Public Pension Crisis: Causes Part I

It is no surprise that public pension funds have been hit particularly hard by the ongoing effects of the recession. However, the shortfalls that have arisen over the past five years are not solely due to poor investment strategies. There are a myriad of systemic problems within the public pension system that have been exposed and exacerbated by the recession. However, before describing this crisis and its causes, one must first describe the nature of a public pension.

Public pensions are defined benefits plans, meaning the employer provides the pensioner a monthly benefit that has been calculated and defined, and will not fluctuate. The pensioner will receive the same amount for the rest of their life, and the employer, the state in this instance, must meet this obligation. This is distinct from defined contribution plans, which are far more popular in the private sector. Such plans define the amount the employer will contribute to the employee’s benefit plan while they work for the company. These amounts are then placed into an account, and the potential benefit cannot be known at the time of the contribution. To clarify: defined benefit plans define what the employee ultimately receives during retirement; defined contribution plans define what the employer contributes to the employee’s retirement fund while they work for the employer.

The former is preferable to many employees because their benefits are immune to economic downturns. This is why they are common among unionized and public workers. The latter is preferable to many employers. They are not required to make potentially cumbersome obligations to their employees in the future. This is why they are more frequently offered by private corporations than defined benefits plans.

Such a distinction is paramount to understanding the current crisis. As public pension funds rely on investments in order to meet their obligations, a severe economic downturn, such as the one that began in 2007, can lead to a shortage of funds to meet said obligations. This is precisely what has happened, not only because the economy has been struggling, but also because many pension funds invested in assets that were far too risky. Several are now, consequently, stuck in something of a negative feedback loop, one in which risky investments become the norm in order to make up for previous losses due to other risky investments.

The Necessity of Risk

As the New York Times reported in April 2012, many public pension funds have been attempting to bridge their shortfalls by investing in “private equity, real estate and hedge funds.” While such risky investments may seem out of place in the portfolio of a public pension fund, they have become very commonplace. These pensions can no longer rely on low-risk investments, such as 10-year Treasury notes (which yield approximately 2-percent), to meet their obligations. As noted by the Heritage Fund, most pension funds’ growth must quadruple that figure if they are to be solvent.

Such gaps are not limited to a few regions, states or individual pension funds. The crisis is endemic. For example, a study by State Budget Solutions found that, for the year 2012, “Market-valued unfunded public pension liabilities make up more than half of all state debt, accounting for $2.8 trillion in total.” If this were solely due to a few bad investments or the increasing number of people going into retirement (approximately 10,000 people will retire each day, the Pew Research Center recently stated, for the next 19 years), it is a problem inherent in the very structure of public pensions and state governments, thereby meaning this crisis will not cease to be an issue once the economy has fully recovered.

These structural shortcomings come in two forms.

A Lack of Transparency

A public pension fund can currently promise to pay someone a given amount in the future without having to include that cost on their books until the time comes to pay. Furthermore, as reported by Bloomberg, many public pension funds are allowed to use higher discounted rates—sometimes greater than 7 percent—than their private counterparts. This is because the assumed rate of return will be equal to or surpass such a discounted rate. According to the same Bloomberg article, “This artificially depresses the recorded cost of promised pension benefits.”

While it may be perhaps too drastic to label these assumptions as arbitrary or fanciful, such predictions can have drastic consequences when they turn out to be wrong. Even a one-percent shortfall becomes a major liability when one is dealing with billions of dollars, which is often the case with public pension funds.

A Lack of Courage

As taxpayers ultimately have to pay for these shortcomings, this is a public concern. Unfortunately, very few politicians will address the issue because it will require unorthodox steps that will infuriate very large and powerful blocs of voters. As described in an exemplary story published in Philadelphia Magazine, this represents a moral hazard on the part of our elected officials. In other words, it is not merely a systemic problem with public pension funds; instead, it stems from a systematic problem with many state and local governments.

There have been numerous proposed solutions, such as checking the inflated projections of the public pension funds by relying on a fair-value approach instead of GASB guidelines for measuring liabilities, an idea that has attracted the interest of the Congressional Budget Office; increasing the amount employees must contribute to said funds; increasing taxes; and allowing state and localities to curb the benefits of employees.

However, such solutions ultimately demand sacrifices that many voters are not willing to accept. No matter the solution, without the courage to address many of the long-term budgetary issues that have arisen on account of public pension funds’ poor decisions and disingenuous predictions, this crisis will continue unabated.

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