Forbes post, “Why Public Pension Pre-Funding Matters (An Explainer)”

Originally published at Forbes.com on April 3, 2018.

 

In the news lately:

“Puerto Rico gov defies board, rejects reform, pension cuts,” April 2, 2018, ABC News (AP).

The powers of a federal control board overseeing Puerto Rico’s finances could soon be tested as the U.S. territory’s governor on Monday defied its calls to implement more austerity measures amid an 11-year recession.

Gov. Ricardo Rossello rejected demands that his administration submit a revised fiscal plan to include a labor reform and a 10 percent cut to a pension system facing nearly $50 billion in liabilities.

“Kentucky teachers to skip work after lawmakers’ ‘bait and switch’ on pension reform,” March 31, 2018, CNN.

More than 20 Kentucky counties had schools close Friday after the state Legislature approved changes to their pension the day before.

Educators, who are furious over the pension issue, called out of work sick or requested substitutes in protest.

The bill, which overhauls the state’s pension, passed mostly on party lines and heads to Gov. Matt Bevin, who supports reforming the system. State leaders say it’s critical to fix the pension crisis, which ranks as one of the worst in the US.

“Court strikes down Chicago Park District pension plan,” April 2, 2018, Chicago Tribune.

Chicago Park District pension fund overhaul that Mayor Rahm Emanuel once held up as a model of city-union cooperation has been struck down by a judge, in a ruling that could produce more vexing financial challenges for both the mayor and taxpayers.

Circuit Court Judge Neil Cohen ruled that a January 2014 state change to the district’s pension system was unconstitutional because it diminished benefits by raising the retirement eligibility age and reducing both cost-of-living increases and disability benefits.

Cohen then ordered that the district return to workers the higher retirement contributions they’ve made as a result, with 3 percent interest tacked on. He also ordered the district to make payments covering reduced disability payments, plus interest.

Three separate news items, each a reminder of the perils of underfunding public pensions.  But let’s backtrack a bit.

Years ago, as an actuarial student, preparing for actuarial exams, I learned the ins and outs of pension plan funding methods and funding requirements, and I have a vague memory of reading about public pensions, which were not a part of my day-to-day work.  I remember pretty much two items:  first, the eye-popping idea that state constitutions promised state and local employees that they could keep their existing benefits, not just for past service accruals, but for all future years of employment; and, second, the notion that it was generally accepted for public plans to be un- or underfunded because, after all, unlike private employers, whose very real risk of bankruptcy was highlighted by the Studebaker plan failure that was the motivation for the Erisa pension funding legislation of 1974, public employers posed no such risk to their employees since state and local governments would always be around.

Now, that particular reading has long since been consigned to the recycling bin, so I can hardly cite chapter and verse on that statement.  Did the author say, “It’s perfectly fine for public pension plans to be unfunded” or maybe just “It’s not as bad a problem as for private employers” or even “Some people might claim that it’s OK”?  I don’t know. In any case, the idea seems antiquated in 2018.

But these various recent news items suggest that now is as good a time as any to actuary-splain a bit: Yes, it matters that public pensions are funded, and, no, it’s not just a matter of greedy pension-cutters using underfunding as an excuse to destroy pension benefits.

 Legacy costs

One key assumption underlying the explicit acceptance of underfunded pension plans, or the indifference to remedying the situation, is that, in fact, public employers will always be there.  Yes, they might declare bankruptcy, either by name or in practice by defaulting on bonds, but no city or state is just going to shut down like a factory closing.

But the first new article above is an instance of this very thing occurring:  the population of Puerto Rico peaked in 2000 at 3.8 million, then declined slowly in the first decade of the 21st century, then precipitously through 2016.  The long-term effects of Hurricane Maria aren’t yet known, but one economist, Lyman Stone, has presented forecasts of population declines in which the population is halved by 2060.

And this is, of course, what has already happened with the city of Detroit:  from a peak of 1.8 million residents in 1950, it has now dropped to less than 700,000 (estimated) in 2016.   It is plain to see that whatever cost of pensions one might consider affordable for a tax base of 1.8 million, cannot possibly be so for less than half the population, nor is it possible to predict whether one’s one state or municipality will be booming and prosperous or shrinking and struggling — at least not with enough time to plan ahead.

Fiscal responsibility

We know the story of what happened with Detroit, or, at least, a brief search brings up the denouement:  retirees took a 4.5% cut in pensions, new employees were moved into hybrid plans, and the major foundations in the city came to the rescue of pensioners and the Detroit Institute of Arts, the collection of which was at risk of being liquidated to pay creditors, in a “Grand Bargain.”

But why did it get that bad?  Here’s the Washington Post, in 2013 (quoting the Detroit Free Press to which it links with an invalid link):

Detroit officials have also made a habit of convincing unions to accept pension sweeteners — shorter terms of employment required, more generous multipliers, or a “13th check,” essentially an annual bonus — rather than pay increases.

And this is the story that’s repeated over and over again.  Pensions are made more generous — with high accrual rates, low retirement eligibility ages, generous cost of living provisions — as a means of providing more generous compensation to state and local employees, without actually needing to pay anything from the current year’s budget.  Costs are deferred until well after current legislators have themselves retired.

Fundamentally, that’s what’s going on in Kentucky: the state’s governor, Matt Bevin, has now recognized the importance of funding pensions, and is maybe a bit embarrassed at the state’s tied-for-last-place pension funding status, but because the past generosity of pensions had been effectively borrowing from future generations, even if without the explicit label of “debt,” there is no money available to shift into better present-day compensation instead.  (See this extensive backgrounder for more.)

And pension debt is even worse than ordinary state debts, for instance, bond issues for building up infrastructure.  Pension debt is nothing other than borrowing to pay for present-day employee salaries.  And, worse, legislators can pick and choose when and whether to “pay off” the debt or allow it to grow (that is, by making, or failing to make contributions to the pension funds).

Sound governance

Third, pension funding is fundamentally a matter of good governance.  The Chicago Tribune article on the Chicago Park District pension reform attempt is just the latest development in the Illinois Tale of Pension Woe.  In fact, it’s actually it’s a counter-example to the usual case in Illinois, in which individual municipalities, school districts, and the like, determine their teacher compensation and pay the corresponding percent-of-pay contribution requirements to the appropriate pension funds, and have no further obligation, with the state taking on the obligation to make up for any underfunding, whether due to failure to make the state’s own contributions, or due to investment losses, or losses due to unfavorable actuarial experience.  Only in Chicago does the city bear full responsibility for deficits — a responsibility which produced, on the one hand, in the case of the Park District, a union agreement for pension reductions, as touted in the above article, and, on the other hand, a lawsuit by the city against the state with the claim that the state’s picking up the underfunding for non-Chicago pensions was “separate and unequal” system of funding.  (What happened in the end?  The usual horse-trading.)

But Illinois has long been dogged by issues of pension spiking, by all of the other government entities who bear no further responsibility after their contributions are made.  As the Chicago Tribune reported back in 2015, the state passed a law as far back as 2005 to counter the regular instances in which teachers received substantial pay increases (e.g., 20%) to boost their pensions at little cost to the local schools; from then on out, local schools were required to pay the additional actuarial cost of the increased pensions resulting from high late-career pay increases in excess of 6%.  But, as the Tribune reports,

The Teachers’ Retirement System of the State of Illinois, known as TRS, used legal exemptions to waive almost 75 percent of penalties for local districts across Illinois, a Tribune investigation found. The waivers shifted the cost of those penalties to taxpayers statewide.

What’s more, at a time of low inflation, the 6% cap still provides a lot of room, and local school boards are maximizing the advantage they take, as reported in 2017, by giving teachers the maximum pay raise in the years preceding retirement, to boost their pension, however much it exceeds that of younger teachers.

It’s a no-win:  if the local government that sets pay levels is the one that bears responsibility for the cost of future pension obligations, the risk of legacy costs overwhelming a town’s budget increases; if the state government is liable, they’re at risk of skyrocketing costs when others game the system.

Finally, I titled this article, “Why Public Pension Pre-Funding Matters,” and, in fact, a well-funded plan goes a long way toward remedying the risk of legacy costs — if the funding valuations and asset allocations are based on assumptions that are sufficiently conservative so as to minimize the risk of future adverse experience.  But it’s not an easy solution to the problem of a legislature that too easily succumbs to the temptation to defer funding, or local school boards that are too eager to game the system.  And pension funds can themselves be at risk of further problems, when the state uses the funds to dole out political favors by means of investment choices or management firms.  But I’ll save for another day the debate about what retirement provision for state and local workers should look like in the first place.

 

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.