In July 2005, Alaska Gov. Frank Murkowski (R) signed legislation that will change the state’s public pension system from a nineteenth century defined benefit plan to a twenty-first century defined contribution plan. That move comes as a first step toward addressing a massive shortfall in the state’s pension fund.
Alaska is not the only state in the nation facing pressing state and local pension system needs. Florida, Colorado, Michigan, Ohio, and Oregon recently have undertaken similar reforms.
Daniel Clifton, executive director of the American Shareholders Association (ASA), spoke about the problems the public pension system is facing, implications for taxpayers, and possible remedies and steps taken by states to alleviate the problems.
Fabry: This year the Washington policy debate has been focused on retirement security, specifically Social Security and some talk about private pensions. What is the status of state and local public pensions? That issue seems to have been neglected.
Clifton: You are absolutely correct in your assessment. Both Social Security and private pensions are in desperate need of reform. But the state and local public pension systems are facing the most immediate and pressing issues. Simply put, the public pension system is a ticking time bomb that is set to explode.
The longer policymakers wait to reform the system, the more dire the problem becomes.
Fabry: When you refer to “the problem,” what are you specifically talking about?
Clifton: Public pension systems, generally prefunded defined benefit plans, are taking up a greater percentage of the states’ budgets.
Under a defined benefit plan, the employer [in this case, the government] promises a specified retirement benefit to the worker and saves and invests the funds in a common investment pool to finance those benefits. Prefunded means the employer and employee contributions pay for their own retirement, unlike Social Security in which today’s workers finance today’s retirees.
However, state and local governments are running huge unfunded liabilities; they are financing retiree benefits with contributions from today’s workers. When the Baby Boomers start retiring in 2008, there will be fewer workers to pay for retiree benefits. Increasing retirement and health care costs with fewer workers is a recipe for economic disaster, as most states will have to raise taxes continuously to maintain the promises to retirees.
This is a real problem, and it needs to be addressed immediately.
Fabry: How are taxpayers affected by this?
Clifton: If public entities continue to use defined benefit plans, they cannot maintain their financial position without major tax increases. During the 1990s boom, state pension plans were flush and were actually overfunded. The politicians then moved to increase benefits. In 1999, former California Gov. Gray Davis (D) boosted public employee pension benefits dramatically–allowing many to retire at age 50 or 55 with 90 percent of their salary for life–without almost any debate.
Moreover, the benefit enhancements were retroactive. Neither employees nor the state had been paying for these benefits during the workers’ lifetime. They were paid from existing plan assets, therefore increasing the unfunded liability.
While this plan was sold as a “cost-free” measure, the change actually cost California $10 billion in added liabilities over 20 years. Many states did this during the 1990s.
Those rapid pension asset gains should have been held without benefit increases to smooth over the down years that followed. Had this been the case, the resulting stock market downturn would not have had a major impact on the pension system. Unfortunately, though, politicians continue to use the pension system as a slush fund to garner votes from public employees.
Fabry: How do you reform the existing system while maintaining promised benefits to workers?
Clifton: I believe the answer is in moving from the antiquated system of defined benefit plans to defined contribution plans for every worker.
Under a defined contribution system, the employer pays a specified amount into an investment account for the worker, and benefits equal what these accumulated invested funds can finance.
Under this system there are no unfunded liabilities, workers have greater control over their retirement income, and no one has to worry about politicians squandering their retirement funds as is currently happening under the existing system.
ASA research finds that two of every three pension dollars in the private sector are now in defined contribution plans. That was not the case 20 years ago, and the only private-sector companies still offering defined benefit plans are large, old, manufacturing firms.
Fabry: How would this fix the problem in state pension funds for both taxpayers and government employees?
Clifton: Within the context of an aging population, increased labor mobility, perverse incentives of the public pension system, and taxpayer frustration over continual contributions to the system, defined contribution plans are the natural alternative to meet these changing needs.
Under a defined contribution plan, workers are able to take the funds paid into their accounts wherever they go. Those who work for a few years in the public sector and then move on, as most now do, would not lose all of their employer pension contributions, as they do with typical defined benefit plans. At the same time, individuals don’t have to worry about politicians mishandling the funds, accumulating unfunded liabilities, or playing politics with the pension fund.
Our research also tells us that short- and medium-term workers would get higher benefits through defined contribution plans because defined benefit plans almost always distribute benefits away from them to the long-term workers. But with the funds under worker control consistently earning average returns over the long run, even the longer-term workers may well earn higher benefits through a defined contribution plan than promised in a traditional defined benefit plan.
Under a defined contribution plan, expenses are fixed as a percentage of payroll each year, with no investment risk or danger of unfunded liabilities. Thus, the benefits to taxpayers include less government budget risk, as the government expenses become more certain. At the same time administrative costs are reduced and the government has better recruitment tools because they are now offering portable pensions.
Fabry: Have states moved to this new system?
Clifton: While state and local governments have not moved fast enough to reform their pension systems, I am encouraged that a shift toward defined contribution plans has been made. Nine of the past 10 changes to public pension systems have been from defined benefit to defined contribution.
In July, Alaska moved to a defined contribution system. Other states that have done so include Colorado, Florida, Ohio, Michigan, and Oregon. California Gov. Arnold Schwarzenegger (R) made this a central part of his reform platform at the beginning of the year.
Due to a quirk in the initiative language it has been put on hold for a year, but I think once California goes to defined contributions, the rest of the nation will follow.
I also believe South Carolina is looking at this option under the leadership of Gov. Mark Sanford (R). I read a press report where he was presented with the 30-year unfunded liability number for the pension system and realized something needed to be done … and done quickly. It is my hope that other governors also realize the enormity of this problem, like Governor Sanford apparently has.
Fabry: What do you see as the major roadblocks stopping reform?
Clifton: Public employee unions. It is really that simple. I spoke at the pension administrator conference last August and told them, “The crisis is upon us. You can be part of the solution or part of the problem.” I offered to work with them in developing solutions. Instead, they continue to keep their head in the sand and want no changes to this antiquated system. At some point they have to realize they are holding onto a dinosaur.
When I testified in California in support of the governor’s plan, what I saw was shocking: The public employee unions presented widows of slain police officers and injured firefighters and lied to these people, telling them that under the plan they were going to lose their survivor and disability benefits. Yet, the plan was for retirement only and would never affect these kinds of benefits. The senators holding the hearing knew this was the case and still let the circus continue.
At that point I realized the public employee unions would stop at nothing. For them, it is not about the retirement security of public employees, but about the power of controlling their workers’ money as a slush fund for political gain. I was offended by the theatrics, to say the least.
But with all that said, the current system cannot continue. And it just is not sustainable for politicians to continue raising taxes on working families to pay retirement and health care costs for public employees, when these taxpayers are struggling to save for their own retirement and health care.
There will be a breaking point. Hopefully we can reform the system before we reach it.
Sandra Fabry ([email protected]) is state government affairs manager for Americans for Tax Reform.
For more information …
More information on pensions and investments is available from the American Shareholders Association at http://www.americanshareholders.com.
See also, “The Gathering Pension Storm: How Government Pension Plans Are Breaking the Bank and Strategies for Reform,” a 138-page report published by the Reason Foundation in June 2005, available online at http://www.reason.org/ps335.pdf.
See also “Illinois’ Public Pension Crisis,” a Heartland Policy Study written by Budget & Tax News Managing Editor Steve Stanek and released in May 2005, available online at http://www.heartland.org/article.cfm?artId=17028.
Additional information on public pension issues is available through PolicyBot™, The Heartland Institute’s free online research database. Point your Web browser to http://www.heartland.org, click on the PolicyBot™ button, and select topic/subtopic combination Employment/Pensions.