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It's overwhelming: State and municipal defined benefit pension plans doomed by fundamental flaws

Bloomberg BNA Pension & Benefits Daily | by Bob Williams | December 10, 2012

A growing chorus of credible voices across the political spectrum confirms that government employees' defined benefit pensions are inherently flawed, and cannot survive without drastic fundamental reform. The current government pension policy presents a systemic risk to the U.S. economy and, even under the most optimistic scenarios, will drain money from taxpayers and decimate essential government services. Reforms to date are not structural and have had little or no impact on the ever-growing unfunded liability. The innate pressure to increase investment risk as workers age ensures inability to pay benefits and annual required contributions, a practice highlighted and exacerbated in 2008 by the economic downturn.

A stringent warning from the Government Accountability Office ("GAO") 33 years ago predicted that this would happen.[1] The GAO warned, "To protect the pension benefits earned by public employees and to avert fiscal disaster, state and local governments need to fund the normal or current cost of their pension plans on an annual basis and amortize the plans' unfunded liabilities."

State and local government failed to provide that funding. The result is a hidden government debt that was at least $4.6 trillion as of 2011, according to a study commissioned by State Budget Solutions, "Public Sector Pensions: How Well Funded Are They, Really?" by economist Andrew Biggs.[2] In June of this year, that debt reached nearly $5 trillion, based on latest data from U.S. Census for the top 100 plans representing 89.4 percent of total state and municipal pension "financial activity."[3]

Embedded in the 3,418 state and local government pensions are lax accounting practices and weak oversight, both of which make failure inevitable. Eventually, politicians succumb to temptation, shorting required contributions as hidden loans to buy support from public workers with false promises of benefits. Even though state and local governments claimed to "reform" pay-as-you-go pensions on an actuarially sound basis, they have not done enough to account for the mismanagement and abuse.

The only real solution to the public pension crisis is to freeze the worst defined benefit plans immediately, and impose a defined contribution, cash balance or hybrid system.

Magnitude of the Crisis

An array of recent studies by objective experts highlight the same conclusion: Current state and municipal defined benefit pension systems are doomed by human and economic flaws that guarantee they will run out of money - some sooner, some later, but all plans will run out of money eventually.

Roger Berkowitz, Executive Director of the Hannah Arendt Center at Bard College, provides a succinct summation of the crisis in "Pension Ponzis: Questions About the Public Interest":

The public pension crisis is eroding the American social contract.... What is now sinking in as reality is that the Ponzi scheme is out of money and falling apart. For anyone who cares about government and wants government to succeed, the pension problem must be addressed, for it threatens not only economic disaster, but political cynicism beyond even today's wildest dreams. Across the country, teachers, policemen and firemen, not to mention civil service employees and others, will see their promised pensions shrink precipitously. Not only will this devastate retirement nest eggs for millions of people, it will fray the social contract-pitting young against old and taxpayers against public employees.[4]

Professor Jack Beermann of Boston University refers to the "pathology" of our state and municipal pensions systems caused by the empty promises made to retired government works, without funding those promises. In "The Public Pension Crisis," to be published in Washington and Lee Law Review, Beermann writes, "Pension promises are overly generous, and subject to abuse by legislators and other officials handing out political favors, and by employees using loopholes and tricks to spike their pensions."[5]

The result? "Fairness aside, if the financial situation... does not improve, many state workers and retirees may suffer severe reductions in their pension benefits as public entities find it economically or politically impossible to meet their obligations to retired workers."

Economists Robert Novy-Marx and Joshua Rauh recently updated their ongoing study, The Revenue Demands of Public Employee Pension Promises. Here, they found that, "Without policy changes, contributions would have to increase by 2.5 times, reaching 14.1% of the total own-revenue generated by state and local governments. This represents a tax increase of $1,385 per household per year, around half of which goes to pay down legacy liabilities while half funds the cost of new promises."[6]

The cost to taxpayers will be extraordinary, but will not produce new or added government services of any kind. Many states and municipalities will have to cut essential services even as they impose a greater financial burden on citizens.

Any debate about the magnitude of this fiscal catastrophe ended when the Federal Reserve Bank of Cleveland released three reports in the Spring 2012 edition of Forefront magazine. "Public Finances: Shining Light on a Dark Corner" emphasizes the woeful shape that state and municipal pension are in right now. The authors highlight the likely possibility that plans run out of money and governments default on their obligations to retirees.[7]

These findings correlate with the conclusions of scholars at the Harvard Kennedy School Mossavar-Rahmani Center for Business and Government who published "Underfunded Public Pensions in the United States: The Size of the Problem, the Obstacles to Reform and the Path Forward:

Across the United States, state and local government-sponsored pension plans are in trouble. They are dangerously underfunded to the extent that their assets are unable to meet future liabilities without either outsize investment returns or huge cash infusions" which may be politically impossible. In debate over the size of pension debt, the authors tilt toward economists who "believe that the true size of the total unfunded liability lies closer to the larger estimates than it does to the smaller.[8]

Beermann states, "Although the matter is not free from doubt...the pension funding crisis is real."[9]

Business and Bipartisan Support for Academic Findings

Recognition of the pension crisis comes from the business sector as well. In March 2011, Bill Gates Jr. noted long-term problems with state budgets that even a recovering economy cannot solve, saying health-care costs and pension obligations are projected to grow at rates that look to be completely unsustainable.[10] In 2010, he spoke at the Aspen Ideas Festival, stating "accounting fraud" allowed lawmakers to skirt pension promises to teachers, and is a significant contributor to "fraudulent" state budgeting systems.[11]

Members of both political parties are starting to comprehend the crisis. Democrat Willie Brown, former California Speaker and San Francisco Mayor, has been outspoken about the pension crisis, saying back in 2010 that "at some point, someone is going to have to get honest about the fact that 80 percent of the state, county and city budget deficits are due to employee costs. Either we do something about it at the ballot box, or a judge will do something about in Bankruptcy Court."[12]

Brown correctly raises realistic concerns about government bankruptcy, and even now, examples of bankruptcies are cropping up nationwide. In Pritchard, Alabama, 150 retired workers stopped receiving pension checks.[13] In Washington Park, Illinois, the pension fund went bust and Mayor James Jones acknowledged that the city's contributions "may not have been enough," and that the firefighters "are stuck."[14] In Central Falls, Rhode Island, retired police and firefighters agreed to sharp pension cuts, an unprecedented step in municipal bankruptcy. Stockton, California's pension costs are eating up 30% of its budget.[15]

Even in cities that have not declared bankruptcy yet, leaders are discussing what the pension crisis may mean for taxpayers. Chicago Mayor Rahm Emanuel told the Illinois House of Representatives that if the Chicago pension system is not reformed, the city will have to raise property taxes by 150 percent.[16] In Los Angeles, former Mayor Richard Riordan and David W. Fleming, former chairman of the Los Angeles Area Chamber of Commerce, said in October this year, "What we're looking at is the city paying $2 billion or $3 billion a year just for pensions. That means every other level of service will be affected. I, for one, don't want to have to wait a half-hour for an ambulance or a fire truck to arrive."[17]

Inherent systemic flaws

Compounding the catastrophic magnitude of the pension funding crisis is the fact that the structure of public pensions locks them into a downward spiral.

In "Pension Fund Asset Allocation and Liability Discount Rates: Camouflage and Reckless Risk Taking by U.S. Public Plans?" authors Aleksandar Andonov and Rob Bauer of Maastricht University, and Martijn Cremers of Notre Dame, document that state and local pensions:

Uniquely increased their allocation to riskier investment strategies in order to maintain high discount rates and present lower liabilities, especially if their proportion of retired members increased more. In line with economic theory, all other groups of pension funds reduced their allocation to risky assets as they mature, and lowered discount rates as riskless interest rates declined. The arguably camouflaging and risky behavior of U.S. public pension plans seems driven by the conflict of interest between current and future stakeholders, and could result in significant costs to future workers and taxpayers.

They concluded, "In sum we argue that U.S. policy pertaining to public pension funds needs drastic reform -as current laws and regulations effectively exempt states and cities from behaving prudently in how they manage and disclose the financing of pension systems."[18]

A pension session held during the National Conference of State Legislatures (NCSL) this year drove home the need for pension reform and increased transparency.

Girard Miller, formerly the public money columnist for Governing Magazine and Senior Strategist at PFM Group, and now Chief Investment Officer for the Orange County Employees Retirement System, warned lawmakers, "... we are going to have another recession, and if you don't get your pension problem fixed now, you never will after the next recession." He told legislators new accounting guidelines for public pensions "will swamp your balance sheets," He also detailed the irrevocable arithmetic of pension finance in a series of slides available on the NCSL website.[19]

Miller pointed out that the conventional wisdom that a pension at 80 percent funding is "healthy" is misleading. If there is more than one recession in the coming decades - on average they occur every 6.2 years - all plans will ratchet down to funding levels that will require increased taxes and severe cuts to current services just to pay pension benefits.

The correct arithmetic is emphasized in an issue brief from the American Academy of Actuaries. In "The 80% Pension Funding Standard Myth" they state, "Frequent unchallenged references to 80% funding as a healthy level threaten to create a mythic standard." All pension plans must set the funding goal at 100 percent to avoid "[...] the potential that the current cost of pension benefits may need to be paid by future stake­holders [...]."[20]

Recent municipal bond ratings agencies and the National Association of Bond Lawyers (NABL) obliterated any remaining doubt about the size and systemic nature of this pension crisis.

This year, in "Considerations in Preparing Disclosure in Official Statements Regarding an Issuer's Pension Funding Obligations (Public Defined Benefit Pension Plans)," NABL stated, "governmental pension plans may have problems that may not be apparent to investors and analysts from either the basic information about a pension plan or system or even from the actuarial valuation."[21] They recommend tough considerations its members should use to cover themselves on bond issues.

Moody's Investor Services[22] recently imposed pension accounting protocols that include a 5.5 percent discount rate and 13-year amortization period. A wave of downgrades[23] followed.

As for Government Accounting Standards Board guidelines set for implementation next year and in 2014, economist Robert Novy-Marx documents in a recent study, that a government pension will be able to look better on paper "... literally by burning money," because the more of its assets it puts in high-risk investments and the less in low-risk, such as cash, the higher value it would show.[24]

Authors of the Notre Dame-Maastricht study spell it out, "As a result, the new GASB proposals would create even stronger incentives to camouflage liabilities and engage in reckless risk-taking for funds that are close to being underfunded (and that may indeed be underfunded if liabilities would be discounted at - currently - lower high-quality municipal yields) and that rationally want to avoid being classified as underfunded."[25]

Compounding the problem are promises of other, additional post-employment benefits, primarily retiree health care. These promises are open-ended, unfunded liabilities. Even though they are not guaranteed, they represent an immeasurable claim on revenues. 

False solutions

Forty-four states recently passed public pension reform, but the "reforms" are widely criticized as inadequate and ineffective.

The Cleveland Fed study concluded, "Indeed, increased public attention on the underfunding problem has motivated pension plan sponsors to work with state legislators to implement substantive reforms. ... But most of these changes have only a limited effect on plan funding."[26]

These reforms inadequately address the problem, in large part because they apply only to new employees and not to current employees and retirees. As a result, the reforms passed thus far have done very little, if anything, to address the unfunded liability.

Other proposed solutions, such as using pension obligation bonds ("POBs"), can actually make the crisis worse Alicia Munnell, director of the Center for Retirement Research at Boston College, and author of "State and Local Pensions: What Now?" wrote in a 2010 research brief, "Pension Obligation Bonds: Financial Crisis Exposes Risks":

"While POBs may seem like a way to alleviate fiscal distress or reduce pension costs, they pose considerable risks. After the recent financial crisis, most POBs issued since 1992 are in the red. ... Unfortunately, most often POB issuers are fiscally stressed and in a poor position to shoulder the investment risk. As such, most POBs appear to be issued by the wrong governments at the wrong time."[27]

Prospects for some kind of a federal bailout could make the crisis worse, as enunciated by Beermann: "There are many practical reasons to be cautious about bailing out public pension funds ..." primarily the "moral hazard problem ... In some states and localities, corruption has contributed significantly to extravagant pension promises. Unless serious consequences are attached to abusive behavior ... losses may continue after bailouts."[28]

Last year, James Spiotto, attorney with Chapman and Cutler LLP, advocated establishing powerful Public Pension Funding Authorities to "avoid the inevitable meltdown."[29]

He concluded, "The definition of insanity is doing the same thing over and over again and expecting a different result. The pension underfunding crisis has reached a level of insanity - it is now time for a change, adult supervision and hard determination of what is affordable and what is not."[30] Spiotto stressed that using public pension funding authorities will provide crucial mechanisms to permanently fix the pension system.

However, no pension authorities have been established or proposed.

Switching to Defined Contribution Plans

The defined contribution solution fits all circumstances, and gives state and municipal governments the ability to avoid an unnecessary federal bailout.

State Budget Solutions outlines meaningful solutions to public pensions here.[31] The solutions are wide-ranging, and while implementation of the defined contribution plans is the best route, governments have a myriad of options to help them address the crisis, including increasing transparency, eliminating abuses such as spiking and double-dipping, and raising the age of eligibility and time required for vesting. 

Lawmakers should be required to fund the full Annual Retired Contribution (ARC) of the plan to be paid each calendar year or legislative per diem will be canceled until full ARC is paid. Governments are still using unrealistic rates of return (i.e. 8%) even though they have not earned that over the past 10 years.

Keith Ambachtsheer, Director of the Rotman International Centre for Pension Management, recently published a study, The Dysfunctional  ‘DB vs. DC' Pensions Debate: Why and How to Move Beyond It, highlighting the problems with defined benefit plans. His analysis of nearly 4,000 public pension plans found inherent flaws in both defined benefit and defined contribution plans, but the fundamental design problems of the traditional defined benefit plans make defined contribution the favored approach, a finding that mimics the general consensus of economists and scholars across the political spectrum.[32]

As the Mossavar-Rahmani Center study states emphatically:

"The sooner plan sponsors (states and, in many cases, local governments) implement meaningful reforms, the less likely the problem will continue to spin out of control. However, many states and municipalities face an uphill climb in implementing reforms, with legal and political obstacles impeding progress. In the case of pension reform, time is money, and any delay in implementing needed changes will likely cost taxpayers __ and public pension beneficiaries - significant resources."[33]

Immediate, achievable reality-based solutions

States and municipalities need to enact reality-based solutions, and they need to do it now. First, officials need to freeze the worst plans immediately. In place of those plans, officials should impose defined contribution, cash balance or hybrid plans. They should also provide a rational glide path for others to do so as the "inevitable meltdown" continues in decades to come.

In some cases, that will require current retirees and government employees to share the sacrifice of reducing current pension obligations because increased taxes and service cuts are unfair to citizens who played no role in this catastrophe.



[1] United States Government Accountability Office, Funding of State and Local Government Pension Plans: A National Problem, HRD-79-66 (Aug 30, 1979), http://www.gao.gov/assets/130/127585.pdf.

[2] Andrew Biggs, State Budget Solutions, Public Sector Pensions: How Well Funded Are They, Really? (July 2012), http://www.statebudgetsolutions.org/doclib/20120716_PensionFinancingUpdate.pdf

[3] United States Census Bureau, Quarterly Survey of Public Pensions (Second Quarter 2012), http://www.census.gov/govs/qpr/

[4] Roger Berkowitz, Hannah Arendt Center, Pension Ponzis: Questions About the Public Interest (March 20, 2012), http://www.hannaharendtcenter.org/?p=4844

[5] Jack Beerman, Washington & Lee Law Review, The Public Pension Crisis (to be published Vol. 70 20212) http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2131481

[6] Robert Novy-Marx and Joshua Rauh, The Revenue Demands of Public Employee Pension Promises (Sept. 16, 2012), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1973668

[7] John Carlson, Federal Reserve Bank of Cleveland, Public Finances: Shining Light on a Dark Corner (Spring 2012), http://www.clevelandfed.org/Forefront/2012/winter/ff_2012_winter_08.cfm

[8] Thomas J. Healey, Carl Hess, and Kevin Nicholson, Harvard Kennedy School Mossavar-Rahmani Center for Business and Government, Underfunded Public Pensions in the United States: The Size of the Problem, the Obstacles to Reform and the Path Forward (April 2012), http://www.hks.harvard.edu/centers/mrcbg/publications/fwp/2012-08

[9] Jack Beerman, Washington & Lee Law Review, The Public Pension Crisis (to be published Vol. 70 20212) http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2131481

[10] John Ellis, Business Insider, Bill Gates Addresses The 'Completely Unsustainable' Crisis In Public Pensions (March 3, 2011), http://articles.businessinsider.com/2011-03-03/politics/30042223_1_budget-cuts-building-budgets-ted-conference#ixzz2AMMIR4ML

[11] John Fund, The Wall Street Journal, Getting Schooled in Aspen (July 13, 2010), http://online.wsj.com/article/SB10001424052748704288204575363100367240836.html

[12] Willie Brown, San Francisco Chronicle, Homeland security chief takes responsibility (Jan. 3, 2010), http://www.sfgate.com/bayarea/williesworld/article/Homeland-security-chief-takes-responsibility-3276937.php#ixzz2AEedVwLp

[13] Mike Shedlock, Market Oracle, Alabama Town Defaults on Pensions, Files for Bankruptcy Protection, (Dec. 23, 2010), http://www.marketoracle.co.uk/Article25214.html

[14] Bob Williams, State Budget Solutions, Pension Update (June 4, 2012), http://www.statebudgetsolutions.org/the_williams_report/detail/pensions-update-june-4-2012

[15] Mary Williams Walsh, The New York Times, Cuts for the Already Retired (Dec. 19, 2011),  http://www.nytimes.com/2011/12/20/business/pension-deal-in-rhode-island-could-set-a-trend.html?pagewanted=all#h[TrwCFp,1]

[16] Mary Ann Ahern, NBC Chicago, Rahm: No Pension Reform? Higher Taxes (May 8, 2012), http://www.nbcchicago.com/blogs/ward-room/Rahm-Testify-Pension-Committee-150588425.html

[17] Rick Orlov, Daily News, Ex-Los Angeles Mayor Richard Riordan's pension-reform plan irks unions (Oct. 15, 2012), http://www.dailynews.com/news/ci_21780399/ex-los-angeles-mayor-richard-riordans-pension-reform

[18] Aleksandar Andonov, Rob Bauer, and Martijn Cremers, Pension Fund Asset Allocation and Liability Discount Rates: Camouflage and Reckless Risk Taking by U.S. Public Plans? (May 1, 2012), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2070054

[19] Girard Miller, National Conference of State Legislatures, Retirement Plan Reform and Intergenerataional Equity (Aug. 8, 2012), http://www.ncsl.org/documents/fiscal/GMiller_Presentation.pdf

[20] American Academy of Actuaries Issue Brief, The 80% Pension Funding Standard Myth (July 2012), www.actuary.org/files/80_Percent_Funding_IB_071912.pdf

[21] National Association of Bond Lawyers, Considerations in Preparing Disclosure in Official Statements Regarding an Issuer's Pension Funding Obligations (Public Defined Benefit Pension Plans) (May 15, 2012), http://www.nabl.org/uploads/cms/documents/Pension_Funding_Obligations_Document_5-16-12_A.pdf

[22] Presentation: Proposed Adjustment to US State and Local Government Reported Pension Data (July 10, 2012)

[23] Barron's Income Investing, Moody's: 80% of 2012 Muni Credit Rating Changes Have Been Downgrades (Oct. 25, 2012)

[24] Robert Novy-Marx, Logical Implications of GASB's Methodology for Valuing Pension Liabilities (June 2012), http://rnm.simon.rochester.edu/research/LIoGMfVPL.pdf

[25] Aleksandar Andonov, Rob Bauer, and Martijn Cremers, Pension Fund Asset Allocation and Liability Discount Rates: Camouflage and Reckless Risk Taking by U.S. Public Plans? (May 1, 2012), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2070054

[26] John Carlson, Federal Reserve Bank of Cleveland, Public Finances: Shining Light on a Dark Corner (Spring 2012), http://www.clevelandfed.org/Forefront/2012/winter/ff_2012_winter_08.cfm

[27] Alicia Munnell, Ashby Monk, Jean-Pierre Aubry and Thad Calabrese, Center for Retirement Research at Boston College, Pension Obligation Bonds: Financial Crisis Exposes Risks (Jan. 2010), http://crr.bc.edu/briefs/pension-obligation-bonds-financial-crisis-exposes-risks/

[28] Jack Beerman, Washington & Lee Law Review, The Public Pension Crisis (to be published Vol. 70 20212) http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2131481

[29] James E. Spiotto, Chapman & Cutler, Unfunded Pension Obligations: Is Chapter 9 the Ultimate Remedy? Is There a Better Resolution Mechanism? (June 2011), http://www.sec.gov/spotlight/municipalsecurities/statements072911/spiotto-slides2.pdf

[30] Id.

[31] Bob Williams, State Budget Solutions, Solutions to the public pension crisis (Aug. 1, 2012), http://www.statebudgetsolutions.org/publications/detail/solutions-to-the-public-pension-crisis

[32] Keith Ambachtsheer, Rotman International Centre for Pension Management, The Dysfunctional  ‘DB vs. DC' Pensions Debate: Why and How to Move Beyond It (Fall 2012), http://utpjournals.metapress.com/content/72782781qv313681/fulltext.pdf

[33] Thomas J. Healey, Carl Hess, and Kevin Nicholson, Harvard Kennedy School Mossavar-Rahmani Center for Business and Government, Underfunded Public Pensions in the United States: The Size of the Problem, the Obstacles to Reform and the Path Forward (April 2012), http://www.hks.harvard.edu/centers/mrcbg/publications/fwp/2012-08

This article was originally published in Bloomberg BNA Pension & Benefits Daily on Nov. 26, 2012.

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