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A judge’s call for 401(k)s

The federal judge who oversaw the Detroit bankruptcy case, Steven W. Rhodes, has offered a blunt assessment of the future of public retirement systems, calling for officials to consider moving to defined contribution plans.

Mr. Rhodes, who retired Feb 18 as judge in the U.S. Bankruptcy Court for the Eastern District of Michigan Southern Division, Detroit, warned about the looming crisis of unfunded public pension plan liabilities at Crain's Detroit Business' newsmakers of the year luncheon on Feb. 25.

Mr. Rhodes is correct in his perception and his call for cities to consider such a move if they fail to get their defined benefit plans on a sound financial basis.

As the judge who oversaw the biggest U.S. municipal bankruptcy case — where pension plans played a major role in the collapse of a city's finances — his observation should draw the attention of legislators and other policymakers and fiduciaries about the consequences of a lack of commitment to pension reform.

But that doesn't need to mean abandoning a defined benefit structure.

Mr. Rhodes at the luncheon was quoted as saying pension underfunding “flies largely under the radar.”

He's right, public pension funding issues don't get a lot of attention and management.

Public sponsors must resolve to put their defined benefit plans on sound financial footing, or else move to defined contribution plans. Moving to DC plans would be costly to participants and taxpayers because defined benefit plans are more cost effective, according to a 2011 study.

The study, commissioned by the Wisconsin Legislature, found defined benefit plans were more efficient than defined contribution plans in delivering pension benefits.

“DB plans can provide the same level of income at roughly half the cost of a DC plan because of DB's superior investment returns and ability to pool longevity risk,” the study said.

But defined benefit plans are only more efficient if they have the funding to be sustainable, such as the Wisconsin Retirement System has.

Citing estimates, Mr. Rhodes said U.S. municipalities, in aggregate, have unfunded pension liabilities ranging between $1 trillion and $4 trillion.

At too many systems, elected officials have put off proper funding for years. Instead they preferred to spend money that should have been contributed to pension plans for other purposes they hoped would gain them more political favor, while often increasing benefits to win support from public employees without regard to the eventual costs.

Public officials contributed to complacency by deflecting concerns, and in part by using unrealistic actuarial assumed rates of returns to value pension liabilities, making them appear less than their real economic costs.

In Chicago's current campaign to elect a mayor April 7, pension finances are a central issue.

Officials at many plans have begun to take notice.

“Between 2009 and 2014, every state made changes to pension benefit levels, contribution rate structures, or both,” according to a study released this month by the National Association of State Retirement Administrators.“ Many local governments have made similar fixes to their plans.”

But for many plans that has not been enough.

A Moody's Investors Service Inc. report released March 17 found employer contributions were insufficient at most of 54 public plans reviewed, causing liabilities to grow.

Even some commitments to improve funding come at additional costs.

The Kentucky and Kansas legislatures have bills pending that would finance plans through the issue of pension obligation bonds, respectively $3.3 billion and $1 billion. That approach is an arbitrage, betting the plans will earn more investing the proceeds of the bond issuance than the cost of the debt, That spiffed-up appearance comes at a risk and does not make the plans any more sustainable.

Municipal systems must resolve to make commitments to fund pension promises properly and promptly under actuarial guidance.

The City of Milwaukee system did so, even though it has been generally 100% funded, or near to it, over the years. Under a policy adopted in 2013, it began funding the plan annually, even if it is fully funded, which in the past would have required no contribution. The new approach reduces volatility in funding and implants in public officials and the city's budget the necessity of maintaining a contribution to sustain funding.

Elected officials and fiduciaries overseeing public plans should listen to voices of concern like that of Mr. Rhodes, and consider approaches like the one in Milwaukee. They must heed the warnings one way or another, if not soon, then potentially one day in bankruptcy court. n

This article originally appeared in the March 23, 2015 print issue as, "A judge's call for 401(k)s".