The irony of the pension plan model is that while it was created to provide a way to responsibly and affordably finance retirement benefits, it has turned into a financial catastrophe for many state and local governments.
A study by the Pew Charitable Trusts' Center on the States, released Feb. 18, quantifies the aggregate depth of the pension funding hole in state retirement systems at some $500 billion. The underfunding rises to a total of $1 trillion when unfunded pension liabilities are combined with retiree health-care and other retirement benefit obligations.
Pew notes its calculation underestimates the financial problem because it does not fully reflect the severe investment declines in pension funds suffered in the second half of 2008, before the modest recovery in 2009, or the amortizing practice in valuation that public plans use to account for investment losses or gains over a period of several years.
The severity of the problem in some state and local government plans has been known for many years and predates the market meltdown. The Pew study underscores that the problem has generally only become worse over time. The time has come for state and other public pension plans in chronic severe underfunding to face their retirement financing problem instead of putting it off.
Either state sponsors should commit to a schedule of contributions to bring their systems to close to fully funded status, or they need to replace the current systems with defined contribution plans. Otherwise, they face out-of-control pension liabilities that will make the system unaffordable and either cause broken pension promises or, for constitutionally protected systems, massive taxpayer bailouts, which would likely wreak havoc on state economies.
Weak economies like the current one are the worst times to raise contributions. Fully funded pension plans can cushion taxpayers, employers and employees from the need for more contributions in times of falling markets and weak economies. But few public employee systems prepared for such scenarios.
Some states don't have the money, or don't want to commit the money, to fund the necessary contributions and have looked in desperation to the market, or pension obligation bond financing, to bail out their systems. Illinois issued $3.466 billion in bonds to finance its contribution for the fiscal year ending June 30. Illinois still has outstanding almost all of the $10 billion in pension obligation bonds it issued in 2003. The state has paid only $100 million in principal on those bonds. But the combined state systems' underfunding has grown to $70 billion now from $35 billion in 2004.
Fortunately, some systems are facing up to the problem.
Among them, Colorado enacted legislation that raises employer and employee contributions and reduces benefits to help the $35.4 billion Colorado Public Employees' Retirement Association.
The Iowa General Assembly has a bill pending that would raise contributions and lower benefits for the Iowa Public Employees' Retirement System and some other state plans.
A funded defined benefit program is the most cost-efficient way to finance retirement income in the long term, according to studies over the years. But that doesn't mean a defined benefit system is best for all participants. The defined benefit system severely shortchanges employees who do not stay for the vesting period.
Iowa, for instance, seeks to raise vesting to seven years from five. In Iowa, 50% of the teachers stay less than five years, causing them to lose the state part of their contributions, in effect forcing them to help shore up the system, according to Michael L. Fitzgerald, state treasurer.
To extend an argument by Mr. Fitzgerald, states should create optional defined contribution plans to allow shorter-term employees a choice to benefit fully from the state portion of contributions on their behalf. That is a failure of the defined benefit system easily remedied.
The defined benefit model can work if funded honestly and appropriately, benefits kept affordable, assets invested in a long-term risk-appropriate strategy and state officials do not regard it as a piggy bank to be raided periodically when politically expedient.
Four state systems, including the $129.4 billion New York State Common Retirement Fund at 107%, were overfunded, according to the Pew study. Among local governments, the $3.96 billion City of Milwaukee Employees' Retirement System, now 99% funded, expects an actuarial study now under way to find it more than 100% funded.
In short, the model isn't the cause of the underfunding. It is the poor discipline in carrying out a plan to implement the model.