Defined contributions a potential solution to states’ unsustainable liabilities
By Annie Dwyer
As candidates across the country ramp up pre-election promises to deplete mountains of debt, something is still missing: real solutions. Pension and healthcare benefits threaten to overtake state and local budgets, and yet few government officials, incumbents and those seeking office, seem to be able to answer the tough questions about their plan to tackle these issues.“The problem is not going away, and public officials cannot cross their fingers and ignore it,” said Eileen Norcross, state and local policy expert at the Mercatus Center at George Mason University. “Philadelphia, Boston, Chicago and New York City are slated to run out of money to pay retirees in the next few years. That means less money for core public services in our major cities.”
According to a study released by Norcross and her co-author, Andrew Biggs of the American Enterprise Institute, the public pension crisis alone will require states to contribute two or three times more of their budgets to fund these obligations, leaving less money for education and basic government service. Unless states embrace serious reforms, the money will run out. Current systems are simply unsustainable.
According to Norcross and Biggs’ calculations, states have a total public pension liability of $5.2 trillion, $3 trillion of which is unfunded. These numbers are significantly higher than official government reports of $452 billion in unfunded state public pension liabilities. That’s because Norcross and Biggs applied the method private sector pensions must use when valuing pension liabilities: the market-valuation of the liability, or using the risk-free discount rate to value the liability.
“Expected returns on risky investments aren’t guaranteed, but public pensions are,” said Norcross. “Legislatures have made promises without looking at the cost, but risk is risk. The government doesn’t have special powers to exempt itself from the risk of its investments.”
The methodology used by Norcross and Biggs highlights a problem: how state actuaries calculate these obligations. Official calculations assume an optimistic eight percent return on investments, but Norcross and Biggs argue that this return projection is much too high. It’s an inappropriate way to measure the liability, Norcross told C-SPAN’s Washington Journal.
“States, like any business, need to request that their actuaries run a range of scenarios for pension obligations from the more conservative estimates to the most optimistic,” said Norcross. “This way states can make informed fiscal judgments on their total liabilities by looking at what they could cost in the long-run.”
Many states though like the rosy, actuarial projections, because they make things look less painful, she said.
“Government officials are scared, and they are perfectly happy with getting bad advice,” said Norcross. “They need to come back to reality and get a handle on the size of this problem.”
Some states are facing reality. Utah recently successfully overhauled its defined-benefit pension system by calculating the reality of how large their obligations were, and planned accordingly.
Before the economic downturn in 2008, Utah’s public pension system was fully funded, but the financial crisis blew a 30-percent hole in the pension system, said Utah State Senator Dan Liljenquist. Facing a $6.5 billion funding gap for long-term obligations, Utah requested that the state actuaries project the cost of the pension fund 40 years into the future. No matter what scenario the actuaries ran, the data showed the state could not grow out of its problem. Utah was broke.
“We made a long-term commitment on faulty underlying assumptions that everything was good,” said Liljenquist. “Year after year we thought we could get above market returns, have no risk and that the taxpayer can always afford more—that was the problem.”
Keeping the system in its current form would have required Utah to increase its annual contribution to the public pension fund by 75 percent over the next 3-4 years, Liljenquist explained. The state simply couldn’t do that as the amount of money involved would have been equivalent to 8-10 percent of Utah’s general and education fund for the next 25 years.
“This is not a short-term fix, it’s a long-term problem we spent decades getting into,” said Liljenquist. “This isn’t a problem that you can get out of overnight.”
In the end, Utah closed their state defined-contribution plan to new hires. They replaced it with a hybrid plan that combined a 401(k) benefit with a guaranteed benefit starting in July 2011. In the previous defined-benefit plan, workers contributed nothing, while this new type of plan shifts more responsibility for funding retirement benefits to employees. The state contribution is capped at 10 percent, and the employee is responsible for contributing anything more than that. Until the current system is fully funded, it will not raise retirement benefits for state employees
The situation in Utah is representative of the problems that face many states; but each state faces a unique set of circumstances. The taxpayer burden of underfunded liabilities varies, and there is not one cure-all solution. Nonetheless, one thing is for certain. The first step to addressing the pension crisis in every state is to gather most complete information on the issue, because this level of debt threatens the financial health of the state and its ability to fix the problem.
It is in everyone’s best interest to help states and municipalities design plans that will work in the future. Government officials, public employees, business owners, union members, private sector workers, and taxpayers must work together in order to ensure that our public servants get what they deserve, and the quality of basic, government-provided services are maintained for public use.
Annie Dwyer is the Media Relations Associate with the Mercatus Center at George Mason University.