Commentary: A roadmap for preventing U.S. public pension funds from becoming a taxpayer burden

Puerto Rico's debt restructuring is pitting pension beneficiaries against bondholders, and based on recent news, it seems pensioners are going to come out ahead. While the commonwealth is a unique entity with debilitating fiscal issues, it has lessons for those states and municipalities with seriously underfunded pension plans. Pension benefits are well-protected by law and kicking the can down the road is not a solution. Now may be a good time to act to ensure these plans remain solvent.

In 1878, New York City began offering police officers a lifetime pension after 21 years of service and so was born the U.S. public pension system. Today, there are more than 5,500 state, county and local plans that play an essential role in protecting the retirements of public-sector workers. Calculating their aggregate liabilities is more art than science, but it's fair to say that their $4.5 trillion in assets represent less than 73 cents of every dollar they owe — some much better, some much worse.

Public pension benefits and contributions are heavily protected by law. So if pension systems are unable to pay promised benefits, the burden will fall on taxpayers. Paradoxically, taxpayers have almost no voice in public pension fund governance. There is a fundamental unfairness between generations if future taxpayers have to bear the burden of decisions made by their forebears.

Plenty of factors led us to where we are today. The impact of political decisions about the level of worker benefits was not fully appreciated by voters. Pensions were promised, but legislatures failed to provide the necessary funding. Demographics shifted. Investment returns failed to meet expectations — most dramatically during the global financial crisis, when public pension assets lost more than 34% of their value.

We studied the 25 largest pension plans — which together represent 55% of all U.S. public pension assets — to identify possible solutions.

Most trustees overseeing public pension systems are selected not because of particular investment expertise, but because they are public finance officials or because — as public-sector workers — they represent their fellow beneficiaries. Pension boards oversee trillions in assets, so trustees should benefit from serious actuarial, investing and governance education, and boards should include professionals in these disciplines.

Actuaries determine how much the plan sponsor should contribute to the pension system each year, but governments have discretion in appropriating necessary funds. Over a 17-year period, six of the top 25 pension systems had perfect contribution records, but three exhibited particularly poor funding. There's an obvious correlation between funding and the ability to cover promised benefits down the road.

Usually, it is negotiations between employee unions and elected officials that determine the level of future pensions. Unions are focused on securing long-term benefits for their members, while elected officials are beholden to the election cycle and the reality of competing spending needs. The voting public cannot expect to be informed unless it fully understands the implications of the resultant compromises.

Actuaries map pension obligations far into the future and discount them at a rate generally equal to the expected return on the pension portfolio. The large pension plans reduced their discount rates to an average 7.3% in 2017 from 7.9% in 2008, but that may still be too high. Overestimating future returns understates liabilities, masking funding needs. Each tenth of a percent decrease in discount rates causes estimated pension obligations to grow by 1% to 1.5%. Transparency will help all parties.

Staffing constraints mean U.S. public pension systems allocate most of their portfolios externally. This is particularly true for alternative investments — such as private equity — for which expense reporting is incomplete and particularly opaque. As a premise of good governance, decision-makers should be fully informed about the overall cost of each investment. The large pension systems reported $9.6 billion in 2017 management fees. The true number could be closer to $18.3 billion. Some states have begun to demand greater transparency. It is in the long-term interests of all parties to improve expense disclosure. One approach to achieving good returns at lower cost and that has proven successful in some countries is for consortia of pension funds to establish properly governed investment managers that invest directly on their behalf.

The U.S. public pension funding gap evolved over decades and will take a long while to remediate, but the challenge is not insurmountable. In the mid-1990s, Canada's national pension system was projected to run dry by 2015. Through a series of reforms to benefits and contributions and enhanced investment management, it is now considered sustainable for the next 75 years. Why not in the U.S., too?

Ingo Walter is the Seymour Milstein Professor of Finance Emeritus at NYU Stern School of Business. Clive Lipshitz is managing partner of Tradewind Interstate Advisors, New York. They are the authors of "Bridging the Gaps: Public Pension Funds and Infrastructure Finance." This content represents the views of the authors. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.