Pension Reform

Denying Pension Realities?

A recent paper published by the Brookings Institution claims that “there is no imminent ‘crisis’ for most pension plans.” At the risk of sounding like a naysayer, this conclusion is incorrect. The problems start with the basic assumptions built into the paper.

The authors argue that pay-as-you-go pension plans (plans with a funding ratio less than 1%) will not inherently lead to the rapid growth of liabilities or cause a plan to be unsustainable.

According to a recent report from the Center for State Fiscal Reform  at the American Legislative Exchange Council (ALEC), the average risk-free funding ratio for a state pension plan is just 35.79 percent.

As recommended, a discount rate (how a plan determines the value of all future liabilities in present day dollars) should reflect a state’s inability to default on those pension promises. As has been noted in states like Illinois, a state is constitutionally obligated to pay out pension promises. This means the discount rate for these pension promises should reflect that obligation using a risk-free discount rate.

What does a risk-free discount rate look like? The closest thing we have is the yield curve (what a bondholder expects to be paid when the bond fully matures) of a U.S. Treasury Bond. The ALEC report Unaccountable and Unaffordable uses a discount rate that comes from a hypothetical 15-year Treasury Bond yield (taken from the average of 10- and 20-year Treasury Bond yields). According to the Government Accounting Standards Board (GASB), the amortization period (the time period for paying off liabilities plus interest in a series of installments) for a pension plan is 30 years.

This is indicative of an imminent crisis for many plans. Many reports have cited an 80% funding ratio as stable, but the American Academy of Actuaries reports that plans should strive for a 100% funding ratio in order to keep future contribution requirements from growing, maintain security for beneficiaries and limit the burden on future taxpayers.

Next, the Brookings authors note that pay-as-you-go plans do become unsustainable if plan costs rise at a faster pace than the underlying stream of funding revenue. This situation is typically caused by demographic changes that increase the number of beneficiaries and/or decrease the number of taxpayers. Alternatively, it can also occur by benefit liabilities increasing faster than tax revenues because more benefits are promised to retirees over time.

Finally, the authors assume that unfunded liabilities are a form of implicit debt that can be rolled over indefinitely without adjusting taxes or expenditures because interest rates are low. But lower interest rates are a double-edged sword for state governments. While it’s easier to borrow with lower interest rates, Treasury Bond yields that states have relied on in part to fund these plans will also be lower. This has (in part) incentivized pension funds to chase returns by investing in increasingly riskier assets.

In past years, state governments could rely on 30-year U.S. Treasury bond yields to fund pension plans. However, those bonds will soon mature and state governments will be reinvesting at less than half the rate they were 30 years ago. States then must make a choice: increase pension contributions in the present (through raising taxes or diverting funds from other spending priorities) or make riskier investments with borrowed money by issuing pension obligation bonds or other high-risk assets.

Many states will choose the latter because they fear the political backlash of raising taxes. However, investors are being advised against buying pension obligation bonds because returns on those bonds are falling far short of expectations.

However, some states have made serious improvements to their pension systems. For example, in 2017, Michigan introduced a 401(k)-style pension plan for teachers, whereas the State Employees Retirement System (SERS) has had a 401(k)-style pension plan since 1997. Much of Michigan’s unfunded pension liabilities came from the Michigan Public School Employee Retirement System (MPSERS).

Other states, such as Pennsylvania, have transitioned to a hybrid defined benefit/defined contribution with a defined contribution option. This option was made available to all employees hired after January 1, 2019.

These are steps in the right direction for Michigan and Pennsylvania to help reduce their unfunded liabilities – a crisis that states can no longer afford to ignore. As Nobel Prize-winning economist James Buchanan correctly noted, the fiscal cost of government debt is put on future taxpayers, who will be forced to make sacrifices to repay debt taken on today.

In Depth: Pension Reform

Modern, 401(k)-style plans are now commonplace in the private sector. For state workers, however, traditional pensions are still the norm. As former Utah State Senator Dan Liljenquist wrote in Keeping the Promise: State Solutions for Government Pension Reform, this is not a partisan issue, but a math problem. State Budget…

+ Pension Reform In Depth