Underfunded

Economist – America’s public-sector pension schemes are trillions of dollars short 11/14/19 Edition

Any official who wants to understand the terrible state of American public-sector pensions should read the financial report of the Illinois Teachers Pension Fund. Its funding ratio of 40.7% is one of the worst in America, according to the Centre for Retirement Research (CRR) in Boston.

Since it was established in 1939, Illinois officials have not once set aside enough money to fund the pension promises made. As a result, three-quarters of the money the state (or rather the taxpayer) now pays in each year merely covers shortfalls from previous years. The situation is getting worse. In 2009 the schemes’ actuaries requested $2.1bn, but only $1.6bn was paid. By 2018 the state paid in $4.2bn, still well short of the $7.1bn the actuaries asked for. The trustees have warned that the plan would be “unable to absorb any financial shocks created by a sustained downturn in the markets”.

Other schemes have attracted similarly stark warnings. Illinois is the class dunce, with six languishing schemes.

Offering workers a defined-benefit pension, where an income based on final salary is paid for the rest of their lives, is an expensive proposition, especially as life expectancies lengthen. Pension shortfalls are common across America, with the average public scheme monitored by the CRR just 72.4% funded. That adds up to a collective shortfall of more than $1.6trn.

When a scheme is underfunded, one of three things can happen. More contributions can be made, by employers or workers or both. Benefits can be cut. Or the scheme can earn a higher return on its investments to make up for the shortfall.

Cities and states are paying more, but still not enough. In 2001 public-sector employers contributed a further 5.3% of their payroll to meet pension promises; now that figure is around 16.5% on average. Even so, in no year since 2001 has the average employer contributed as much as demanded by actuaries. Last year’s shortfall was just under 1% of payroll.

This reluctance is understandable. Politicians dislike raising taxes—or cutting services to pay for higher contributions. Workers do not want to see their current pay reduced by higher deductions, or their future benefits cut. And in any case, in some states courts have ruled that pension benefits, once promised, cannot be taken away.

So states and cities have crossed their fingers and hoped that their investments will bail them out. America’s buoyant stockmarket has done its best to help. Returns on government bonds have also been good for much of the past three decades. Even so, the average public-sector scheme is less well funded now than it was in 2001.

Such severely underfunded schemes risk entering two vicious circles. The first involves costs. Kentucky’s public pension scheme covers a wide range of state employers and some have to pay 85% of payroll to cover their pension obligations. Employing someone on $50,000 a year requires an extra $42,500 of contributions. They naturally seek to lay off workers to reduce this cost. But that leaves fewer people paying in without changing the number currently receiving retirement benefits. That increases the short-term squeeze.

The second concerns the accounting treatment of public-sector funds. Many assume nominal returns on their portfolios of 7% or more after fees. This optimism has a big impact. 

These calculations look surreal by comparison with private-sector pension funds. Their accounting rules regard a pension promise as a debt like any other. After all, courts insist pensions have to be paid, whatever the investment returns. The discount rate must therefore be based on the cost of debt—for companies, the yield on AA-rated corporate bonds. Since that yield, now around 3%, is far lower than the return assumed by public-sector funds, private-sector pension liabilities are very expensive. Faced with a $22.4bn shortfall, General Electric recently froze pension benefits for 20,000 employees.

These different accounting approaches seem to imply that it is cheaper to fund a public-sector pension than a private-sector one. In reality, that cannot be the case. The public-sector pension deficit is therefore much larger than the $1.6trn estimated by the CRR.

This is a crisis no one wants to solve, at least not quickly. The Chicago Teachers scheme is aiming for 90% funding, but not until 2059—long after many retired members will have died. New Jersey’s teachers’ scheme is not scheduled to be fully funded until 2048. Such promises might as well be dated “the 12th of never”. The bill for taxpayers seems certain to rise substantially. For the states with the biggest pension holes, political conflict is in store.

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