At the turn of the millennium, public pensions seemed to be riding high. By their own accounting, most such funds were more than fully funded, and public workers’ retirement benefits were more generous than ever after a round of enhancements in the 1990s. But the two decades that followed have decimated the finances of many public-pension funds, resulting in steeply rising taxpayer costs and serious negative effects on public workers’ salaries, jobs, and benefits.

The great irony is that the retirement systems that were meant to protect public workers, shielding them from the vagaries of the market, have often accentuated the effects of market swings, increasing the threats to public workers’ financial well-being. Today’s strong economy means policymakers are not under maximal pressure: They can see the problem, but they do not yet truly feel it. That time will come, however, and if public pensions are going to survive over the long term, funding and investment practices must improve, and benefits need to be modernized to flexibly meet the needs of today’s public workforce.

There won’t be a better time to avert the next pension crisis. And there are a few key steps that every jurisdiction should be taking.

Growing Benefits, Growing Risks

To understand what must change, we must first appreciate some of the history of how public pensions got to where they are. Most public-pension systems were established in the first half of the 20th century, and for their first few decades, the value of promised benefits and their annual costs were small relative to the budgets of their sponsoring governments. In those early years, public-pension investment portfolios were also relatively safe because policymakers restricted plans’ ability to invest in risky assets. The fact that public-pension plans were small and not very volatile made them easy to manage and meant they presented little or no risk to state and local budgets.

Over time, however, public-pension plans have naturally matured, and their financial situation inevitably grew more complex. As the years passed, more public employees eligible for the programs neared and reached retirement age; as a result, total plan membership grew, and there were fewer active workers for every person drawing a benefit check. Between 1960 and 2017, total public-plan membership more than quadrupled, and the ratio of active workers to retirees fell from just under 7 to 1.4.

But plan maturation was not the only thing driving public-pension membership growth. State and local governments were also adding large numbers of workers to their payrolls. Between 1960 and 2017, the United States population grew by 80%; over the same period, state and local government employment grew by 186%. As governments added more public workers and the membership of public plans aged, the total amount of promised benefits (that is, the plans’ liabilities) grew precipitously.

Meanwhile, governments also significantly enhanced benefits beginning in the late 1980s through the 1990s, propelling liabilities even higher. In a recent working paper, the American Enterprise Institute’s Andrew Biggs used data from the National Income and Product Accounts to document how public-pension generosity has changed over time. Up until the late 1980s, the taxpayer cost of the retirement benefits earned by public workers in any given year (the so-called “employer normal cost”) remained relatively stable, hovering between 8% and 10% of payroll. But from that point forward, public workers began earning much more generous benefits for each year of work. Employer normal cost increased by 76% between 1988 and 2017, growing from 9.6% to 16.9% of payroll.

Together, the maturation of public plans, growing public payrolls, and benefit enhancements have led to a meteoric rise in pension liabilities. The federal government maintains data on public-pension assets and liabilities going back to 1945. Comparing historical data on pension liabilities to the national gross domestic product provides a reasonable measure of the size of promised benefits relative to taxpayers’ overall capacity to pay. In 1960, state and local pension liabilities totaled approximately 12.6% of GDP. By 1990, the ratio had nearly doubled to 22.2% of GDP. Then between 1990 and 2017, the ratio nearly doubled again, growing to approximately 42% of GDP. The total value of retirement benefits already earned by public workers is higher today than it has ever been.

Unfortunately, state and local governments did not fully fund benefits as workers earned them. Instead, they used debt to finance a large portion of the last 30 years of pension-liability growth. In each year since 2001, governments have, on average, paid 12% less than the actuarially determined contribution, or the amount that would cover normal cost and pension debt service. Over time, this consistent underpayment adds up. If state and local governments had paid their full pension bill every year since 2001, public-pension funds would be better funded by more than $315 billion.

Responsibility for today’s historic levels of pension debt cannot be fully laid at the feet of policymakers, however. Pension plans themselves deserve a hefty share of the blame. Although public-pension plans claimed to be more than 100% funded at the turn of the millennium, in reality they were well short of that benchmark. Arcane accounting practices allow public pensions to discount future benefit payments using their expected investment returns, which, in the irrational exuberance of the late 1990s, were 8% or more for most plans.

This practice creates the opportunity and incentive to understate the cost of benefits. Discounting using a higher rate reduces annual contributions in the near term, by betting that investment returns will cover a greater share of the cost. Plans have taken advantage of this fact by adopting optimistic return assumptions that make benefits look cheaper than they really are. But if returns fall short of expectations, costs can rise quickly because of the power of compounding. And that is exactly what has happened. Since 2001, average annual investment returns have totaled just 6.4%, far below expectations, resulting in growing pension debt and rising cost.

It is more accurate to calculate pension liabilities using a high-grade bond yield, which reflects both the guaranteed nature of benefits and prevailing economic conditions. That’s what the United States Bureau of Economic Analysis does when it tabulates public-pension liabilities. Using those data, average state and local public-pension funded ratios (the share of accrued liability that is funded) topped out at just over 83% in 1999 and fell precipitously thereafter. In fact, 1999 was the high-water mark for pension funding, and was the result of decades of progress toward full funding. Today pensions are just 47.5% funded, hardly better than they were in 1983. Pension plans’ consistent underestimation of the cost of retirement benefits is a huge reason for this regression.

It is easy to understand why pension plans made such a big bet on their investment performance. The final two decades of the 20th century delivered the best market performance ever recorded. Researchers have been able to estimate the equivalent of the S&P 500 index, a broad measure of United States stock-market performance, going back to 1871. And in that nearly 150-year history, no 20-year period had higher average annual returns than the one that ended in 1999, with a whopping 16.88%. Pension plans had fortuitously positioned themselves to take advantage of that market run-up. As noted previously, in their early years, pensions faced limitations on risky investing. Those restrictions were largely removed in the 1970s and 1980s at the pension plans’ behest, following which public pensions shifted out of safer assets like bonds and into riskier assets like stocks. In 1960, approximately 10% of pension investments were in risky assets; today, 72% are.

In the background, as plans reaped the market gains of the 1980s and ’90s, the economy was shifting, changing the calculus of pension financing. Interest rates, which had reached new heights in the preceding decade, began to fall consistently through the 1990s and into the 2000s. Meanwhile, pension plans’ investment-return assumptions, which had followed interest rates up, did not follow them back down. As a result, plans were expecting the return on their investments to exceed the “risk-free” rate (the return on the relatively safe bet on United States government bonds) by a growing margin over time. To achieve the same return, plans needed to take on more risk or give up some liquidity — and they did both.

Researchers estimate that, to get the same 7.5% to 8% return, pension plans need to take three to four times more risk today than they did 20 to 30 years ago. As risk increases, pension assets become more volatile. As a partial solution to this problem, pension plans began shifting into less liquid, alternative investments like private equity, hedge funds, and real estate. In theory, giving up some liquidity and diversifying will somewhat reduce risk for any given return target. Since 2001, public pensions have tripled the share of their portfolios devoted to alternative investments from 9% to 27%. But based on the available evidence, it’s doubtful that this shift into alternatives has delivered on its promise: Returns have fallen well short of targets, fees are up, and volatility is still a problem.

The upshot of this history is that public pensions are bigger and riskier than ever. Pension liabilities and debt have never been so large relative to taxpayers’ capacity to pay, and pension investments have never been so uncertain. Public pensions’ finances have continued to deteriorate despite a decade-long bull market that has seen the S&P 500 index grow by more than 300% from its bottom in 2009. It’s clear that pension plans are not simply going to grow their way back to fiscal health, and that more must be done to reverse the deleterious effects of rising pension debt.

Continue reading the article at National Affairs for a discussion of the costs of pension debt, reforms that matter most, and averting a deepening crisis.

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This article republishes selections from “How to Avert a Public-Pension Crisis” by Josh B. McGee, an article published is National Affairs Summer 2019 issue.