Dealing with those underfunded pensions

Posted: July 08, 2013

Underfunded pensions are potential time bombs facing most state and local governments. Pennsylvania faces a shortfall in excess of $40 billion, so we are talking big bucks here. But that doesn't mean it is easy to fix, and mimicking the private sector could be the exact wrong approach.

First, let's get something clear: The pension plans are underfunded because they were, well, underfunded. The state legislature boosted benefits but failed to make the required payments into the system.

It was more fun to use the money for other purposes. As Moody's Investors Service noted recently, "States that have the largest relative pension liabilities have at least one thing in common: a history of contributing less to their pension plans than the actuarially required contributions."

The investment returns for pensions systems have hardly been stellar. For the five years ending December 2012, which includes the 2008 stock market collapse, the Pennsylvania State Employee Retirement System (PSERS) earned a rate of return exactly equal to zero, according to its annual financial report.

It is hard to keep a pension plan solvent if the managers don't make any money for five years.

That said, the system must be made sound. A pension is a promissory note made by the state to its retirees. If the state is to live up to its responsibility, it and the public entities that are part of the system must start paying their required share. That could either mean raising taxes or cutting other spending. Good luck with that.

Alternatively, benefits could be cut, requiring retirees - not taxpayers - to shoulder the costs of the political and financial management failures. OK, many of the irresponsible legislators who allowed the system to become underfunded will pay a price, but the bulk of the burden will fall on current and future retirees.

Public sector employees argue that that would be unfair, since they pay into the system. Their contributions range from 5.25 percent to 10.3 percent of payroll. The employees signed contracts that included those benefits, and, just like in the private sector, contracts should be respected. Taxpayers, of course, would beg to differ.

While it will be left to politicians, there are solutions that make good financial sense and others that don't. Critically, the public sector might not want to follow the private sector's approach to the problem.

Consider the idea of moving new employees to 401(k)-type plans, called 403(b) plans. Private-sector firms did that to reduce their pension costs. Since new pension liabilities would disappear, the remaining major expense is the government's matching payment. When times get tough in the private sector, companies could cut the matches, which has happened with a vengeance lately.

That sounds great, right? Not so quickly. There is a state pension plan that is underfunded but still must be funded. Yet new hires who are only on the 403(b) plan no longer pay into it. By reducing the number of people who contribute to the pension plan, the costs are pushed onto those remaining in the program, as well as the state - and that means the taxpayers. While the estimates vary, those costs - shortfall, really - are in the $40 billion range.

But the private sector made this transition, so what is different? Few private firms required payments by their employees. That's a huge difference. Firms paid most, if not all, of the costs out of earnings. The state and local entities only pay a portion. In 2012, governments contributed about $566 million while employees paid about $348 million.

So maybe privatizing the state pension plans is not the greatest idea since sliced bread. What about cutting benefits? Let's say the multiplier on eligible income declines from 2.5 percent for each year worked to 2.0 percent. That immediately reduces the potential payout.

Unfortunately, there's the little problem of worker reaction. Employees would see a 20 percent reduction in their pensions if they worked the same number of years. What might most do? Work longer!

Well, Social Security saved money by raising the retirement age, couldn't the pension system do the same thing? Yes, but it would come at a cost. School districts, for example, would have older, higher-paid employees. That would increase payrolls and pension plan contributions. Taxpayers would lose as their taxes increase to pay those added expenses.

Ultimately, the costs of resolving the pension issue will be a burden to everyone. Taxpayers who benefited by their representatives using the required contributions for purposes other than pension funding might face higher taxes, while employee benefits may fall or contributions rise.

But without knowing the full costs of the proposals, all we have are political ideas, not financial solutions.

Joel E. Naroff is president and chief economist for Naroff Economic Advisors Inc. in Holland, Bucks County. Contact him at

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