Public employee pension plans around the country are facing a shortfall of at least $1 trillion, and some of the largest plans are beginning to radically cut promised benefits because they have not stashed away enough to meet their obligations. The California Public Employees’ Retirement System (CalPERS) recently announced that it would be cutting benefits for retirees whose municipal employers had not funded their benefits, while pension plans in New Jersey and Dallas are expected to run out of money within the next decade.
Despite such warnings for governments not fully funding their pension plans, a new proposal by a university think tank would make the problem infinitely worse by recommending a costly new financing method that’ll jeopardize workers’ retirement security and push today’s costs onto future generations.
A new report by the Haas Institute at the University of California, Berkeley asserts that the public pension crisis is overblown, and that most pension funds would be fine following the practices that were embraced by certain CalPERS employers, New Jersey and Dallas. The report argues that public sector retirement systems are not really in danger — they are just victims of overzealous Government Accounting Standards Board rules related to reporting risk. The Haas report contends that it is wrong to treat permanent governments like private companies that may shut their doors because this creates avoidable financial pressures on government employers.
While a thoughtful and nuanced critique, this report nonetheless seeks to upend pension accounting in ways that would—counter to its intention—jeopardize retirement security for public employees, not enhance it.
The core proposal from the Haas Institute is that governments should abandon the accounting rules for defined benefit plans that require “pre-funding” — i.e., a practice of setting aside enough money each year that, when combined with investments returns, will be enough to provide annuitized retirement benefits for a worker on the day that they retire. Instead it is proposed that governments adopt the Social Security-style, pay-as-you-go (PAYGO) approach to funding state and local worker retirement benefits.
This approach runs counter to how public pension systems are intended to function.
Pensions are not designed to function as PAYGO, Ponzi-like operations where the contributions made by current employees are used to cover the benefits earned by retirees. The pre-funded accounting concept is supposed to avoid asking future generations to pay for the deferred compensation of workers that deliver public services enjoyed by the current generation—and avoid harm to the cause of intergenerational equity.
While it’s true that the pre-funded accounting design has been perverted over the last two decades by the proliferation of unfunded pension liabilities, this is primarily because pension boards failed to adjust their actuarial assumptions to reflect a lower-yield investment environment. The accounting methods underlying modern pension finance are nonetheless still rooted in a foundational principle that today’s taxpayers and workers should collectively share the full costs—including retirement benefits—associated with providing the government services enjoyed by citizens today.
By contrast, PAYGO forces future generations to pay for today’s workers, creating an intergenerational equity problem. Today’s politicians decide on the pay and benefits they want to provide today’s public workers, but then require future taxpayers—who have no voice in the matter and do not benefit from the delivery of those services—to pay for part of that compensation package.
Similarly, pension plans that do not strive to achieve 100% funded status in the near-term are effectively embracing a PAYGO-lite funding approach, where benefits earned today are partially paid for with current tax dollars and partially debt financed through future taxpayer dollars covering any shortfalls in what is necessary to pay benefits (known as unfunded liability amortization payments).
To make matters worse for struggling municipal governments, PAYGO is a more expensive approach to providing retirement benefits than pre-funded defined benefit pensions or defined contribution retirement plans. Since PAYGO does not focus on making contributions to a fund targeting a certain investment return over time—ensuring sufficient assets available to fund promised future pension benefits—more taxpayer contributions would be needed now and in the future since to make up for the missing investment returns.
Particularly galling is that paying for retirement benefits as costs come along with future tax dollars is simply disrespecting the promises made to generations of public workers. When the next recession comes or the next budget deficit hits, politicians will inevitably prioritize spending money on providing current services rather than continuing to pay for services rendered years ago, thus subjecting retiree benefit payments to the whims of politicians with short-term economic incentives.
Ultimately, if a state wanted to create a new plan for future workers funded on a PAYGO basis, then it can do so — though taxpayers should know explicitly what they are getting into. But state and local governments faced with large unfunded liabilities on their current pension plans should not try to get out of their mess by embracing intergenerational inequity and just kicking the costs down the road. They should honestly account for the traditional pension plans and ensure they are fully funded.
None of this is to say that there are not legitimate gripes with current pension funding policy and practice—we have many. But it would be far better for public workers and retirees to reform debt-ridden pension systems to put them on track to reach full funding than to surrender and jeopardize retirement security by subjecting worker benefits to the whims of limited-vision politicians in the sausage-making of government budgets.
This piece originally appeared at Forbes.com, by Anthony Randazzo and Leonard Gilroy on April 6, 2017.