Debates about public sector retirement income and healthcare plans, in particular topics like “pension reform” have become unnecessarily divisive.
- Political debates too often boil down to “pensions versus 401(k)s,” even though that binary framing is an inaccurate, oversimplification of ways to think about pension deficit challenges.
- There is a lot of misinformation about retirement plans that can drive certain actors to oppose changes that are to their own benefit.
- Even bipartisan movements to improve retirement systems don’t always avoid strife — sometimes the art of the possible does not sit well with some who prefer to pursue their idea of the perfect reform.
Public pension plans are facing sustainability challenges, as the funding deficit of pension plans continues to grow.
On average, today’s state and local pension plans have just 68% of the money they should in order to pay promised retirement benefits. That may not sound bad, but…
It shouldn’t be this bad — Consider that pension funds were originally designed to invest employer and employee contributions, using the returns to pay future retirement benefits — unlike Social Security which relies on today’s workers to pay for today’s retirees. That means funding deficits for pension plans can create real risks of insolvency.
A few states, like Wisconsin and South Dakota, have strong “funding ratios.” But many states and cities are so close to running out of money that one bad year could bankrupt their pension funds. Most of the nation’s public employee pension funds are somewhere in the middle, but collectively they are trillions of dollars short of where they should be today — yes, trillions. With a T.
Some financial and economic experts think the pension shortfall may be two to four times this amount that states and cities are reporting.
It used to be a lot better — Back in the 1990s, the average pension fund had all the money it needed to pay promised benefits. But since the turn of the century, pension debt has been steadily growing.
Before the financial crisis in 2008-09, pension debt had already grown to around $500 billion. By 2016, the shortfall of pension funds reported by states themselves had passed the $1 trillion mark. And today, some economists and financial experts think that if the funding deficit were properly accounted for it could be greater than $4 trillion.
It is complicated — There are many reasons this is happening: pension funds do not always get the contributions that are actuarially necessary; investment returns have not been as strong as expected; actuarial assumptions about payroll growth, retirement patterns, and mortality have not always matched up with the actual lived experience of individuals.
The costs of debt financing retirement systems today is crowding out the ability to use taxpayer resources on other public goods and services.
Funding pension plans used to be relatively inexpensive. Public sector employers and their employees could collectively chip in around 10% of salary into a pension fund, invest with relatively low risk, and use investment returns to fund the majority of promised benefits. However, today, financing pensions has become very expensive relative to the past for two reasons:
- Payments to catch back up to where we should be — Debt financing the payment of previously promised pension benefits costs a lot of money. Back in 2001, the average state pension fund needed employer contributions equal to 5% of employee salary. Today, the required contributions have grown to over 16% of salary.
- Changes in the economy — Interest rates have fallen from double digits in the 1980s to around 3% today. While that’s good for consumer credit, it’s bad for organizations like pension funds that used to loan money at an interest rate that could provide a healthy return. This means pension funds need to take more risk to earn higher returns, and it is harder to earn the same kind of investment yields as in the past. And as pension funds expect to earn less in the future, they need increases in contributions today to make up for the difference.
The growing costs of funding pension plans and health care are the two primary drivers of state and local fiscal challenges today. As pension debt costs grow, the result is a need to increase revenue (tax increases), reduce services (such as closing libraries, taking police off the streets, or shutting down social programs), and freeze wages. Or all three…
…for example, state education budgets increased about 1.6% on average between 2005 and 2014 (the most recent data available). But the growth in school district costs for pension and healthcare benefits over that same time period was 22%. The net result is less money in classroom and downward pressure on teacher pay.
Public sector retirement systems are not working for everyone and, as a result, millions are not given access to a strong path to a secure retirement.
The vast majority of public employees participate in a defined benefit pension plan that provides guaranteed monthly income based on final income and years spent working in public service.
To earn a pension benefit that is enough to provide real income security in retirement, an individual in most pension plans will need to work 25 to 35 years (or more) in the same retirement system. For some teachers, police, firefighters, or other municipal workers this may make sense as a career — but not everyone who is a teacher or town clerk or hospital nurse will spend their entire career working in the public sector. Or within the same state.
For example, roughly 90% of teachers participate in a “final average salary”-style defined benefit pension plan. However, on average less than 50% will work long enough to qualify for that pension. In most states, less than 30% will earn a pension that is worth more than the value of their own contributions to that pension plan. This style of defined benefit plan certainly works to provide retirement security for some teachers, but not for all teachers.
That is not to say defined benefit pensions based on final salary should be ditched just because they do not work for everyone. They can very effectively provide retirement security for individuals who work full service careers. However, it is important to recognize that the common pension design does not ensure adequate retirement savings for all members. And we should not assume that improving the sustainability of today’s retirement systems will be enough to provide retirement income security to all participants.
Other retirement system designs include defined benefit plans that guarantee investment returns, defined contribution plans, or retirement plans that mix some of these styles (called “hybrids”). But of course, there are some retirement security limitations with these too.
Some public sector employees have access to defined contribution retirement plans that allow them to transfer the value of their retirement plan from a private sector employer or out to the private sector when they leave government work. While these portable plans may work better for the majority who won’t stay a full career in public service, they can only provide a path to retirement income security if there are appropriate contributions being made into the system. And in some states, that is not happening.