Employee pension plans urgently need guidelines, not more bailouts

To avoid another congressional bailout, it’s time to enact legislation to protect the pensions of all state and local government employees.

In the past 20 years, across the board, the funded status of state and local government employee pension plans has worsened while the cost burden on taxpayers has increased significantly. According to Boston College estimates as of May, the average funded ratio (assets divided by liabilities) of these plans was estimated to be about 75 percent in 2021, down from 76 percent in 2010, despite overall good investment returns and down from ratios over 100 percent in 2000. This average hides a range of funded ratios across the country, from 15 to 117 percent in 2021. Analysis shows that the range has grown wider over time, with the lower funded plans struggling and falling behind.

Measures of liability depend upon the discount rate used to convert future cash flows to a single value appropriate for accounting. Conventional measures employ an optimistic view of future investment fund returns as the discount rate. If instead of the expected return on risky assets, the lower rate on safe long-term bonds was used (an approach recommended by most economists for reporting purposes), liabilities would be larger and the average funded ratio in 2017 would have been 48 percent instead of the reported 71 percent. Instead of nearly $186 billion actually contributed in total to fund these plans, correct discounting would require $338 billion to be contributed to prevent a rise in unfunded pension liability. This is 14.6 percent of 2017 state and local government revenue, up from 12.7 percent in 2015.

This body of research, assembled by several different teams, consistently identifies certain states and local government pensions as particularly troubled, in addition to actual bankruptcies and pension losses in recent years in Detroit and Puerto Rico. These government plans include Chicago, Philadelphia, Omaha, Ne., Kentucky, Illinois, South Carolina, New Jersey, Alaska and Connecticut.  

In my own research in the paper, “The Trouble With State and Local Government Employee Pension Plans: The Case of Connecticut,” I focused on the three main employee pension plans for Connecticut state and municipal workers and teachers. Even as a reflection of the median historical investment experience, and certainly under realistic alternative investment returns with lower bond interest rates, projected funded ratios for 2030 would be, at the median, lower (by as much as 4 percentage points) and required contributions higher (by as much as 10 percent) than forecast under the plans’ current assumption.

Moreover, despite recent reforms lowering benefits to new workers and increasing contributions, the Connecticut pension plans are still a large risk to taxpayers. This is shown by a range of simulated possible outcomes. If investment returns are a little lower than expected over the next 10 years, in 2030 the largest plan in Connecticut will have a funded ratio of 35 percent which is lower than today’s ratio of 39 percent. In turn, required contributions will have to rise to 51 percent of payroll instead of today’s 44 percent.

Yet, even with these risks and costs, the Connecticut plans and others like them continue to accrue benefits and report optimistically. Many might think this is a problem only for the taxpayers, workers and retirees of irresponsible states and that others in more assured circumstances need not worry. That’s incorrect. 

The recent $86 billion congressional bailouts of private multiemployer union pension plans show that imprudent tactics such as consciously inadequate funding, too generous benefits and investment, demographic and economic assumptions in reporting that are consistently more optimistic than actual realizations do not have limited impacts. They impose the costs of insolvency on all taxpayers, even those who were responsible funders of provident plans.

To prevent the current bad situation from getting worse  — or, even better — to allow for slow but steady improvements, I recommend that Congress take the following steps:

1. Require the accurate and prudent measurement of plan assets and liabilities, and disclose them plainly to taxpayers and workers. Importantly, include the use of yields on taxable state government bonds as the discount rates.

2. Impose federal funding requirements, following those used in accounting for private pension plans. If the state/local economy is growing with or above national trends, full funding and quick amortizations would not be imposed.

3. If a plan is poorly funded, it must be closed to new workers. Existing workers should be given the option to not participate in it, and the plan should be replaced by a defined contribution plan, as is nearly universal in the private sector. 

If adopted soon, these changes would responsibly address the risks that government pension plans present to all taxpayers. They would start a movement toward fairer and more secure retirement benefit plan systems for state and local government workers. 

Mark J. Warshawsky is a senior fellow at the American Enterprise Institute. He previously served as deputy commissioner for retirement and disability policy at the Social Security Administration.