Introduction

State and local budgets across the nation are facing enormous distress. Although part of this hardship can be attributed to the worldwide financial crisis and the recession that followed, a significant portion has been caused by widespread, unsound budgetary practices. By and large, the financial crisis merely uncovered deep, veiled structural flaws. Chief among these flaws is the perpetual underfunding of public employee benefits. Failing to address the public pension crisis promptly would be economically catastrophic, triggering bankruptcies of cities, school systems and potentially even entire state governments.

The states' own estimates of the unfunded liability due to their pension benefit promises grew to $1.26 trillion in fiscal year 2009, up from $1 trillion just one year earlier.1 However, using standard private sector accounting rules, the shortfall estimate increases to approximately $3 trillion, a sum that represents roughly one-fifth of the United States' gross domestic product.2 In other words, the assets that states have set aside to pay for employee retirement benefits fall short of what they owe for those benefits by approximately $3 trillion. As a comparison, the 2009 federal stimulus bill cost taxpayers an estimated $787 billion, or less than one-third of the current unfunded liability due to state-run pensions.

The size of the public pension debt per household is overwhelming in many areas, and the economic and social costs of this crisis are potentially crippling to our nation.  The average family living in Chicago today is burdened with $34,599 in liability due to underfunding at the state level, and an additional $41,966 at the municipal level for a total debt burden of $76,565.

Because of this shortfall, states, municipalities and school districts will soon be forced to take drastic measures to pay for their pension obligations. They will pass the burden on to the public either in the form of increased taxes or, more realistically, cuts to services that are critical to society, such as education. Without significant changes to the current systems, public pension payments will quickly begin to crowd out other discretionary spending.

The Laura and John Arnold Foundation (LJAF) seeks to remedy this untenable financial situation by educating policymakers and the public about the nature of the pension problem and developing structural reforms that are comprehensive, sustainable and fair. Sound pension reform meets four general criteria: (1) establish transparency with respect to the true cost of the benefits promised to public employees; (2) mandate that the pension plan sponsor pay the full cost of accrued benefits each year; (3) mandate that the pension plan sponsor pay down the unfunded accrued liability over a reasonable time horizon and (4) improve the generational equity, portability and security of benefits for public employees.

Proposed Solutions

The fundamental problem of the current DB system stems from the way benefit promises are made. The system promises an employee a specific benefit without regard to, and without a full understanding of, what it will ultimately cost the state or municipality to provide that benefit.

The way to create a sound, sustainable and fair retirement savings program is to stop promising a benefit and instead promise an accrual or savings rate. This would mean that instead of committing to a fixed percentage of final average salary after a specified number of years of service, the employer would instead commit to contributing a fixed percentage of salary for every year worked. This would eliminate cost uncertainty by making benefits a constant percentage of earnings and by linking benefit promises directly to employer contributions. Under this approach, employers can be as generous as they desire with employees without the danger of underfunding. Additionally, employers can adopt and offer to employees a variety of investment strategies for the retirement funds, minimizing costs, creating choices for workers, and limiting market exposure for both the employee and taxpayers.

Promising a savings rate as opposed to a defined benefit also addresses the labor market problem by smoothing pension wealth accrual. Employees would earn a fixed percentage of salary per year for retirement, which would eliminate the back-loading of benefits and thereby solve the portability and equity issues of a typical DB plan.

A shift toward promising a savings rate instantly fixes the structural problems created by the current system and can be implemented in a way that maintains all of the protections for workers that are hailed as the primary benefits of the current system (e.g., easy annuitization, managed investments, employer-employee risk sharing). There is a range of specific options for making this shift. Recent reform efforts have shown that implementation of new systems is very flexible and certainly not "one size fits all." Below is a summary of the most frequently discussed alternatives, each of which would move plan sponsors toward a financially sound system:

Solution #1: Defined Contribution
In a defined contribution (DC) plan, the employer promises each employee a fixed percentage of salary. These contributions are placed in an account that is managed by the employee. The employee has the flexibility to choose her investment allocation and to make individual choices about the timing and structure of her retirement. The market risk of these choices is borne solely by the employee. Michigan has had a DC in place for state employees since the 1990s, and higher education and many private sector firms have used the DC structure successfully for decades.

Solution #2: Cash Balance
Cash balance plans have features that are commonly associated with both DB and DC plans. A cash balance plan is a DB plan, but unlike the traditional DB plan, benefits are defined as a lump sum or "cash balance" in an employee's account. Under a cash balance plan, much like in a DC plan, the employer promises a fixed percentage of salary and contributes that amount to an account for the employee. However, unlike a DC plan, the employee does not manage her account. Instead, the retirement system manages the funds for the employee and promises an average investment return. When an employee reaches retirement age, the employer may offer the employee an annuity based on the size of her retirement account and/or the ability to take all or a portion of the account as a lump sum. Nebraska and many private sector firms use the cash balance structure.

Solution #3: Side-by-Side Hybrid
In a side-by-side hybrid, the sponsor maintains both a DB and DC plan and allows employees to choose between the plans. When implemented correctly, the sponsor institutes strict accounting controls to keep the problems created by the DB structure in check. Utah and Florida operate DB and DC systems side-by-side, allowing employees to choose between the two structures.

Solution #4: Stacked Hybrid
In a stacked hybrid system, employees are offered a small DB, meant to provide a minimum amount of retire- ment security, with a DC stacked on top. The federal em- ployee retirement system and the recently adopted reforms in Rhode Island use a stacked hybrid approach.

Solution #5: Cap on Employer Contri- butions with Explicit Cost Sharing
This approach is agnostic about the specific plan structure and seeks only to eliminate cost uncertainty and provide a political incentive to keep future cost increases controlled. A proposed ballot initiative in California takes this approach. The proposed initiative caps employer cost at a specific percentage of earnings and specifies that the cost of all benefits will be divided equally between employee and employer.