A Bottomless Pit: The Coming $1 Trillion Public Pension Crisis
By Bill Wilson
Last week, Pew Center on the States reported that "at the end of fiscal year 2008, there was a $1 trillion gap between the $2.35 trillion states and participating localities had set aside to pay for employees' retirement benefits and the $3.35 trillion price tag of those promises."
It's quite a hole, and unfortunately, the states are still digging. Soon it will be a bottomless pit.
That gap, reports Pew, will in all likelihood become even worse because it does not take into account the market crash of late 2008. For most states, fiscal year 2008 ended June 30th, 2008, before the stock market tanked.
What's worse, the current $1 trillion gap is widening as the economy continues to struggle and state tax revenue remains low. This year alone, as ALG News has previously reported, states face budget gaps totaling $180 billion. As noted above, the pension systems are in even worse shape to the tune of $1 trillion in unfunded liabilities.
Pew's diagnosis of the problem is generally spot-on: "pension funding levels declined over the past decade from states' failure to fully pay for their retirement obligations as well as investment losses…"
The report also cites several factors "self-imposed by the states" weighing on the pensions systems: early retirement incentives; cost-of-living adjustments in some states that have not been taken into account; in other states benefits have been increased in good times but not reduced when revenues fall short; retirees have been allowed to "double-dip" by coming back to work while still collecting their pension benefits; and workers have managed to get great increases in salary, promotions, and other "salary spiking" practices immediately before retirement that increase the final dispensation of benefits.
So, as life expectancy has increased and public sector unions have managed to successfully lobby state legislatures to lavish increased retiree benefits upon their members, the systems have increasingly been rendered insolvent. Liabilities in these programs have grown by $323 billion since 2006 alone, whereas assets accumulated for the funds since then only totaled $236 billion, an $87 billion deficit. Since 2000, reports Pew, the deficit has been $500 billion.
The situation in retiree health care and other non-pension benefits is even worse: states face a $587 billion long-term liability, but have only $32 billion on-hand to finance that obligation.
In short, the benefits owed are far in excess of contributions by employees and the states, even as the costs of those contributions are increasing. All of which leaves taxpayers holding the bill.
But, it does not have to be this way. The trouble with the current state pension system is actually quite simple. As reported by the Huffington Post, 90 percent of public sector workers are currently enrolled in defined-benefit plans, plans that promise to pay a certain amount of benefits for every year of retirement based on factors like salary and duration of employment.
The establishment of defined-benefit plans by the several states has been the essential root cause of the crisis. The costs for benefits have far exceeded the projected need for contributions, and may even exceed what is possible to be raised through increased contributions by employees and taxpayers if the system is not reformed soon.
Pew outlines some of the catastrophic implications that have come along with the defined-benefits approach: "high annual costs that come with significant unfunded liabilities, lower bond ratings, less money available for services, higher taxes and the specter of worsening problems in the future." This cannot continue.
One of the reforms proposed, as summarized by the Washington Post, would "increase employee contributions and subject new employees to tighter eligibility requirements for more modest benefits." The trouble with this proposal is that it is only a half measure, and an unfair one at that.
That plan, in essence, is a bad deal for younger and new workers, who would increasingly be saddled with the costs of paying for current retiree benefits while simultaneously being forced to stay in a system that will likely be insolvent when they retire, if not before then. This, of course, is the same problem Social Security faces on a grander scale.
Instead, when one is in a hole, the solution is always to first stop digging - before it is cemented over.
If today states just stopped adding new employees to their defined-benefit plans, as has been done in Alaska and Michigan, and switched to portable, IRA-like defined-contribution plans (as corporate America has already done with much success) while simultaneously offering younger workers an option to switch into the IRA, they could immediately takes steps to address the inherent cause of the crisis by limiting the universe of unfunded liabilities.
Today, that number is $1 trillion. If this proposal were adopted in every state, the unfunded liabilities would not grow that much more, and the states over time could bring the pension funds to fully funded levels from their general funds.
The second part of the solution would be to make up the remaining shortfalls. As Pew implicitly notes, Alaska for example has yet to take the second step, and currently has a $3.522 billion unfunded liability. Michigan, too, is in a similar situation, with an $11.514 billion shortfall. But, because they have stopped adding new employees to the defined-benefit plans - limiting the universe of unfunded liabilities - those costs will not rise as fast as states that require such unsustainable systems.
The greatest obstacle to such defined-contribution reforms, Pew notes, is from the public sector unions: "Because unions and other employee representatives often have vigorously opposed defined contribution plans, it is unclear whether any state will find such a switch viable, or if such plans are primarily being proposed as a starting point for hybrid plans or other compromises."
However, switching to defined-contribution plans in this manner provides the best opportunity for states to equitably solve the public pension crisis while keeping their contractual commitments to current and soon-to-be retirees.
As noted above, in just the past ten years, the unfunded liabilities have grown by some $500 billion. Ominously, those costs are likely to escalate, unless states first stop digging themselves into a bottomless pit. Instead, there is a way out.
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