Some government pensions have become too generous in recent years. Costs to taxpayers to fund retirements have been skyrocketing, forcing choices involving more taxation, more borrowing, more cuts to government services, or some combination. Wisconsin has long been an exception to this trend, embracing defined-contribution reforms and providing more than adequate funding for its pension plan. According to Standard & Poor’s, Wisconsin’s pension funding ratio of 102.7 percent is behind only South Dakota as the best funded state pension fund in the United States.
Wisconsin’s pension system, the ninth-largest public pension fund in the United States and the 25th-largest public or private pension fund in the world, is successful because the state government has been proactive in implementing important reforms. A new reform being proposed by Wisconsin lawmakers would increase the retirement age from 55 to 60 for most new public workers (public-safety workers could retire at 52 instead of 50) and change one important way pension payments are calculated to improve the system’s long-term solvency.
In 2016, the Wisconsin Retirement System (WRS) paid nearly $4.9 billion in benefits to retired Wisconsin public employees. WRS currently uses years of service and the average of the highest three years of earnings to determine pension payouts. Under the new proposal, payments would be calculated by averaging workers’ top five years of pay, instead of the top three. The goal of the change in years is to prevent pension spiking. Benefit-spiking happens when an employee’s pension rate, which is often determined through either an average of the employee’s salary over time or the last few years of employment, is increased by the employer to improve their retirement benefits.
Pension spiking can be prevented by implementing rules against multiple pensions and basing pension benefits on an average covering additional salary years – instead of determining pension payouts using inflated salaries earned at the end of a person’s career – which this proposal is designed to do.
A Milken Institute study found that if pension plans were to base benefits on employees’ compensation over five years or even a whole career instead of the abuse-prone final year, the overall cost of funding could be lowered by up to 30 percent.
According to the Wisconsin State Journal, an actuarial study conducted by Michigan-based Gabriel, Roeder, Smith & Co. found “state contribution rates would eventually decrease by between 0.43 percent and 0.7 percent depending on the type of employee under the proposal.” The bill’s sponsors estimate government pension contributions would be $59 million lower if the measures were in place today.
One aspect of Wisconsin’s pension system could act as a model for other states. A Wisconsin pensioner’s benefits rise or fall above the minimum level based on the pension plan’s performance. This method, known as a shared-risk model, prevents taxpayers and retirees from being stuck with all the potential losses from a financial crash. These adjustments are automatic, so no vote is needed.
If there were one additional area in which Wisconsin’s pension system could use improvement, it would be its expected rate of return, which is currently set at 7.20 percent. Anthony Randazzo of the Reason Foundation points out that even with recent market improvements, which may or may not last, most state pension plan have yet to recover their losses related to the 2008 market crisis. Results from recent years are equally poor, and most plans have missed their assumed rate of return for the 2015–16 fiscal year. Pension experts recommend states use an expected investment return rate of 3.1 percent, which is based on 30-year U.S. Treasury bond yields.
The following documents examine state pension funds and how they can be reformed in greater detail.
The Limits of Retrenchment: The Politics of Pension Reform
Daniel DiSalvo of the Manhattan Institute examines pension reform and argues states serious about keeping pension costs under control are introducing defined-contribution options or hybrid plans at a growing rate. As more states take this step, it will become less controversial and easier for other states to adopt similar reforms.
Not So Modest: Pension Benefits for Full-Career State Government Employees
Examining the benefits paid to state and local government employees, Andrew Biggs of the American Enterprise Institute argues drastic benefit reductions for current retirees would be unfair, but reforms to make public- and private-sector pensions more equitable should be on the table.
The State Public Pension Crisis: A 50-State Report Card
This Heartland Institute report examines problems currently facing public pension systems, including the enormous burdens public employee pensions pose in some locations. The report ranks each state according to the operation and relative disposition of the pension plans in the 50 states and suggests ways states might go about solving their pension system problems.
Pension Funds Expected Rates of Return: Biggest Lie in Global Finance
The Illinois Policy Institute examines the high expected rates of return on pension investments used by state and local governments, arguing the high rates are misleading taxpayers into believing pension funds are more stable than they actually are.
Properly Funding a Defined-Benefit Plan Requires Solid Average Returns and Some Luck
Adam Millsap of the Mercatus Center discusses the problems created by overly optimistic investment-return assumptions and how they add risk to defined-benefit pension plans. “The risks associated with the variability in returns is another reason why many pension reform advocates recommend defined contribution plans rather than defined benefits plans. Defined contribution plans don’t promise a specific amount of benefits, which means they are not subject to the same underfunding risks as defined benefit plans,” wrote Millsap.
Public Pension Investments: Risky Chase for High Returns
Truong Bui writes in Budget & Tax News about a recent Pew report that shows a systematic shift of public pension plans away from fixed-income investments toward equities and alternative investments over the past 30 years.
The Market Value of Public-Sector Pension Deficits
Arthur Biggs of the American Enterprise Institute argues that because states currently assume plans can earn high returns without risk, they are underfunded by more than $3 trillion. Although states recognize their public-employee pensions are underfunded, Biggs argues the situation is far worse than their accounting demonstrates. Unless policymakers take proactive steps now, he says, taxpayers will have to cover an enormous shortfall when the bills come due.
The Origins and Severity of the Public Pension Crisis
Dean Baker of the Center for Economic and Policy examines the origins of the shortfalls in public pension systems and discusses the appropriate rate of return to assume for pension fund assets.
Keeping the Promise: State Solutions for Government Pension Reform
This report from the American Legislative Exchange Council describes the variety of pension plans governments use today and the advantages and disadvantages of each plan. It also provides several tools legislators can use to ensure governments can affordably fund retirement benefits for their employees.
Nothing in this Research & Commentary is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit the Budget & Tax News website at https://heartland.org/publications-resources/newsletters/budget-tax-news, and The Heartland Institute’s website at http://heartland.org.
Whether sending an expert to your state to testify or brief your caucus, hosting an event in your state, or simply sending you further information on the topic, Heartland can assist you. If you have any questions or comments, contact Heartland Institute Director of Government Relations John Nothdurft at [email protected] or 312/377-4000.