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Public Pensions Arnold Foundation

Public Pensions Arnold Foundation

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Published by Texas Watchdog
The state of public pensions in this country and what can be done to fix them.
The state of public pensions in this country and what can be done to fix them.

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Categories:Types, Research
Published by: Texas Watchdog on Dec 01, 2011
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Laura and John Arnold Foundation
www.arnoldfoundation.org • 1800 Post Oak Blvd • Suite 380 • Houston, TX 77056 713.554.1349
State and local budgets acrossthe nation are acing enormousdistress. Although part o thishardship can be attributed to the worldwide nancial crisis andthe recession that ollowed, asignicant portion has been causedby widespread, unsound budgetary practices. By and large, the nancialcrisis merely uncovered deep, veiledstructural aws. Chie among theseaws is the perpetual underundingo public employee benets.Failing to address the publicpension crisis promptly wouldbe economically catastrophic,triggering bankruptcies o cities,school systems and potentially even entire state governments.Te states’ own estimates o the ununded liability dueto their pension benet promises grew to $1.26 trillion inscal year 2009, up rom $1 trillion just one year earlier.
 However, using standard private sector accounting rules,the shortall estimate increases to approximately $3 trillion,a sum that represents roughly one-th o the UnitedStates’ gross domestic product.
In other words, the assetsthat states have set aside to pay or employee retirementbenets all short o what they owe or those benets by approximately $3 trillion. As a comparison, the 2009ederal stimulus bill cost taxpayers an estimated $787billion, or less than one-third o the current unundedliability due to state-run pensions.Te size o the public pension debt per household isoverwhelming in many areas, and the economic and socialcosts o this crisis are potentially crippling to our nation.Figure 1 highlights the ununded liability per household in
Creating a New Public Pension System
By Josh B. McGee, Ph.D.Vice President for Public Accountability Initiatives
selected jurisdictions. As shown above, the average amily living in Chicago today is burdened with $34,599 in liability due to underunding at the state level, and an additional$41,966 at the municipal level or a total debt burden o $76,565.Because o this shortall, states, municipalities andschool districts will soon be orced to take drastic measuresto pay or their pension obligations. Tey will pass theburden on to the public either in the orm o increasedtaxes or, more realistically, cuts to services that are critical tosociety, such as education. Without signicant changes tothe current systems, public pension payments will quickly begin to crowd out other discretionary spending.Te Laura and John Arnold Foundation (LJAF) seeksto remedy this untenable nancial situation by educatingpolicymakers and the public about the nature o thepension problem and developing structural reorms that arecomprehensive, sustainable and air. Sound pension reorm
1) PEW Center on the States (2010) and (2011).2) Novy-Marx and Rauh (2011a). Liabilities discounted at the taxable municipal rate.
Source: Novy-Marx, Rauh (2011a) and (2011b). Liabilities discounted at the Treasury rate.
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 benets promised to publicemployees; (2) mandate that the pension plan sponsor pay the ull cost o accrued benets each year; (3) mandate thatthe pension plan sponsor pay down the ununded accruedliability over a reasonable time horizon and (4) improve thegenerational equity, portability and security o benets orpublic employees.
Structural Problems with theCurrent System
Overview of Dened Benet Plans
Most public pension systems use the traditionalDened Benet (DB) structure. Under a DB plan, anemployee’s retirement benet is “dened” based on aormula 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 specied 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 benets 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 benets 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 satisy pension obligations)come rom three sources: the employee contributions, theemployer contributions and investment earnings. Whenan employee reaches retirement, her benet should beully unded by pension wealth accrued rom these threesources. Unless there is severe underunding and thereorea cash-ow problem, the contributions o new and currentemployees are not needed to supplement benet paymentsto retirees.One o the primary drivers o the current pension crisisis the systems’ accumulation o ununded liabilities or debt.Tis begs the question: How do traditional DB pensionsystems become underunded? Tere are three reasons:(1)
Lower than expected investment returns:
Pensionund 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 benets,but when the unds do not meet expectations,taxpayers are let making up the dierence;(2)
Insufcient contributions:
Pension und sponsorsoten 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 intergenerationaltranser o wealth rom one generation o taxpayersto another; and(3)
Prediction error:
Successully estimating the costo uture benets requires a signicant numbero accurate predictions (
, employee tenure, wage growth and lie 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 underunding, and in act,provides a signicant political incentive to underund em-ployee benets.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 Underund and (3) LaborMarket Distortions. All three o these structural aws stemrom the way that retirement benets are promised in atraditional DB system. Solving these three problems wouldeliminate uture pension underunding and would increasethe security and utility o benets or public employees.
Unpredictable Costs
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 satisy uture benetobligations. Tey are orced to make highly subjectivedeterminations with respect to many variables that inuencethe true benet 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 outowshave reached a point where they exceed contributions. I current unding and benets levels remain constant, Social Security will reach pure “pay-as-you-go” status in the relatively near uture.
Laura and John Arnold Foundation
www.arnoldfoundation.org • 1800 Post Oak Blvd • Suite 380 • Houston, TX 77056 713.554.1349
and lie expectancy. Tis is an inherently difcult task that isprone to estimation inaccuracies.Even i employers were able to calculate accurately theuture costs o the benets they have promised, a high level o uncertainty would remain due to the variability o the unds’investment returns. Most government-sponsored pensionplans assume investment returns o somewhere between 7percent and 8 percent annually. Tis becomes problematic when these oten overly optimistic return assumptions areincorporated into the calculation o the unds’ liabilitiesand into the amount that must be set aside today to pay orbenets in the uture. Te basis o this uncertainty is twoold.First, even though the historic returns o a und have reachedthe predicted level, there is no guarantee that uture returns will match that perormance. Economic shocks may makeachieving the unds’ predicted return exceedingly difcultover a long period o time. Second, investment returns areoten treated asymmetrically. Tat is, when unds experiencea period o returns that beat their prediction, the surplus isoten spent on benets enhancement instead o being savedor downturns.It is important to recognize that the bulk o employees’benets is unded through investment returns earnedover the course o their careers. I the sponsor misses theirinvestment target by even a small amount, there will be asignicant unding gap between the benets that werepromised and the assets available to pay or those benets.For example, the Caliornia Public Employees’ RetirementSystem (CalPERS), one o the largest public pension unds with more than $200 billion under management, assumes a7.75 percent rate o return on its investments. Over the pastve years, however, the und’s return was 3.41 percent. Inthe last ten years the und’s return was 5.36 percent, and overthe past teen years it was 6.97 percent. One has to look at atwenty-year horizon, a period that includes the boom o the1990s, beore the plan beats its assumed rate o return.
Teconsequences o these less-than-expected returns could bedevastating. I CalPERS misses its investment target by hal a percentage point over the next 30 years, the result wouldbe an ununded liability o nearly $300 billion. I the undmisses its target by a ull percentage point over that sameperiod, the resulting unding gap would balloon to morethan $540 billion.
Tis is not a problem that is particularto Caliornia’s public employee plan; according to recently published data, over the past ten years, state pension unds’median investment return was only 3.9 percent.
Incentive to Underfund
Because the typical DB is pre-unded, there is asubstantial time period between the time that the stateunds the benet and the time that the state pays thosebenets to the employee. Tis creates a dynamic wherepoliticians and government ofcials today are makingnancial commitments and promises that others will haveto pay long ater those elected ofcials have let ofce. Inlight o the time lapse between unding and payment, itbecomes convenient or politicians who ace tight budgetsto stop making the ull annual payments to the pensionund. Tis is indistinguishable rom borrowing rom theund. Politicians nd this type o borrowing attractivebecause it keeps the debt o o the plan sponsor’s ofcialbooks; however, the debt has an eective interest rateroughly equal to the retirement system’s investment returnassumption. In most cases, this will be signicantly higherthan the sponsor’s bond rate; thus, they are borrowing atabove market rates. In 2009, only 22 states paid the ullcost o their pension promises. Te remaining 28 statesmade the choice to borrow rom their pension unds andunderund employee benets.
Figure 2 illustrates theunding shortall in selected key states.In addition, the current ramework creates a politicalincentive to make additional promises to employees (
,increasing pension benets) to gain their political support without due regard or the ull cost o those promises.Tese promises will be paid out in the distant uture by thenext generation o taxpayers and politicians. Tis currentpolitical incentive creates pressure to make additionalbenet promises in both good and bad times. When apension und experiences a period o returns that beatpredictions, there is considerable pressure to “spend” thosereturns on benet enhancements instead o saving themor downturns. However, in hard times when budgets aretight, plan sponsors are oten willing to promise additionalbenets in exchange or a short-term reduction in thepension payment. An oten-cited example o this is SanDiego. In 2002, the City increased employee benetstwice, while simultaneously decreasing its payment into
4) Marois (2011) and Marois and Fu (2011).5) CalPERS asset base was $237.5 billion as o June 30, 2011.6) PEW Center on the States (2011).7) PEW Center on the States (2011).

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