Is Wall Street to Blame for the Pension Funding Crisis?
As the public pension crisis gains visibility across the country, it is natural to search for explanations for the trillions in unfunded liabilities that state and municipal governments have built up. The truth is that there are many. They include:
- Accounting standards requiring plans to discount their liabilities according to overly optimistic investment return assumptions;
- State and local governments that regularly skip their Annual Required Contributions;
- A massive financial crisis that wiped out many plan portfolios and helped reveal their already tenuous funding footing; and
- Legal barriers that frequently stand in the way of even the most minor benefit adjustments.
Each of these items, and many other factors, have played a part in growing unfunded plan liabilities. A separate narrative, however, is emerging that blames systemic underfunding on a borderline conspiratorial connection between state and local governments and Wall Street fat cats. While it contains some truth, it at most only tells a small sliver of the story.
This narrative ignores the flawed structure of standards and incentives that have pushed leaders at all levels of government to shirk responsibility for obligations not due until years in the future.
The narrative largely ignores that fact and instead contends that for decades, defined benefit public pension plans provided a modest yet secure retirement at an affordable cost to governments and taxpayers. Here’s how the story goes:
Politicians made a habit of skipping payments pension contributions, effectively stealing from the pockets of retirees, to fatten the wallets of corporations and business interests through subsidies and tax expenditures. At the same time, Wall Street pushed politicians to shift pension fund assets into risky “alternative” investment classes to reap millions in hedge fund management fees. Now, underfunded from a combination of these factors and the 2008 market crash, public sector retirement plans are under further attack from reform groups that vastly overstate plan underfunding in hopes of converting defined benefit plans to defined contribution plans.
A September article in Salon magazine by David Sirota argued that comprehensive pension reform is an unnecessary undertaking once unfunded liabilities are put in the context of corporate handouts and other business incentives given out by state and local governments. According to the New York Times, these total $80 billion per year from states, cities, and counties. Targeting Pew Charitable Trusts and the Laura and John Arnold Foundation, two groups heavily involved in the pension reform debate, he writes:
“In each of these states and many others now debating pension “reform,” Pew and Arnold have colluded to shape a narrative that suggests cutting public pension benefits is the only viable path forward. This, despite the fact that a) cutting wasteful corporate welfare could raise enough revenues to prevent such cuts; b) the pension “reform” proposals from Pew and Arnold could end up costing more than simply shoring up the existing system; and c) pension expenditures are typically more reliable methods of economic stimulus than corporate welfare.”
To make his first claim regarding corporate welfare, Sirota cites Pew Charitable Trust’s “Widening Gap Update,” which found state plans to be underfunded by $1.38 trillion. As a basic starting point for understanding the current situation faced by public defined benefit plans, this is flawed.
State Budget Solutions’ report “Promises Made, Promises Broken – The Betrayal of Pensioners and Taxpayers” found that state administered plans are underfunded to a far greater degree – $4.1 trillion. The difference in the size of the liability is caused by the discount rate used in its calculation.
Public pension plans discount their liabilities according to the assumed investment return on plan assets, usually around 8 percent. The problem, of course, is that a discount rate that reflects plan assets has no meaningful relationship with the benefits promised, i.e. the liability. By assuming high investment returns that, by definition, may or may not be earned, states, cities, and municipalities are able to contribute less today because the amount of money they owe in the future appears smaller than it actually is.
So when Sirota claims that state governments’ combined $1.38 trillion unfunded liability can be washed away simply by redirecting $80 million a year from corporate handouts into pension funds, it is based on an understated value of unfunded liabilities.
The math simply does not add up.
Starting from the understanding that a market-valued assessment of plan liabilities is the one best suited to guaranteeing retirement security, Robert Novy-Marx of the University of Rochester and Joshua Rauh of the Stanford University School of Business looked into the revenues required to fully close the public pension funding gap. Their 2012 paper found that without policy changes, contributions to defined benefit plans would have to be 2.5 times greater than they currently are, and take up 14.1% of all state and locally generated revenues.
According to the Census Bureau’s 2011 Annual Survey of Public Pensions, total state and local government contributions to defined benefit pension plans were over $96 billion. So even assuming state and local governments eliminate all $80 billion in business incentives cited by Sirota and direct the resources straight into their defined benefit pension plans, they still fall billions short of full funding.
Even if business handouts do not tell the whole story, underfunding itself tells us there is some degree of misplaced priorities. Rolling Stone’s Matt Taibbi rightly noted the regularity with which state governments skip out on large portions of the Annual Required Contributions (ARC).
“Among the worst of these offenders are Massachusetts (made just 27 percent of its payments), New Jersey (33 percent, with the teachers’ pension getting just 10 percent of required payments) and Illinois (68 percent). In Kentucky, the state pension fund, the Kentucky Employee Retirement System (KERS), has paid less than 50 percent of its ARCs over the past 10 years, and is now basically butt-broke – the fund is 27 percent funded…”
The fact is that the tradeoff far more suited to explaining current pension underfunding is between funding for services provided today and funding necessary to keep promises not due for several more decades. State and local governments’ repeated failure to set aside what will be required to keep benefit promises should serve as an indictment of the overall politicization of retirement security that public defined benefit plans bring.
The notion that it is defined benefit plans, not defined contribution alternatives, that lend themselves to cronyism and abuse seems lost on many. Take the contention, made by Taibbi, that the very same hedge fund managers pressuring state governments to shift assets into “alternative investments” are those pushing for reforms that would end defined benefit plans and replace them with defined contribution plans.
As economist Andrew Biggs has pointed out, defined benefit plans are the nation’s largest holders of alternative investments, while defined contribution plans hold almost none. If defined benefit plans are such a cash cow, why on earth would anyone reaping the benefits want to change them?
Defined contribution plans, on the other hand, take politics out of the equation. In Detroit today, many retirees who served their communities for decades now find their promised benefit at the mercy of a bankruptcy judge simply because city leaders so often diverted their eye from long term financial needs. But under a defined contribution system, any employee owns his own retirement fund from the start. Instead of contributing (or not contributing) into a fund that may or may not exist 30 years down the road, employers contribute a constant percentage of salary into an individual retirement account that would belong to the employee forever.
Writers like Sirota and Taibbi are rightly concerned with the dangerous uncertainty that so many public employees now face when it comes to the security of their retirement finances. But the tendency of politicians to sacrifice the future in exchange for the needs of the current day is hardly new or unnatural.
The best solution is to put an end to the types of retirement systems that make it so easy for political gamesmanship to threaten employees and taxpayers alike. If the goal is to both end the pension cronyism that is ripping off public workers and ensure them a secure retirement, defined contribution plans are the way to go.