Taxpayers and Public Workers Face a “Brutal Awakening” on Pension Debt

A recent article in The Economist asserts that trillions of dollars of unfunded pension liabilities—mainly driven by poor actuarial practices—will eventually pose a “brutal reckoning” for public workers in the United States and put the retirement security of public employees at risk if timely and informed changes are not made.

Public pensions in the U.S. are underfunded anywhere from $1.6 trillion to $5.96 trillion, depending on the methods used to discount the pension promises made to past and current workers. As The Economist points out, colossal pension debt burdens in many jurisdictions, with cities in Illinois serving as a notable example, are imposing tremendous budgetary pressure on governments and taxpayers.

Another example is the Kentucky Retirement Systems, which combined were around 120 percent funded in 2001, with employers contributing just 1.9 percent of their payroll. Fast-forward to 2018, the state’s retirement system was less than 60 percent funded—meaning the system has 60 percent of the money to pay for benefits already promised to workers— on average, while employers contribute 41 percent of payroll costs to the system.

The Arizona State Retirement System and Georgia’s Teachers Retirement System are other examples where outdated assumptions about investment return and funding practices have helped generate billions in pension system shortfalls.

As the Pension Integrity Project has highlighted previously (here, here, and here), the main culprits of the public pension shortfalls are investment returns failing to meet overly optimistic expectations and insufficient pension contributions from employees and employers. 

Furthermore, with actual payrolls growing slower than plan actuaries have assumed (partly due to shorter careers and a slow post-recession recovery by state and local governments), and many public workers living longer than estimated, the key assumptions that pension plans have relied on to predict their future costs have often been out of sync with the changing reality. 

One piece of the puzzle is the loose actuarial rules on assumptions and funding mechanisms, which vary significantly between private and public-sector retirement systems. For example, under the federal Employee Retirement Income Security Act of 1974 (ERISA) law enacted to help protect the solvency of private-sector pension plans, the discount rate used by private plans must be based on the cost of debt, which is the yield on AA-rated corporate bonds. Thus, by law, corporate pension systems tend to recognize the higher costs of pension promises by applying less risky, lower discount rates, which are the rates pension systems use to put a value on the current cost of their future pension obligations.

That is why, for example, faced with a $22.4 billion shortfall, General Electric recently froze pension benefits for 20,000 employees. Similarly, FedEx, facing $4 billion in pension debt, recently decided to discontinue its traditional pension plans for new hires. FedEx says it will be offering a higher 401(k) plan contribution match for new and current employees starting in 2021.

These different accounting approaches might lead one to erroneously infer that it is cheaper to fund a public-sector pension than a private-sector one. But in fact, it all comes down to the way pension costs are accounted for.

In reality, the American public-sector pension deficit is likely closer to the $4.4 trillion estimated by Moody’s Investors Service than some of the other lower estimates.  For context, $4.4 trillion is equivalent to the economy of Germany.

The Economist’s article is yet another reminder that the public-sector pension crisis requires an honest reexamination on the actuarial cost of public pension promises. States and cities need concrete reforms (like those enacted in Michigan and Arizona) that promote a “shared sacrifice” mentality, reduce insolvency risks, and make pension funding more resilient to economic turbulence.

Comprehensive reforms that address all of the causes of the current pension debt are needed not only to protect taxpayers from unchecked growth in costs but also to ensure the retirement security of teachers, public safety personnel and other public employees around the country who are expecting the pension benefits they’ve been promised to be there when they retire.