56 on $63000/ year for the rest of their lives.

Unlike the 401k plans prevalent in the private sector the defined benefit plan income is guaranteed by the State’s taxpayers no matter what return is achieved by the underlying pension assets. The town of Fairfield recently lost $40,000,000 on a Madoff investment and has just raised taxes in order to cover the expected shortfall. Although not the victim of a scam, the neighboring city of Bridgeport experienced such losses in the recent downturn that it had to come up with $25,000,000 to cover its shortfall.

The very generous pensions enjoyed by members of the government class in Connecticut seem miserly compared with some other states. On a recent visit to San Francisco  I read the local paper and found it full of news of the draconian budget cuts proposed in that nearly bankrupt state. San Francisco itself was being forced to cut essential services to balance its budget. Nevertheless, buried inside the paper was an article detailing the incredible pension benefits of its municipal employees.

The article referred to over 480 retired city workers and their survivors who are “knocking back $100,000 or more a year in pension money.” To keep it simple, if 480 people receive $100,000 per year, that’s a minimum of $48,000,000 a year in pension benefits. At 4% interest it would take $1.2 billion to provide $48,000,000 per year. However, in a low interest rate environment such as we’ve been through in the last few years, the pension actuaries must demand that even more be allocated to fund plan benefits. That is why so many of these plans are underfunded.

Budget difficulties in New York State and City have led to new taxes and fees. However, the generous pensions of retired New York State and City employees are not subject to either State or City income taxes. Could there be greater proof of the disparity between the two nations?

A call for pension reform does not imply criticism of government employees and their work. Like the rest of us most of them work hard at their jobs and deserve to be financially secure in retirement. Nevertheless, their defined benefit pension plans are dinosaurs that are crushing the rest of us under foot. They even prevent cities and states from hiring much needed teachers, police, firefighters, medical, and social workers.

How did such a disparity come about? Basically, defined benefit plan formulas were designed to protect employees, who were typically underpaid, from being destitute in old age. Until the last decade or so government salaries were too low to allow employees to save for retirement on their own. However, recent increases in salaries were not matched by modifications in retirement plan benefit formulas.  In Connecticut an attempt to change the average pay calculation formula from a 3-year average to a 5-year average failed largely through the efforts of the teacher unions and their friends in the legislature. Minor modifications in pension benefit formulas can produce millions in savings and still provide adequate retirement income for state and municipal employees.

Basing final average pay on the last 5 or 10 years of service would produce significant savings. Just ask the actuaries. Of course, the Social Security system, the primary source of retirement income for the rest of us in the private sector, uses 30 years to calculate final average pay. Using more years to calculate final average pay would also eliminate a common form of abuse where municipal employees find ways to significantly boost salaries in the last years of service.

A first step in the reform process should be the removal of elected officials, especially members of Congress and State legislators, from any future participation in these retirement plans. Their current pension benefits should be frozen, and future payments placed into a defined contribution retirement plan. Otherwise, they would have no incentive to modify the existing arrangements.###