Laura and John Arnold Foundation
• www.arnoldfoundation.org • 1800 Post Oak Blvd • Suite 380 • Houston, TX 77056 • 713.554.1349
meets our general criteria: (1) establish transparency withrespect to the true cost o the benets promised to publicemployees; (2) mandate that the pension plan sponsor pay the ull cost o accrued benets each year; (3) mandate thatthe pension plan sponsor pay down the ununded accruedliability over a reasonable time horizon and (4) improve thegenerational equity, portability and security o benets orpublic employees.
Structural Problems with theCurrent System
Overview of Dened Benet Plans
Most public pension systems use the traditionalDened Benet (DB) structure. Under a DB plan, anemployee’s retirement benet is “dened” based on aormula that includes variables such as the employee’sage, service and salary. Te typical DB plan provides theemployee with an annuity that is equal to a percentage o the employee’s average salary over a specied number o years at the end o the employee’s career.raditional DB plans are pre-unded systems. Assuch, each year the employer (in this case, the state ormunicipality) together with employees set aside enoughmoney to pay or the benets that were accrued in thatyear. Tis is distinct rom a “pay-as-you-go” system likeSocial Security, where contributions today are used to pay or retiree benets today.
Te annual contributions tothe DB pension plan are placed in a trust that is managedand invested by the state. Te unds in that trust (that is,the unds that will be used to satisy pension obligations)come rom three sources: the employee contributions, theemployer contributions and investment earnings. Whenan employee reaches retirement, her benet should beully unded by pension wealth accrued rom these threesources. Unless there is severe underunding and thereorea cash-ow problem, the contributions o new and currentemployees are not needed to supplement benet paymentsto retirees.One o the primary drivers o the current pension crisisis the systems’ accumulation o ununded liabilities or debt.Tis begs the question: How do traditional DB pensionsystems become underunded? Tere are three reasons:(1)
Lower than expected investment returns:
Pensionund sponsors have assumed historically that they will make above-market returns on their pensioninvestments, between 7 and 8 percent on average.Using an overly optimistic prediction allows themto contribute less now to und uture benets,but when the unds do not meet expectations,taxpayers are let making up the dierence;(2)
Pension und sponsorsoten neglect making their ull annual requiredcontribution to the pension und so that they might spend that money on other public services.Tis practice is equivalent to borrowing rom thepension und - the result being an intergenerationaltranser o wealth rom one generation o taxpayersto another; and(3)
Successully estimating the costo uture benets requires a signicant numbero accurate predictions (
, employee tenure, wage growth and lie expectancy). Any error inthe pension plan sponsor’s prediction will havenumerous implications or uture cost.Te structure o the traditional DB pension systemcreates these three sources o underunding, and in act,provides a signicant political incentive to underund em-ployee benets.Tere are three primary structural problems that mustbe addressed in order to create a sound, sustainable and airretirement savings system or public employees: (1) Unpre-dictable Costs, (2) Incentive to Underund and (3) LaborMarket Distortions. All three o these structural aws stemrom the way that retirement benets are promised in atraditional DB system. Solving these three problems wouldeliminate uture pension underunding and would increasethe security and utility o benets or public employees.
Because DB plans are pre-unded, pension plan sponsorsmust make what amounts to an educated guess as to how much money to set aside today to satisy uture benetobligations. Tey are orced to make highly subjectivedeterminations with respect to many variables that inuencethe true benet liability, including employees’ tenure, wages
3) Social Security is not a pure “pay-as-you-go” system because it does accumulate excess revenue in a trust und. However, Social Security’s outowshave reached a point where they exceed contributions. I current unding and benets levels remain constant, Social Security will reach pure “pay-as-you-go” status in the relatively near uture.