The City of Detroit’s recent bankruptcy filing has raised questions about whether the city’s pension fund will be able to make good on its promises to workers. Detroit’s downfall has cast light on other public pension systems facing troubles, including the City of Chicago and the State of Illinois.
While the headlines seem to suggest that all state and local government pensions are in trouble, that’s not actually the case. Some systems are doing just fine, while others, though facing difficulties, are making reforms to put their systems into balance. But certain systems are dealing with huge challenges.
At one level, these problems reflect a decision-making problem surrounding long-term obligations like pensions. It’s difficult for the decision-makers involved to make hard choices today—easier to kick the can down the road. At a given moment in time, governments and labor leaders are happy to negotiate higher retirement benefits. The extra cost in the short run is usually negligible for taxpayers, and it’s easy to downplay recommendations from the actuary to contribute more to the plan. Years later—when the government and labor leaders are long gone—the bill comes due.
Now it may seem like this is solely a problem of government institutions. But I recall the story of a private company executive explaining the financing of his company’s pension plan in the late 1990s. The markets were so generous that the company could continue to provide benefits at zero cost. Unfortunately, that outlook ended with the weak markets of the 2000s. So myopia isn’t exclusively a problem of the public sector.
Another problem is that most workers—and their bosses—don’t realize the capital needed to finance a generous pension. Let’s suppose you start your career earning $50,000 a year in a government job, receiving 1% merit increases above inflation each year. The pension system is very generous (by private sector standards) and promises you a pension that will replace half of your preretirement income—$25,000 today, but higher when you retire. Assuming a fixed 4% real investment return after costs, and a 30-year working period (say age 35 to age 65), that worker and his employer need to contribute 16% of wages per year to buy a current annuity paying the pension at age 65. If the pension provides a cost-of-living adjustment in retirement—and that is true of many systems—the employer and employee need to contribute about 23% of pay per year.*
This is the core of the problem with some of the more generous pension promises. The contributions needed to fund such pensions (private or public) are quite high for the benefits promised. Few recognize this—on either side of the bargaining table.
This gets to the heart of the question about the pension systems that are doing well. They’re committed to making required contributions. They resist efforts at increasing pensions and making them more generous without a commitment to boost funding (either from tax revenue or from employee pay). This causes a lot of headache and tension along the way. But in the end, it means that the promises they’ve made are more secure. They avoid the decision-making error of putting it all off until tomorrow.
In today’s retirement narrative, the conventional wisdom is that pensions are safe and 401(k) plans are risky. But the headlines remind us that narrative is too simplistic. Pensions do have risks—perhaps not day-to-day stock market risks for the individual workers—but risks that the long-term promise might be not fully materialize.
*Two caveats about this calculation. First, it’s based on current annuity rates in the marketplace, which likely overstates the required savings given today’s interest rate environment. Second, it assumes static investment returns, which understates the required contributions.