Public employee pension systems have long been a source of problems. State government politicians are continually tempted to underfund pension plans in favor of using that money for something with an immediate payoff. Those same politicians also tend to grant increased pension benefits to state employees because it is a simple vote-buying scheme with no immediate budgetary cost. However, a sign of how bad the morass of public pension funds has become is that most of them have become more underfunded in the past five years. If public pensions get more underfunded in years with positive stock market gains, what hope is there for their survival?
Morningstar considers a pension plan to be so underfunded as to be declared “not fiscally sound” if it is less than 70 percent fully funded. According to Bloomberg, in 2012 there were 26 states whose pension plans met that standard. That is bad, but when you check the pattern over time, the trend is worse.
Of those 26 states in the most trouble, only one improved its funding status from 2009 to 2012. Yet those years were after the stock market drop of the recession and during a robust stock recovery. For the years from 2009 through 2012, the S&P500 index had a cumulative return of 71.1 percent. Obviously, public pension plans are not invested only in stocks and their returns were surely lower across their full portfolios. Still, one would have expected pension plans to be in bad shape in 2008-2009 at the market bottom, but to be in improved financial health by 2012 after the market bounced back.
If public pension plans are losing ground on their funding status in years when the market is delivering above normal returns, is there any hope for their survival?
The answer is probably not, but if there is a way to save public pension funds, it will require a new political calculus by the two parties most responsible for the current sorry state of affairs: state politicians and government employee unions.
In the current state of political compromise between (mostly Democrat) politicians and unions, politicians vote in favor of generous pension benefits for public employee union members and then union representatives accept under-funding of those pensions. This makes the generous pension benefits seem affordable by hiding the full cost of those giveaways.
Politicians win because they avoid the spending cuts to popular programs or the tax increases necessary to actually pay for the benefits they voted for; union leaders win because they can tell their members about the new pension benefits they secured. Unfortunately, since nothing in life is free, a cost most be paid for these decisions. That cost is the higher probability the public pension fund will collapse under the weight of this under-funding and those public sector union members will lose their pensions.
The deals hinge on a key assumption in the calculation of the cost of any deferred benefit: the expected future return on the invested funds between now and when the benefits are collected. This future expected return on the pension fund investments controls how much money the politicians need to pay into the workers’ pension funds now. A higher assumed rate of return means less money is needed now thanks to all the money the investments are assumed to make in the future.
Right now politicians and union leaders are taking a huge gamble by using expected future rates of return that are much more optimistic than reasonable. The hope is that either investment returns will save the politicians from their irresponsibility and the workers from poverty or that the courts will force states to pay up enough later to keep their promises. Union leaders are accepting such a risk because they see the only alternative to be accepting smaller pensions.
New York City’s pension funds are a prime example. In 2000, the City’s pension funds were more than fully funded, sitting at 136 percent of what was needed and annual contributions were around $650 million per year, or 2 percent of the city budget. Today, New York City is paying $8 billion per year (11 percent of the budget), yet the funds now hold only around 60 percent of what is needed to be fully funded.
How could this happen? Poor investment returns, optimistic expected investment returns, longer lives in retirement, and promises of more generous pensions for city workers. If Mayor de Blasio agrees to more pension benefits for workers in his current union contract negotiations, the problem is only going to get worse.
So far, union leaders have agreed to this risky strategy of overpromising and underfunding, feeling safe in the strength of many state laws protecting public employee pensions from future cuts. However, Detroit’s bankruptcy case has shown a definite flaw in this strategy. If Detroit’s final plan involves pension benefit cuts, every public employee union will need to reassess their negotiating strategy.
Having politicians and union leaders conspire to reward public employees with generous pensions and then push the costs off onto future generations was never a particularly noble endeavor. It began and still continues today because both sides win from the deal, one in votes and the other in prestige and union dues. However, Detroit may finally show the hidden dangers in such a game.
If Detroit makes other cities and states face reality and adjust their pension plans to economic reality rather than political agendas, at least Detroit’s poor employees and retired workers will have done something positive for millions of other public sector employees out there. In the meantime, public sector employees and their union leaders need to make a hard choice: settle for realistic, smaller pensions that they are sure to collect or gamble on larger pensions that can only be paid for with well-above average future investment returns or by huge tax increases. Bigger pensions only look attractive until you factor in the risk of collecting nothing.
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