Pensions and Retirement Benefits: Defusing the Budgetary Time Bombs
Employee compensation is typically the largest single element
of a city's budget. As if current wages and salaries weren't
costly enough, however, cities are also increasingly saddled
with expensive deferred compensation promises that divert
scarce resources from the vital public servicessuch
as police and fire services, street maintenance, parks, and
educationthat cities exist to provide.
Taxpayer-funded contributions to the nation's state and local
government pension systems jumped by 82 percent between 2000
and 2007. For local plans, the increase was fully twice as
large. But in the wake of the 2007-08
financial crisis, the worst is yet to come. Public pension
fund asset values dropped 20 to 30 percent in the latest market
downturn, a loss collectively estimated at $1 trillion.
For some of the nation's largest citiesincluding Chicago,
Los Angeles, and New Yorkannual pension costs already
soak up 10 to 15 percent of total expenditures. Most municipalities
will soon find themselves facing similarly large annual pension
bills. Some chronically underfunded municipal pension systems,
such as Pittsburgh's, are already desperately seeking state
bailouts. While some local governments run their own pension
systems, most participate in statewide pension plans. But
even the best managed of these have seen their asset values
battered by the Wall Street meltdown.
State and local governments have also amassed huge unfunded
liabilities for "other post-employment benefits"
(OPEB), chiefly retiree health coverage. Most cities were
doing nothing to address these liabilities even before the
economy turned sour. If they continue to do nothing, the result
will be a steady erosion of their balance sheets, even as
they struggle to emerge from the effects of the recession.
Fortunately, it is not too late to rein in retirement costs
that threaten to crowd out the core functions of effective
government. This essay presents five practical steps that
cities can take to shatter the old paradigm and reform their
public pension systems.
Municipal pensions in the United States date back to 1857,
when New York City policemen were first granted a retirement
disability benefit. By the 1920s, states and cities were offering
pensions to most of their full-time civil-service employees
The standard model was the defined benefit (DB) plan, promising
a stream of monthly retirement income based on an employee's
longevity and final salary. While the earliest municipal pensions
were financed on a pay-as-you-go basis, cities and states
turned to pension trust funds based on actuarial calculations
as the number of eligible retirees inexorably grew. Since
retirement benefits for government employees were usually
guaranteed by state laws or constitutional provisions, public
pension funds were initially invested mainly in slow-growing
but low-risk assets, such as government and corporate bonds.
Along with job security, a generous pension was considered
compensation for the relatively low wages paid to civil servants
during the first few decades of the twentieth century. However,
long-term public pension obligations rose significantly as
the widespread unionization of public employees during the
post-World War II era brought with it an expansion of municipal
payrolls and wages.
When money was tight, elected officials placated unions by
agreeing to additional retirement benefits whose financial
impactalways difficult to compute with certaintycould
be deferred into the future. Statutory and constitutional
guarantees ensured that benefits for current employees and
retirees could head in one direction only: up. By the 1970s,
state and municipal employees were enjoying competitive salaries,
job security, and time-off allowances, plus retirement
benefits far more generous than those available to workers
in the private sector.
The whole house of cards nearly collapsed during the stagflationary
economy of the 1970s. By May 1980, the New York Times
was reporting: "The cost of financing
pensions for retired and disabled employees is growing so
fast for many American cities that some have been forced to
curtail public services just to pay for pensions."
Cities and other public employers avoided a full-blown pension
crisis in the early 1980s only through a combination of good
luck and risky financial behavior. A spike in bond interest
rates during the 1982 recession created some breathing room
by driving up short-term returns for pension funds. Then,
as Wall Street boomed, public pension fund managers began
to heed the advice of financial advisors to invest more heavily
in stocks. As if on cue, the markets began producing annual
double-digit returns, prompting even greater reliance on stocks
and, in recent years, new investment vehicles, such as private
equity and hedge funds.
Required employer contribution rates, which typically exceeded
25 percent of salaries in the early part of the decade, dropped
to the low single digits in many jurisdictions by the late
1990s. Unions responded by demanding a larger share of the
pie for their membersand often got it, in the form of
larger pension benefit payouts and earlier retirement ages.
No sooner had pension benefits been sweetened in many jurisdictions
than the "tech bubble" burst on Wall Street. By
autumn 2002, the Dow Jones Industrial Average had dropped
by nearly 40 percent from its 2000 highs, dragging down the
nation's public pension fund values with it. Cities and other
government employers soon experienced a sharp spike in their
contribution rates; in New York, to cite an extreme example,
the taxpayer-funded pension contribution more than quintupled
between fiscal 2000 and 2005 (it now stands at $6.7 billion,
more than ten times its 2000 level).
The impact of the market downturn was most severe in cities
that had used fiscal gimmickry to reduce their pension costs
during the 1990s. The most egregious high-profile offender
was San Diego, whose finances were nearly ruined by an agreement
between management and union trustees to simultaneously increase
benefits and shortchange the city pension fund (and hide the
cost on financial statements, to boot).
The V-shaped stock-market recovery and accompanying real-estate
boom between 2003 and 2007 led to a temporary stabilization
of pension contribution rates, since funds based their rates
on "smoothed" values over a multiyear period. But
the 2007-08 market meltdown will inevitably bring further,
bigger increasesjust when cities can least afford them.
Public pension managers are lucky that their systems aren't
held to private-sector accounting standards. If they were,
the bulk of these funds would appear to be in even worse shape
than they do now.
The discount rate applied to future obligations is a crucial
determinant of a system's necessary funding levels: the lower
the rate, the larger the contributions required to maintain
"fully funded" status. Private plans must discount
their liabilities based on a market ratetypically, a
corporate or U.S. government bond ratewhich is often
much lower than the plans' projected returns.
Public funds, however, are allowed to discount their long-term
liabilities based on the targeted annual rate of return on
their assetswhich, for most public funds, is pegged
at an optimistic 8 percent or higher. In other words, the
risk premium in the investment target is compounded in the
The typical public pension manager doesn't just hope
to earn 8 percent a year. For all intents and purposes, he
or she assures trustees, beneficiaries, and taxpayers that
the fund is certain to earn an average, long-run return
of 8 percent. Bernie Madoff went to prison for less.
While most public pension managers continue to resist the
idea, a growing number of independent actuaries and financial
economists agree that the net present value of risk-free public
pension promises should be calculated on the basis of low-risk
interest rates such as the rate on a thirty-year U.S. Treasury
bond, which was 4.5 percent in mid-October 2009. Using this
approach, two University of Chicago economists recently estimated
that the nation's state and local pension funds were actually
$2 trillion short of what they will need to make good on their
obligations. This estimate doesn't
even take into account the impact of the 2008 market downturn.
Health-insurance benefits for retired municipal employees,
unlike pensions, are financed in most cities out of current
budget appropriations on a pay-as-you-go basis. In effect,
this means that future taxpayers are being saddled with a
portion of the cost for current services. Newly implemented
government accounting standards have revealed that the collective
unfunded liability for these OPEB amounts to between $1.5
and $2 trillion, according to an estimate by the Pew Center
on the States. Thus, state and local
governments may fall short of their combined public pension
and OPEB obligations by over $4 trillion. Even in an era of
trillion-dollar federal deficits and financial-sector bailouts,
that's real money.
Stopgap Measures vs. Real Reform
Many state and city retirement systems sought to minimize
the impact of their post-2000 pension cost increases by adjusting
contribution schedules, "smoothing" investment return
assumptions over longer periods and allowing government units
to spread their increased annual contributions over a number
of years. But this kind of tinkering merely pushed costs into
the future, compounding the impact of the recent downturn.
Even under the deceptive accounting standards now used by
government funds, public pension managers are being overly
optimistic. For example, managers of California's massive
CalPERS pension fund say that they require an average return
of 7.6 percent a year over the next fifteen years in order
to achieve "fully funded" status. But one of the
nation's leading public investors has warned that this is
unrealistic. "You're not going to get a 7.6 percent return
when the U.S. is seeing a subpar (economic) growth rate of
2 to 3 percent," BlackRock Inc. chairman and CEO Laurence
Fink told the CalPERS board. "You'll be lucky to get
6 percent on your portfolios, maybe 5 percent."
Even if public pension funds hit their optimistic 8 percent
return targets, they will fall below half of their required
funding levels within the next fifteen years because of projected
growth in the retired population, according to a recent analysis
So What's the Alternative?
The answer lies in switching most employees from the traditional
defined-benefit pension plan to a defined-contribution (DC)
model. Instead of a single common retirement fund, a defined-contribution
plan consists of individual accounts supported by employer
contributions and usually matched, at least in part, by an
employee's own savings. These contributions are not subject
to federal, state, or local income taxes. The accounts are
managed by private firms and invested in a combination of
stocks and bonds.
The most common example of a defined-contribution plan is
the 401(k), which has become the backbone of retirement planning
for most private-sector workers (those who have any retirement
plan, that is). Such a plan is not unheard of in the public
sector; for example, it has been the sole pension for state
government employees hired since 1997 in one major state (Michigan)
and as an option in another (Florida). A DC-type plansuch
as the annuities packaged by the Teachers Insurance and Annuity
Association (TIAA-CREF)has been the retirement vehicle
of choice for most employees of public higher-education systems
throughout the country for decades.
The vast majority of private-sector workers with access to
any employer-sponsored retirement plan are in DC plans, while
less than one-third have access to a DB plan.
Timing is a key difference between the two types of plans.
Under a DB system, the employer promises to deliver a future
retirement benefit for a large group of current and former
workers. The contribution rate necessary to fund the benefit
promise is no more or less predictable than the financial
markets in which the fund manager has invested its assets.
Under a DC system, the employer does not take on a future
obligation but instead makes current contributions to the
retirement accounts of each employee, usually with some matching
contribution from each worker. The size of the ultimate retirement
benefit generated by a DC plan depends on the amount of savings
and investment returns that the worker is able to accumulate
over the course of a working lifetime. The downside risk of
unanticipated investment losses and the upside potential for
unanticipated investment gains are both shifted from the employer
to the employee. The upside, for the employers and the taxpayers
ultimately footing the bill, is that the cost of providing
these benefits is completely predictable and transparent.
A 401(k)-style plan would offer significant new advantages
to many workers as well. Benefits for public employees would
finally be portable from job to job, between levels of governments,
across jurisdictions, and from public sector to private sector
or vice versa. Portability will particularly benefit those
who spend only a portion of their careers working for government,
such as the "Teach for America" volunteers who have
pumped new energy and effectiveness into many urban schools.
While the advantages for employers are obvious, politicians
understand that moving toward such plans will upset public-sector
unions. Even in San Diego, which could be considered a case
study in the financial and moral hazards of DB pensions, city
officials have been unwilling to move to the DC model, settling
instead for a scaled-back DB plan and improved financial controls.
For all its obvious benefits to employers and taxpayers,
a DC plan does not reduce the legacy costs of the traditional
pension system. The disturbing but inescapable bottom line:
in the short term, even after closing the plans to new entrants,
there is no fiscally prudent way for cities
and states to avoid higher DB pension bills in the near future
without unfairly shifting a massive burden to future taxpayers
and jeopardizing their own financial stability and growth
in the process. Amortization, or stretching out pension fund
payments in order to lessen their impact, can only be justified
in cases where employers have embraced fundamental reform.
Here are five steps to a better system:
- Calculate the true long-term cost of the traditional DB
plan, discounting projected liabilities based on interest
rates for Treasury bonds. The resulting figure will be shockingly
large. However, unfunded pension liabilities must be honestly
confronted and acknowledged for what they are: long-term
- Permanently close the DB pension plan to new entrants,
enrolling all new employees in DC plans modeled after existing
public university plans or the Thrift Savings Plan
offered to federal employees. (Cities may still prefer early
retirement plans with a DB element for physically demanding
police and firefighter positions; but even in those cases,
the minimum retirement age should be reset to fifty or fifty-five,
the use of overtime in calculating pensions should be ended,
and the DB plan should be calibrated to deliver its maximum
benefit after the employee has reached normal retirement
- In states where it is legally possible, such as Ohio,
require current employees in DB plans to share the burden
through increased contributions to their plans.
- Steer the DB pension fund investments into less risky,
less volatile, asset classes.
- Develop an amortization schedule designed to pay down
and ultimately eliminate pension debt in the long term while
capping DB contribution rates at the maximum tolerable level
for current taxpayers.
The route to reform and control of retiree health benefits
is a little less rocky, if not much easier politically. Retiree
health benefits, unlike pensions, generally are not guaranteed
by state laws and constitutions, although they are often subject
to collective bargaining. Therefore, cities can significantly
reduce their unfunded liabilities by working to scale back
promised health-insurance coverage for future retirees, especially
early retirees. Once controlled, the remaining unfunded liabilities
should be financed through deposits to separate trust funds.
Mayors and council members in cities that control their own
pension plans have the advantage of being able to act quickly
to implement such reforms. Most others will need to lobby
their state legislatures to make these changes and, in many
cases, negotiate them with public-employee unions.
This will obviously require considerable political courage,
persistence, and creativity on the part of city officials.
In the long run, cities that fail to shatter the existing
public pension paradigm will, at worst, be financially doomed;
at best, they will be consigned to starving future public
services in order to provide deferred compensation to employees
who delivered those services in the past.
- See http://www.census.gov/govs/www/retire.html.
- "Public Workers' Pensions Strain Cities and Increase
With Inflation," New York Times, May 19, 1980,
- Robert Novy-Marx and Joshua D. Rauh, "The Intergenerational
Transfer of Public Pension Promises," Nation Bureau
of Economic Research, working paper 14343, September 2008,
- See http://www.pewcenteronthestates.org/ttw/
- Pia Sarkar, "Fink Tells CalPERS 7.6% Annual Return
Unlikely," Pensions & Investments, July
31, 2009, http://www.pionline.com/article/20090731/REG/907319998.
- David Cho, "Steep Losses Pose Crisis for Pensions,"
Washington Post, October 12, 2009, http://www.washingtonpost.com/wp-dyn/content/article/2009/10/10/AR2009101002360.html?hpid=topnews&sub=AR&