Policy Documents

Fixing the Public Sector Pension Problem: The (True) Path to Long-Term Reform

Richard C. Dreyfuss –
February 1, 2013

Even as the federal government struggles to stabilize its finances, many states are facing their own daunting sets of fiscal deficits. These take the form of unfunded liabilities totaling almost $1.4 trillion and stemming from obligations to pay for public employees’ pensions, retiree medical insurance, and other retirement benefits. Reform efforts ostensibly being made to solve this crisis have fallen short.

These "reforms" include:

1) Issuing new bonds to refinance existing liabilities. But these merely add to the total sum of indebtedness, and the capital they raise is subject to raids serving other purposes.

2) Adopting new or modified defined-benefit plans that create new risks for current and future taxpayers. Optimistic investment-return assumptions further mask the true magnitude of these deficits.

3) Assigning existing unfunded liabilities to younger, more recently hired workers, whose own benefits will likely prove unsustainable as their salaries rise.

4) Early-retirement incentive plans. But these often turn out to be expensive, hampering productivity while not achieving long-term objectives.

Because governments must use taxpayer money to make up any shortfalls, they have an incentive to overstate the contribution that future investment gains will make to the holdings that ultimately fund retirees’ benefits. Such practices are commonplace. An assumed rate of return that reflects lower future market expectations would reveal cumulative deficits even more yawning than those currently estimated.

The necessity for real reform is problematic for policymakers, who must deal with a workforce resistant to the loss of guaranteed monthly pension benefits; and for political constituencies, including government workers and their allies, whose support for defined-benefit pensions in the public sector stems as much from ideology as from financial selfinterest. This is a balancing act that leaves policymakers with few politically popular choices. Yet politicians’ current approach to evading such opposition—that of adopting incremental reforms while repeatedly deferring liabilities—is no longer viable.

Systems that continue to add workers to their defined-benefit plans, which obligate them to make fixed benefit payments, have mitigating steps available to them in many cases. Such steps include:

1) Reducing as-yet-unearned benefits.

2) Increasing the age of retirement or modifying early-retirement provisions.

3) Moderating or eliminating pension cost-of-living adjustments.

4) Increasing the financial contributions that workers must make to the plans.

While governments confront very steep legal obstacles to extricating themselves from obligations already incurred, they can free themselves from the political pressures, crystal-ball gazing, and monumental financial risks that defined-benefit plans make almost unavoidable. They should take a page from the private sector and shift to defined-contribution plans. Under such plans, to which employees as well as employers may contribute, investment risk is borne by plan members, not by taxpayers. A majority of Fortune 100 companies have already adopted such plans. Only 16 percent of large companies still offer their retirees medical coverage.

By sharing a complex of risks with the beneficiaries, states and municipalities would be able to devote far more of their time and resources to the more immediate concerns of today’s voters and taxpayers.