The Perils of Pensions and Prosperity

Published August 30, 2017

During the city of Detroit’s bankruptcy, the state-appointed administrator sought to cut pension payments for thousands of retired city workers in violation of Michigan’s state constitution.  City retirees eventually accepted a 4.5 percent cut in benefits, in part to prevent possibly larger cuts.  Many private sector pensions are also shaky; the Federal pension insurance agency is currently assisting a record number of multi-employer plans.

Pensions are complex contracts, on which employers can try to take advantage of workers.  Timing presents a challenge for pensions: employees work before receiving a pension.  Markets involve voluntary exchange to mutual benefit.  But when one party must act first, the second can always refuse to perform as promised.  In a simple deal like, “I’ll scratch your back if you scratch mine first,” I could fail to return the favor.  Reneging on a promise converts an exchange into a one-sided rip-off.

Complex business arrangements enable prosperity.  We will likely do business only with people we trust, like close family and friends, if we cannot contract successfully with strangers.  But you cannot run a national or global business with only trusted associates.

Fortunately, many solutions for tough contracting problems now exist.  For instance, you and I might take short turns scratching each other’s back.  A pension, however, must be paid after workers finish working.  The problem is worst for defined benefit pension plans, where the plan accumulates contributions to pay benefits according to a formula.  If the plan is underfunded and cannot pay the promised benefits, a worker cannot take back her years of work.  The danger is not as pronounced for defined contribution plans, because workers will see on their quarterly statements if contributions are not being made and then can look for a new job.

Government employers can also renege on pension promises.  Indeed, the problem may be worse because our elected representatives cannot force future representatives to appropriate funds to the pension in say 2025.  Tax dollars that should go to the pension can be spent on other services.

States have taken a variety of measures to protect public sector pensions.  A new study from the Center for Retirement Research at Boston College examines how such measures affected public sector pension reforms since the 2008 recession.  Several states protect promised benefits for current workers in the state constitution, while two states offer no legal protections.  The remaining states (including Alabama) rely on contracts affording workers some legal protection.

Have stronger measures better protected promises?  The answer is yes for state constitutional protection.  Furthermore, fewer states have either reduced benefits or increased contributions for current employees than they have for new employees.  For example, 60 percent of state pensions increased the years of service to retire for new employees, versus only 4 percent for current employees.  This is significant because only current workers or current retirees have truly been promised pension benefits; reducing benefits for workers not yet hired does not renege on a promise.

Reneging on promises others rely on is never good, but some context can help us understand why this occurs.  Illinois has perhaps the nation’s worst-funded state pension plan, thanks in part to the “Edgar ramp” plan.  Illinois’ state pension was already in bad shape in 1994 when Governor James Edgar and the legislature agreed on a schedule involving fifteen years of modest contributions followed by steeply escalating payments.  Meeting scheduled contributions in 2016 would have required over one quarter of Illinois’ general fund tax revenues.

Any Illinois state legislator or voter under age forty today was not eligible to vote when the Edgar ramp was adopted.  We can understand why they might balk at slashing spending for schools or prisons or raising taxes to honor a promise which they did not make.

We do not live in a world where everyone’s word is their bond.  Underfunded employer pensions result in part from a timing dilemma plaguing many types of exchanges.  Fortunately, legal and constitutional guarantees for public employee pensions have limited politicians’ reneging on their promises.