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The Paradox Between Pension and Promise

This last year has resurfaced issues leading to greater action towards change and exposed new crises that have left Americans feeling fearful of change. The Black Lives Matter movement protested the murder of George Floyd and advocated for the defunding of the police. At the same time, the high-risk environment that healthcare professionals and teachers have faced during the COVID-19 pandemic reinvigorated the fight for higher pay for such workers. However, in both cases, the common narrative has resisted thoughtful analysis of state budgets and their many components if such changes were to be implemented. Buried beneath flashier state projects is one increasingly important aspect of state finances that is seldom discussed: pensions. 

Pensions are formulated out of a comprehensive retirement system that aims to provide secure and adequate retirement for public employees. There is an ongoing number of pension programs. One familiar type of plan is called “defined contribution” (DC) — a form of this commonly known as the 401(k). The typical 401(k) is a “tax-advantaged” plan where contributions to funds are made by both employers and employees, and tax benefits are awarded to both parties. Advocates for these plans argue that they are less complicated and remove reliance on employers, which prevents mismanagement of pension funds. Those that oppose these plans argue that they put employees at too much risk by leaving the investments of these funds up to the market. 

The more widely used plans are called “defined benefit” (DB) pensions. Under the DB method, pensions are funded by employee and employer contributions, with employers paying the majority share. Employees are guaranteed a certain amount of retirement funds by their employers, which are based on their current salary, the number of years worked, the number of years benefits will be collected and how well the plan’s investment grows. 

Ideally, the predictions for the “defined” amount granted to each pension fund would be correct, and as a result, the expected assets would equal expected liabilities. Put simply, the money coming in would be enough to cover spending on retirees’ benefits. However, a miscalculation on these returns on investments, among other things, can have harmful consequences — the build-up of “unfunded liabilities.” Unfunded liabilities, or in simpler terms, debt, can accumulate at a rate that can’t be paid off fast enough. This vicious cycle continues because employers have an obligation to continue growing investments to ensure the security of pensions for future retirees. But to what end? 

Yes, it’s an arcane topic, but public pensions demand massive fiscal responsibility, given their considerable effect on active public servants, retirees and taxpayers. Approximately 2 percent of the U.S. workforce is comprised of public school teachers, who collectively educate over 50 million students. Over 18,000 federal, state and local agencies compose the web of American law enforcement, with department sizes ranging up to 30,000 officers. Together, just police and public teachers account for millions of pensions.

Around 5.2 percent of all state and local budgets are used to fund pensions, but this can vary between 2 percent and 10 percent. While this may appear like a small percentage, for the fiscal year of 2019, a total of $168 billion by state and local government was contributed to pension benefits. Nevertheless, according to the National Pension Coalition, every dollar invested in a public pension amounts to $943 billion a year in economic activity. So what does this mean? Are pensions a sound investment that benefits pension holders and even contributes to the economy? Or are these funds being mismanaged at the expense of pension holders and taxpayers? 

Notice the following pattern: overestimates on investment returns, state mismanagement of these funds and lowered contributions so to provide more generous pensions lead to debt accumulation that jeopardizes pension promises and requires taxpayers and workers to make up the deficit.

In January 2020, the Dallas pension system filed a lawsuit against the city for withholding pension contributions up to $2 million from police and firefighters. This wasn’t the first time there had been pension problems in Texas. In 2017, the growth of unfunded liabilities, up to around $3 billion, almost bankrupted the Dallas pension fund. The state legislature intervened by passing a bill to avert the crisis that slashed pension benefits by $1.4 million over 30 years and cost taxpayers and workers a pretty penny — an additional $1.3 billion in pension contributions over the following 30 years. Young people continue to bear the brunt of this cost to preserve older retirees’ pensions. This same remedy was called for the crisis in 2020. Mayor Mike Rawlings called the bill “a brutal blow” to Texans, who he believes are being “asked to contribute too much money” that will “certainly force cuts to city services.” Yet he isn’t the only mayor dealing with this problem. Even before the crisis in 2017, Moody’s, a credit rating and financial analysis firm, found that Dallas, Austin, Houston and San Antonio owed $22.6 billion in pension debt. A combination of overestimates of growth rates on investments and lowering contributions were found to be the main perpetrators.

Beyond police pension budgets, educator pensions face similar challenges, particularly in Illinois. In the last twenty years, the state has contributed only 77 percent of what is needed to pay the State University Retirement System (SURS). In 2020, pension debt increased $7.1 billion to a total of $144.4 billion, consuming 28.5 percent of the state budget. By 2022, taxpayers will face a burden of nearly $11.6 billion. Not only are taxpayers affected, but spending on higher education, new teachers and other public sector employees will suffer as well. In nominal terms, without adjusting for student enrollment or inflation, Illinois has reduced its higher education spending by about $630 million over the last two decades. Pensions continue to be propped up because of pension protections in Illinois state law, which demand reform if structural deficits are to be fully addressed. But again, miscalculations on investment returns, insufficient state contributions and overgenerous pensions appear to be the same causes of growing unfunded liabilities. 

New Jersey also seems to be playing the same game. 2021 is the fifth consecutive year of increasing taxes, spending cuts and borrowing necessary to revive the pension system. This year has demanded an even larger jump in fiscal spending. Governor Phil Murphy of New Jersey has remained resolute in keeping up with pension payments to “cover a $6 billion state budget shortfall”  because of the risk of collapse of the entire retirement system. Yet, as other states have struggled with, the volatility of the market will make predicting investments that much more challenging and that much more damaging during the current pandemic because of the strain on government revenue.   

As seen with Texas, Illinois, and New Jersey, the issue of unfunded liabilities is not a new or easy issue to discuss but dramatically affects taxpayers and pension-holders despite being tucked away behind “bigger” state issues. From 2001 to 2016, 13 states’ funding ratios dropped under 100 percent. The fall in funding ratios tells us that these states haven’t saved enough relative to what they owe in pension benefits. This isn’t necessarily a bad thing initially ‒ as long as the economy continues to grow, investments will fare well. Yet some argue that this drop in funding can be attributed to the fact that pensions leave roughly two-thirds of $4.4 trillion in assets up to the whims of the market. However, despite the recession during the Financial Crisis, in the last ten years, the S&P 500 has had an annual average return of 13.6 percent, which trumps the average of 9.2 percent over the last 140 years. Thus, the Equable Institute, along with the Hunt Institute, attributes these unfunded liabilities largely to “underperforming investments, missed assumptions, and failure by many states to pay their full actuarially required contributions.” This is not to say that all states have fallen into a crisis; as the Brookings Institution describes, this issue should not be labeled a crisis but instead a “stressful” situation. Stressful or dangerous, some alternatives may be worth discussing. But is there one promising alternative? 

Countless reforms have been proposed in several states: Texas, Illinois, New Jersey, Pennsylvania, Utah, Michigan and Georgia, to name a few. America may also see some changes, like it or not, with its new president.   

In response to the pension crisis in Texas in 2017, the Texas Pension Review Board (PRB) implemented structural changes to prevent bad incentives, particularly those that threatened financial integrity. These changes include providing unbiased support on all issues related to public pensions. 

Illinois pension problems in 2014 necessitated changes as well. With great political mismanagement of pensions, specifically in Chicago, the Illinois Policy Institute proposed a hybrid plan that entails a self-managed portion and a Social Security-like benefit. With this plan, retirement accounts would have had steadier returns because benefits would be left up to the market but also secured by Social Security-like payments. Current pension holders would have been able to hold on to their pensions, and career workers with limited pensions would’ve been protected. Unfortunately, in May 2014 the bill proposed, initially by Governor Pat Quinn in 2013, was rejected because it violated the state’s constitutional law concerning earned and unearned benefits to current workers. The current governor, Jay Robert Pritzker, appears to be following in Quinn’s footsteps. In 2020, the General Assembly filed the House Joint Resolution Constitutional Amendment 38, which would reduce pension debt by limiting the future growth of current workers’ pensions. The Paul Simon polling Institute found that 51 percent of Illinoisians supported this amendment. However, as of January 13, 2021, the house adjourned and the legislation died. When the house reconvenes, it could be reintroduced; yet, with politicians vying for union support by bartering salaries and benefits and Pritzer’s opposition to the amendment, it appears the necessary reforms won’t be passed. 

In 2019, Democratic leadership in New Jersey introduced a hybrid plan, similar to the Illinois pension proposal bill, that guarantees up to $40,000 in benefits, the defined benefit part, and puts anything on top of that amount into a 401(k), making it more of a shared risk plan between employees and employers. This plan would affect employees who’ve worked for five years or less and new hires. It also involves raising the retirement age from 65 to 67 and most likely will include other changes to the contribution amounts. Like in Illinois, future payments for current workers would be reduced because older retirees’ pensions are protected by law. Governor Phil Murphy seemed skeptical of Senate President Shawn Sweeny’s support for this bill, given his push for an amendment that would only require legislative support. Further opposition has come from unions, like the New Jersey Director from Communications Workers of America, which claimed this would only minimally chip away at unfunded liabilities at the grave expense of working-class people. Given the pandemic and elections in November 2021, Murphy is in a difficult position between battling unions, the pandemic, and the desperate need for pension stability. 

Utah, Michigan and Georgia have all taken a step forward in considering  “hybrid” versions of defined contribution and defined benefit plans. These states have used the “parallel approach,” in which employees contribute to a 401(k) and a defined benefit plan. Alternatively, the Center for Retirement Research at Boston College has proposed a “stacked” approach. This type of plan would keep the defined benefit plans and “stack” the defined contributions on top, securing earnings on top of the defined amount. This protects lower and higher earners and ensures safer risk-sharing, which prevents taxpayers from making up for the shortfalls. Since 2014, Philadelphia has proposed using the stacked approach, which is in effect for new hires as of 2019. Pew Research found that the risk from investments could be avoided but that if the defined contribution portion of benefits continued to increase, as we’ve seen with other states, the problem would persist. 

In the next four years, Biden will offer tax breaks to encourage saving for retirement, particularly aimed at helping lower-income Americans. Biden will also offer a 401(k) option for those who don’t have a plan, which will be valuable to low earners but not high earners, which may incentivize higher earners to move their money into defined benefits to reap greater tax benefits. Biden also plans to pass the Butch Lewis Act, which will provide loans to underfunded employers, an act which had passed in the Democratic House in 2016 but had not been voted on by the Republican senate. But will this help states clean up their unfunded pension disaster? 

Despite this growing acknowledgment of pension debt build-up, if the real causes of pension debt aren’t addressed, any new changes to state financing, including that which some hope to see with police reform, workers pay or in terms of COVID needs, will only worsen in the long-run. It’s one thing to forecast the weather; it’s another to get it right. Let’s hope policymakers can figure it out. 

Featured image source: BPR Design Team  — Tanya Jain. 

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