Five Principles for Public Pension Reform

Policymakers all too often overpromise services, goods, and outcomes, all the while spending away taxpayer dollars without worry of the future. Sadly, the same practice is true on the state and local level. The fiscal stability -- or lack thereof -- of the public pension system is a perfect example of governments being too optimistic and too willing to appropriate taxpayers’ dollars for future benefits. The next generation of taxpayers are often left on the hook for these unaffordable promises that have been made to the current workforce.

According to American Legislative Exchange Council’s report entitled “Unaccountable and Unaffordable 2016,” the total unfunded public pension liabilities at the state and local level equate to nearly $5.6 trillion. If everyone in the United States had to share this burden it would cost every person $17,400 in taxes.

According to a Pew Charitable Trusts report, the difference between the amount of assets set aside to finance pension benefits versus the level of pension liabilities totaled more than $900 billion in fiscal year 2014. This gap has existed every year since 2002, but new reporting standards put in place in 2014 by the Governmental Accounting Standards Board (GASB) show a truer picture of its size. The GASB hopes these revisions will better reflect the “industry standards” and allow for a better comparison between different types of pension plans.

Without public pension reform, these unfunded pension liabilities and the annual funding gaps will place an unbearable burden on taxpayers and/or hinder local governments from providing services like education or emergency services. For example, the public education pension system in Chicago is in such poor shape that 89 cents of every dollar in education funding goes to public pensions, leaving only 11 cents per dollar for actual education expenses.

Some states, like Wisconsin, have public pensions in better shape than others, like Kentucky, but all states have funding shortfalls in their public pension systems. Governors and legislators must come to understand the health of their pension systems, accept that they experience significant funding gaps, and make changes to ensure long-term funding of their pension plans. States should look to one another to see what policies have worked in similar states with similar problems.

Reforms to public pensions should predominantly focus on the financial problem, not be driven by political ideology. Additionally, reforms should be mostly, but not exclusively, phased-in to future employees’ public pensions. There are five general reforms and principles that can be adopted to better situate the financial well being of public pensions:

  1. Stability, Affordability, and Predictability: There are a number of different pension plans, such as Defined-Benefit, Defined-Contribution, 401k, Cash-Balance, and hybrid plans, throughout the public pension system. States should focus on those plans that are more predictable and place taxpayers in positions to bear as little as risk as possible.  Generally, Defined-Contribution or 401k plans should be used since they place the investment risk and reward on the public employee, allowing public employers to better understand their obligations to the pension system and set aside their required annual contribution.

  2. Eliminate Bad Assumptions: State and local government must avoid engaging in fictitious accounting gimmicks that allow the financial health of their public pension system to look better than they do. States on average assume an extremely high rate (7.37%) of return for their public pension systems. Since it is exceedingly difficult to imagine the market consistently producing at that rate of return, actuaries and economic theorists believe this rate of return is an unreasonable assumption. This expectation only allows states to continue to rack up pension obligations and lower their contributions in hopes the stock market will bail them out. Moody Investment’s recommends states assume 4.3% rate of return and the Society of Actuary recommends assuming a 2.34% rate of return. States should adopt lower assumed rates of return and be prepared to contribute the additional immediate contribution that will have to follow. Even if reducing the assumed rate means increasing current contribution levels on the part of governments, eliminating these bad assumptions will help improve the long-term health of the public pension system.

  3. Cover Current Obligations: Policymakers should first ensure the benefits workers have already accrued are paid for, and then they should begin to focus on reforming public pension systems for future public employees. However, there are situations where current employees pension plans must be reformed to prevent pension bankruptcy. In order to prevent this disaster, state and local governments can implement structural reforms that increase employee and employer contribution requirements, increase work requirements, and place limits on cost-of-living adjustments and annual pension benefit payouts. These reforms can also be applied to future employees. The changes will require minor immediate adjustments, but they will protect taxpayers from incurring even larger liabilities in the long run.

  4. Prevent Pension Spiking: Since legislators control how their state pension system functions and how their own benefits are determined, some legislators might be tempted to alter the rules of the pension system. This could be seen by increasing their pension benefits, and leaving any mess to be addressed by the next legislature or generation. In order to prevent legislators from acting on this incentive, reforms should eliminate the practice of pension spiking. Pension spiking is where employees approaching retirement manipulate the variables used to calculate their life-long pension benefits by accumulating an excessive amount of sick days off and overtime hours to intentionally balloon their pension benefits.

  5. Target Major Reforms for Future Employees: Since there are a number of legal barriers that prevent major changes to existing pension plans, reforms should be implemented with future employees who do not yet have a legal claim to the benefits. Regardless of the specific plan, future pension plans should increase the level of responsibility and ownership that new employees have over their pension and should include “statutorily established employer contributions.” Ownership and mobility of pension plans is especially important for the Millennial workers, since they tend to change their careers more often than older generations.

Sadly, there is no magical formula that will solve every public pension problem, but these guiding principles and policy ideas are beneficial starting points. States will have to assess their individual pension systems and shortcomings, then establish plans of actions as soon as possible. States should find ways to structure fair, transparent, and predictable pension programs that are based in reality and do not place taxpayers on the hook for luxurious and unaffordable promises.