No. 74 February 2013
FIXING THE PUBLIC SECTOR PENSION PROBLEM:
The (True) Path to Long-Term Reform
Richard C. Dreyfuss, Senior Fellow
Who's Winning the Pension Wars?, Richard Dreyfuss, Inside ALEC, April 2013
Montana Public Pension Reform Challenges, Richard Dreyfuss, Helena Independent Record, 3-10-13
Make honest pension reform a priority in Pa., Richard Dreyfuss, Philadelphia Inquirer, 02-04-13
IN THE NEWS
Pension bonds would be risky, illegal maneuver to ease PA debt, Pennsylvania Independent, 3-11-13
Linked on Heritage Insider, 2-4-13
Pennsylvania Pension "Fix" Could Add To Woes, Reuters, 02-10-13
A Handy Guide to Pension Fixes, True and False, PublicSectorInc.org, 02-4-13
PCN's "On The Issues," 3-5-13
The Blaze TV's "Wilkow! with Andrew Wilkow," 2-18-13
Fox Business Network's "Varney&Co," 2-8-13
KGVO 1290 AM's "Talk Back w/Peter Christian & Jon King," 4-4-13
CRN's "Talkback with Chuck Wilder," 2-22-13
GCN's "Jason Lewis Show," 2-20-13
WITF's "Radio Smart Talk," 2-7-13
94.3FM's "The David Madeira Show," 2-7-13
|Table of Contents:
|About the Author
|The Defined-Benefit Pension Plan and the Case for Reform
|Five Pension "Non-Reform" Reforms
|Sustainable and Comprehensive Reform
|A Five-Point Plan for Comprehensive Reform
|Pension "Transition Costs" in Moving from DB to DC Plans
Even as the federal government struggles to stabilize its finances, many states are facing their own daunting sets of
fiscal deficits. These take the form of unfunded liabilities totaling almost $1.4 trillion and stemming from obligations to
pay for public employees’ pensions, retiree medical insurance, and other retirement benefits. Reform efforts ostensibly
being made to solve this crisis have fallen short.
These "reforms" include:
1) Issuing new bonds to refinance existing liabilities. But these merely add to the total sum of indebtedness, and the
capital they raise is subject to raids serving other purposes.
2) Adopting new or modified defined-benefit plans that create new risks for current and future taxpayers. Optimistic
investment-return assumptions further mask the true magnitude of these deficits.
3) Assigning existing unfunded liabilities to younger, more recently hired workers, whose own benefits will likely
prove unsustainable as their salaries rise.
4) Early-retirement incentive plans. But these often turn out to be expensive, hampering productivity while not
achieving long-term objectives.
Because governments must use taxpayer money to make up any shortfalls, they have an incentive to overstate the
contribution that future investment gains will make to the holdings that ultimately fund retirees’ benefits. Such practices
are commonplace. An assumed rate of return that reflects lower future market expectations would reveal cumulative
deficits even more yawning than those currently estimated.
The necessity for real reform is problematic for policymakers, who must deal with a workforce resistant to the loss of
guaranteed monthly pension benefits; and for political constituencies, including government workers and their allies,
whose support for defined-benefit pensions in the public sector stems as much from ideology as from financial selfinterest. This is a balancing act that leaves policymakers with few politically popular choices. Yet politicians’ current
approach to evading such opposition—that of adopting incremental reforms while repeatedly deferring liabilities—is
no longer viable.
Systems that continue to add workers to their defined-benefit plans, which obligate them to make fixed benefit
payments, have mitigating steps available to them in many cases. Such steps include:
1) Reducing as-yet-unearned benefits.
2) Increasing the age of retirement or modifying early-retirement provisions.
3) Moderating or eliminating pension cost-of-living adjustments.
4) Increasing the financial contributions that workers must make to the plans.
While governments confront very steep legal obstacles to extricating themselves from obligations already incurred, they
can free themselves from the political pressures, crystal-ball gazing, and monumental financial risks that defined-benefit
plans make almost unavoidable. They should take a page from the private sector and shift to defined-contribution
plans. Under such plans, to which employees as well as employers may contribute, investment risk is borne by plan
members, not by taxpayers. A majority of Fortune 100 companies have already adopted such plans. Only 16 percent
of large companies still offer their retirees medical coverage.
By sharing a complex of risks with the beneficiaries, states and municipalities would be able to devote far more of their
time and resources to the more immediate concerns of today’s voters and taxpayers.
About the Author
Richard C. Dreyfuss is a senior fellow at the Manhattan Institute’s Center for State and Local Leadership and
a regular contributor to PublicSectorInc.org. Dreyfuss is an actuary and business consultant. He worked for The
Hershey Company (formerly Hershey Foods Corporation) for 21 years, and held numerous positions there, including
director of compensation and benefits, prior to his retirement in 2002. He was also involved in the establishment
of the Pennsylvania Health Care Cost Containment Council in 1986 and was its chair in 2001-02. This independent
state agency is responsible for developing comparative information about the most efficient and effective health
care providers to individual consumers and group purchasers of health services. Dreyfuss is a pension and health
care expert who has written and testified before Congress and the Pennsylvania General Assembly on strategies to
effectively manage long-term employee benefit costs. His op-eds have appeared in major newspapers including The
Philadelphia Inquirer and The Pittsburgh Post-Gazette and he has been quoted in The Wall Street Journal and The
New York Times. He holds a B.A. in mathematics and economics from Connecticut College and an M.A. in actuarial
science from Northeastern University.
At the same time that the federal government is wrestling
with the debt it has run up, which has come to be measured
in the tens of trillions of dollars, the states are facing their
own daunting sets of fiscal deficits, which take the form of
unfunded liabilities. The Pew Center on the States recently estimated
their total, representing public employees’ pensions, retiree medical
insurance, and other retirement benefits, to be over $1.38 trillion,
according to FY 2010 data, the last year for which data are available,
and it is likely that subsequent reports will reveal further increases.
This total comprises $757 billion posed by defined-benefit pensions
and $627 billion by other post-employment benefits (OPEB), which
include retiree health-care plans.
This is the current value of amounts owed over and above any dedicated assets already accumulated within the various employee-benefit
trust funds. Such deficits are growing daily with interest. Pew reports
that 38 states have OPEB liabilities that are less than 10 percent
funded, effectively putting their plans on a pay-as-you-go basis.
Separately, an October 2012 study, prepared by the actuarial consulting firm Milliman,
of the 100 largest public-sector defined benefit plans,
estimated the current deficit to be $1.193 trillion,
representing only 67.8 percent of the amount
currently needed to provide benefits for present and
future retirees enrolled in the plans. These figures are
predicated upon an optimistic annual rate of return
on assets of 7.65 percent.
Such findings are evidence that the current definedbenefit pension system, which provides formulabased monthly payments to beneficiaries, is unsustainable. Many states that have touted their plandesign reforms find themselves facing the necessity
of additional measures sooner rather than later.
The Wall Street Journal reported in September 2012
that the reforms adopted by many states have fallen
short of significantly reducing unfunded liabilities,
which now total approximately $800 billion and are
likely to grow.
Not surprisingly, Moody’s recently
reiterated its negative outlook on the states for the
fifth consecutive year and currently reports a negative
outlook on nine states.
An example is Pennsylvania, where, despite changes
to the state’s two largest pension systems affecting
new hires, which were adopted in 2010, the systems’
solvency has been further undermined. By reducing
the assumed rate of return on assets from 8 percent
to a slightly more realistic 7.5 percent, the state added
over $6 billion in new liabilities. Additional measures
instituting proper funding policies and including a
defined-contribution plan will need to be considered
in 2013. "Governor Tom Corbett has compared
the state’s growing liabilities to a PacMan poised to
chomp away at the rest of the state’s budget."
Comprehensive pension reform entails coupling a
transition to defined-contribution plans, such as a
401(k), with equally important funding reforms.
These involve ensuring that pension benefits are
funded as they are earned, so as to avoid assigning
existing and future deficits to the next generation of
employees and taxpayers.
The necessity for such changes is problematic for policymakers, who must deal with a workforce resistant
to the loss of guaranteed monthly pension benefits, and political constituencies, including government
workers and their allies, whose support for definedbenefit pensions in the public sector stems as much
from ideology as from financial self-interest. This is
a balancing act that leaves policymakers with few
politically popular choices. Politicians’ current approach to evading such opposition—that of adopting incremental reforms while repeatedly deferring
liabilities—is no longer viable. There are daily reports
of bond-rating downgrades, bankruptcy filings, and
pessimistic long-term financial analyses. U.S. cities,
in particular, are in increasingly dire financial straits.
The current path is unsustainable.
The Defined-Benefit Pension Plan and the Case for Reform
A defined-benefit pension plan provides a
"definitely determinable benefit," or, in layman’s terms, a monthly benefit based upon a
predetermined set of formula(s) typically reflecting
a member’s pay and years of service. (In the public
sector, such plans generally require contributions
by participants.) These plans require an actuarial
valuation that informs the plan sponsor of what the
periodic employer contributions need to be. Whether
these employer contributions are actually made
is a separate matter. These member and employer
contributions, together with investment earnings,
are intended to provide sufficient accumulations of
capital to properly fund current and future benefits.
The investment risk lies predominantly with the plan
sponsor, which is liable for any shortfalls.
In contrast, a defined-contribution plan is one to which
the employee and generally the employer make regular
contributions. The resulting accumulations finance
future retirement benefits. The participant can invest
in any of a set of investment funds made available by
the employer. Investment decisions and the associated
risks and returns reside with the plan participant.
There are certain variations on these basic plan
designs; in some cases, the terminology can cause
confusion. The term "hybrid plan," for example, is
used to encompass many dissimilar arrangements.
Sometimes the term refers to cash-balance plans,
which are another form of defined-benefit plan,
in which the accrued benefit is expressed as an account balance. Here is how such a plan was recently
described: "And then there have been Republican
innovators like Louisiana Gov. Bobby Jindal, who in
June signed legislation to move new state hires into
the sort of 401(k)-style retirement plan that will finally
allow states to manage their long-term liabilities"
Of the many state and local governments wrestling
with these long-term pension and OPEB liabilities,
some have implemented changes, while others have
gone no further than mentioning reform as an
important policy priority. Such a variety of largely
inadequate responses raises the questions of who
and what defines pension reform and against what
standards the results are to be measured.
Some states describe their efforts as "incremental"
pension reform. In Pennsylvania
and New Jersey,
recent reforms perpetuate the problem of underfunding. Other states, including Rhode Island
reamortized (deferred) existing unfunded
liabilities. Many of these plans assume optimistic
annual asset returns of 7.5 percent (or higher), posing the risk that the cost of covering shortfalls will be
legislatively assigned to future generations.
What are the elements of pension reform? This paper
subjects nominal efforts at reform in various states
to a systematic set of criteria, devoid of political
considerations. It first explains why certain kinds of
so-called reform measures do not deserve the designation. These feeble attempts, which are all too much in
evidence, often do little more than temporarily mollify voters and other critics while deferring liabilities.
In some cases, these efforts are too little and too late
and further reduce funding.
This paper focuses on defined-benefit pension systems, while recognizing that significant reforms are
also needed in the design and funding of OPEB,
such as retiree health-care plans. OPEB are distinct
from pension benefits, yet they similarly lack affordability or the demographics to support them adequately. Indeed, most OPEB arrangements
proceed on a pay-as-you-go basis, meaning that they
are not prefunded and, as such, possess significant
unfunded liabilities. A further risk to plan sponsors
involves uncertainties in the nation’s health-care
system, the unpredictable number of those retiring
before they are old enough to qualify for Medicare,
and the nature and extent of reforms to programs
such as Medicare and Social Security.
Some observers are predicting that municipal deficits,
culminating in bankruptcy, will become state—and
ultimately, perhaps, federal—obligations. Unfortunately, given the size of the federal government’s
deficits, it is hardly in a position to offer help, and
some would maintain that principles of federalism
should preclude such a step.
Five Pension "Non-Reform" Reforms
The pseudo-reforms undertaken in recent years
can be organized into five categories. They
are listed below and are summarized in the
It is, at best, a half-truth that enrollment of new members in defined-benefit plans can sustain such plans
if the new members bear their proportionate share
of the unfunded liability. The problem with this line
of reasoning is that proper funding is achieved when
benefits are funded as they are earned. A policy of
transferring costs attached to one set of beneficiaries
to yet another cannot be justified unless one believes
that an amortization period can be perpetual, since
government entities like states—unlike companies—
don’t go out of business. A 2004 report issued by the
state of Pennsylvania actually made such a claim:
"Full funding may be a necessary standard for a
private plan, but it is not necessary for a public plan
because a public entity can assume perpetual life."
1) Pension Obligation Bonds
Some officials contend that issuing pension obligation bonds or using other debt-leveraging techniques
can be an effective financing scheme for reducing unfunded liabilities. This technique involves borrowing funds at a low interest rate (around 4 percent) to
earn an assumed return of around 8 percent on the
proceeds deposited within the pension fund. Even if
one accepts the logic of this risk-arbitrage strategy,
there is a natural political predisposition over time
to separate the bond from the newly fortified pension plan. Not surprisingly, the frequently observed
result is the subsequent and sometimes retroactive
enrichment of pension benefits with this new influx
of capital. Further complicating matters is that many
pensions fail to achieve their targeted rate of return.
About pension obligation bonds, former New Jersey
governor Jon Corzine remarked in 2008: "It’s the
dumbest idea I ever heard. It’s speculating the way I
would have speculated in my bond position at Goldman Sachs…. It’s lousy public policy."
2) Early Retirement Incentive Plans
By offering a financial incentive, these plans induce
members of a particular group to elect retirement.
Such initiatives are generally designed to reduce
staffing levels, often as part of an overall fiscal reform
plan. The incentive often involves, but is not limited
to, an enhanced pension benefit. Such enhancements,
if paid through the retirement plan, inevitably result
in an unplanned increase in plan liabilities. Often
an accompanying goal is to reduce head count or to
expand opportunities for younger employees.
The question of whether such approaches are cost effective is generally answered by identifying the targeted "backfill" rate: that is, the percentage of retiring
employees that are replaced. While the variables of
any particular initiative can vary considerably, a rule
of thumb is that not more than 40 percent of the
retirees should be replaced, if this tactic in net terms
is at least to break even. Backfill rates in the range of
80–100 percent are generally not cost-effective, in
the experience of this author, unless unusual circumstances exist. An important question is whether the
anticipated savings are illusory, since the lower-paid
employees assuming these new responsibilities are
presumably less productive than the retiring, higher-paid employees they are replacing.
3) Reamortizing the Unfunded Liability
This is a favorite financial tool of pseudo-reformers, since it can assist in propagating the illusion
that current costs are manageable. It is often accompanied by the amorphous characterization
of a plan as "actuarially sound." The strategy effectively defers some or all of the existing deficits
while assigning the unaffordable liabilities to the
next generation of taxpayers and employees. Some
plans even decide every year to assign (the technical term is "fresh start") the unfunded liability to
a new payment period of up to 30 years, thereby
creating rolling amortization schedules, perhaps
in perpetuity. Typically, plans that resort to such
tactics also assume annual returns in the neighborhood of 7.5 percent. There are many variations on
this basic theme.
Such practices will be more closely scrutinized in
the future by the financial community, given the
mandatory compliance of state and local municipal
deficits with the newly promulgated Statements 67
and 68 of the Government Accounting Standards
Board (GASB), which will require greater disclosure.
In addition, unfunded liabilities will appear on the
balance sheets. The provisions of Statement 67 are
effective for financial statements for fiscal periods
beginning after June 15, 2013. The provisions in
Statement 68 are effective for fiscal years beginning
after June 15, 2014. Earlier application is encouraged
for both statements.
4) Politics and Defined-Benefit Plans
Politics and defined-benefit plans are a toxic combination. For the purposes of this paper, politics means
forces within the pension system responsible for the
following actions, which can be carried out singly or
in combination, in single years or repeatedly:
a) The tendency of plan sponsors and fiduciaries
(typically influenced by elected officials and plan
participants) to promise and perpetuate retirement benefits that are generally benchmarked only
against other public-sector pension systems rather
than their counterparts in the private sector
b) The use of rosy economic assumptions to minimize
current and future costs
c) The failure to contribute the actuarially recommended contribution
d) The deferral of costs so as to avoid raising taxes,
or the direction of funding away from favored line
items in the annual fiscal budget
e) Postponing the attainment of a 100 percent funded
ratio to a time well beyond the average remaining
career span of the current workforce
f) Retroactively improving benefits
g) Granting ad hoc benefit improvements
Although it can be argued that defined-contribution
plans are also susceptible to the influence of politics
in the form of varying the size of an employer match
or discontinuing it, the same powerful incentives do
not exist to do so.
5) "Hybrid plans" and other types of
As previously discussed, "hybrid plan" can refer to
defined-benefit plans in which the accrued benefit is
expressed as an account balance. Such plans are commonly described as "cash balance" pension plans. Admittedly, they are hardly immune from the political
foibles enumerated above. Cash-balance plans have been commonplace in the private sector for many
years. However, such plans have been largely replaced
by defined-contribution pension plans because of the
unpredictability of employer costs and thus, often,
their unaffordability, since employers must make up
shortfalls in asset performance. For example, for 2005
and beyond, IBM discontinued its cash-balance plan
for new hires in favor of a 401(k) plan.
The term "hybrid" can also describe arrangements
in which defined-contribution and defined-benefit
plans are offered as separate, stand-alone plans.
Sustainable and Comprehensive Reform
Large companies over the past couple of decades
have been replacing their defined-benefit plans
with defined-contribution plans. This shift is
occurring because plan sponsors have lost faith that
the former are able to achieve costs that are:
3) Current (no unfunded liabilities)
Predictable costs are those generally expressed as a
standard percentage of current or future payrolls. A
plan is affordable if its costs correspond to those posed
by a comparable labor pool in the private sector. If
the public workforce’s salaries and benefits are more
generous than what is found in the private sector, they are unlikely to be reasonable or affordable for
taxpayers. Such a comparison is important because
the public sector is ultimately dependent upon the
private sector as its source of funding. Often, however, the benchmark is other public defined-benefit
pension systems, frequently those with unfavorable
financial profiles. Moreover, many comparisons unrealistically assume an annual return on assets of 7.5
percent or higher.
Finally, a plan needs to be current, which means
that benefits should be funded as they are earned
and fully "paid up" at retirement, thereby achieving
a funded ratio
of 100 percent. Since pensions represent deferred compensation and their purpose is to
replace income at retirement, such an imperative is
only sensible. The sums as they accumulate need to
be systematically set aside so that they can ultimately
support future payouts. Deferral of funding for a
period extending well beyond the beneficiaries’ date
of retirement destroys the logic and soundness of
this financial model, translating it effectively toward
a system of pay-as-you-go. So what if the current
benefit recipients are aware of this evasion? It still
represents a transfer of costs to the next generation.
A recent publication
of the American Academy
of Actuaries stands up for full funding of alreadyincurred obligations. According to senior pension
fellow Don Fuerst: "Somehow 80 percent has become
a perceived standard but that is a myth we need to
replace with facts."
Sadly, many politicians involved in overseeing
public-sector defined-benefit plans lack a consistent
approach to the three principles just enumerated.
The tendency of plan sponsors to favor long-term
irresponsibility over short-term pain and an honest
accounting of the scope of a system’s obligations
is documented: "Pittsburgh pension board members refused [on August 23] to consider lowering
the fund’s annual investment-earnings projection
[from its current 8 percent level], saying the move
would require increased cash contributions each
year that the city could fund only on the backs of
employees or with a tax increase."
defects of defined-benefit plans, as well as their implication in a system of decision making impaired
by political considerations, necessitate a wholesale
shift from defined-benefit to defined-contribution
plans. Despite fewer such pressures in the private
sector, many Fortune 100 companies have made
the switch. The pattern of change is depicted in the
chart below. These companies are generally leaders
in pay, benefits, and human-resources practices as
Closely related to the decline of defined-benefit pension benefits is a decline in OPEB (principally, retiree
health-care plans). Shown below are the results of the
2011 Mercer National Survey of Employer-Sponsored
Health Plans on the prevalence of employer-provided
retiree health-care coverage by 2,844 employers.
lack of predictability and affordability, together with other factors, has led to a decline in the number of
these programs as well.
A Five-Point Plan for Comprehensive Reform
Described below is a five-step template for
achieving comprehensive and sustainable
pension (and OPEB) reform. It is not meant
to preclude a process of refinement, as lessons are
learned and policies are adapted to new circumstances. Administrative costs should decline as the
In many states, the annual actuarially recommended
contribution represents an amount greater than a
government entity wishes to contribute. Generally,
underfunding carries few, if any, consequences other
than an obligation to repay with interest at a later
date, which only adds to ever-increasing deficits.
For fiscal year 2010, the Pew Center on the States
reported that 31 states contributed less than 100
percent of the actuarially recommended contributions to their major pension plan(s), with the three
lowest states being Pennsylvania (29 percent), New
Jersey (32 percent), and Washington (53 percent).
This continuing practice will likely be sustained in
Therefore, pension contribution levels are often
predictable and affordable, but few, if any, plans are
current—that is, reflecting a 100 percent funded
ratio. Plans falling below this threshold are unlikely
to meet it even in 15 years or in whatever period the
underlying demographics of the plan would seem to
support full funding. Even those plans that have a
funded ratio of 100 percent (or better) may not be
fully funded, since many assume overly optimistic
rates of return on assets.
Some actuaries have suggested that perpetual pension
deficits are almost desirable, since the prospect of a
100 percent funded ratio encourages politicians to
further enrich benefits packages. Irresponsible public
officials will, in some cases, proceed with such enhancements despite their aggravating effect on deficits
A defined-contribution plan with costs of 4–7 percent
of payroll, by contrast, will ensure that employer
costs for new hires are not only predictable and
affordable but current as well, having eliminated
any possibility of unfunded liabilities imposed by them. This is the important first step. The state of
Michigan, for example, enrolled its new hires in a
defined-contribution plan in 1997. Doing so saved
over $2.3 billion.
While an intensive discussion of appropriate
retirement-replacement ratios (the percentage of
pre-retirement earned income replaced by pension
income) is beyond the scope of this paper, setting
a proper ratio is the first step in enacting pension
reform. One study suggests that combined employee
and employer contributions in the range of 12–15
of earned income should provide an acceptable standard of living in retirement, while another
study suggests that 10–16 percent
would be the
proper ratio. For those not yet covered by Social
the suggested target is 18–20 percent.
As noted, the uncertainties dealing with inevitable
reforms required in federal entitlement plans such as
Medicare and Social Security will affect retiree healthcare plans and are a significant factor in determining
an appropriate level of retirement income.
The second step involves prohibiting the creation and
issuance of new debt to finance existing liabilities,
typically by issuing pension obligation bonds.
and financial minds might resort to other, equally
unacceptable, creative techniques.
The third step is arranging adequate funding by reducing, if not eliminating, unfunded liabilities and
improving funded ratios, an unpalatable measure for
officeholders because it does not yield an immediate
political payoff. Benefit improvements resulting in
funded ratios falling below 90 percent should not be
considered. A good starting point is to make funding policies generally consistent with the recently
adopted GASB Statements 67 and 68. They call for
using amortization periods that take into account the
demographics of the underlying population. By way
of illustration, if the average age of a working group
is 45 and it is assumed that its members retire, on
average, at age 60, then any plan deficits (unfunded liabilities) funded over periods of up to 15 years would
be appropriate. Another aspect of this accounting
rule requires that plan assets be valued on the basis
of their fair market value at a given moment in time instead of on the basis of some other criterion, such
as rolling yearly averages. The choice of a proper
funding interest rate could and should be lower than
the present norm of 7.5–8 percent. The volatility
and thus predictability of asset performance, plus
other variables such as increased longevity, are further
reasons to shift to a defined-contribution plan, in
which the plan participant assumes the investment
risk. The alternative is inflicting these costs on the
next generation, which is already burdened with a
myriad of other legacy costs.
The fourth step involves reducing benefits that have
not yet been earned by enrollees who are still working. Doing this would include, but not be limited to,
increasing member contributions, raising normal and
early-retirement ages, reducing or eliminating pension cost-of-living adjustments (COLAs), and prohibiting deferred retirement optional plans (DROPs),
which permit an individual to be effectively employed
and retired at the same time. Since prevailing statutes
and labor practices vary by state, such a strategy needs
to be developed accordingly.
The fifth step is to implement this comprehensive
strategy without increasing taxes.
An accompanying initiative should reform the design
and unreliable financing of retiree medical plans,
since these unfunded liabilities are nearly as large as
those of public pensions.
Pension "Transition Costs" in Moving from DB to DC Plans
As mentioned, the amortization periods of
unfunded liabilities generally span durations that are insufficiently supported by the
underlying demographics of the plan in question,
effectively transferring costs to the next generation.
In addition, many funding schedules are based
on a constant percentage of pay, which effectively
backloads the contribution schedule, since annual
contributions will increase along with the size of
future payrolls. In a level-dollar payment schedule,
which characterizes most fixed-rate mortgages and other types of consumer loans, by contrast, payments
Shortening the amortization period would by itself
increase the annual contribution in the manner of a
mortgage, for which annual or monthly payments
are greater in those that mature sooner (other factors,
such as interest rate, being equal).
The transition from a defined-benefit to a definedcontribution regime presents its own set of challenges. Any existing unfunded liability in the
former will need to be paid off, and usually more
quickly than it would have had to be if the plan
were retained. Such shortening can influence the
sponsor, in consultation with the actuary, to revise
the assumed interest rate downward, especially if it
is overly optimistic. The impact will be to raise the
size of the sponsor’s contribution to compensate for
the smaller contribution resulting from the slower
expected appreciation of assets. Such matching
should be the hallmark of every plan. To characterize
any of these funding reforms as imposing new costs
mistakenly implies that accelerated and more timely
contribution schedules are doing something beyond
matching assets to liabilities.
Some observers contend that the accounting treatment of a level-dollar amortization schedule of a
closed defined-benefit plan demanded by GASB
entails an increase in contributions. A recent study by
Robert M. Costrell debunks the myth that the conversion of a defined-benefit to defined-contribution
plan incurs such a "transition" cost.
Simply stated, we need to avoid pseudo-reforms
in their entirety in favor of the five recommended actions designed to achieve comprehensive
and sustainable reform. Specifically, annual employer pension costs should be targeted at 4–7 percent of
payroll, or at a level consistent with patterns established in the private sector.
Most reform initiatives focus on new hires. But
these reforms do little or nothing to reduce existing unfunded liabilities. Yet improvements can be
achieved by reducing unearned benefits for existing
participants, increasing the age of retirement, and
modifying cost-of-living adjustments for current or
future retirees, for example.
Benefits should be funded as they are earned, partly
because unfunded liabilities are always at risk of increasing beyond forecasts, to the extent that expected
investment returns and other actuarial assumptions
are not achieved. However, such a structure carries
a low political rate of return. Unhelpful plan-design
changes are, regrettably, often accompanied by great
fanfare. By contrast, a deferral of existing deficits
and other deceptive techniques resulting in an immediate but temporary reduction in costs usually
receive little scrutiny. The more responsible course
risks jeopardizing the funding of a favorite current
program or making an unpopular tax increase inescapable. The people who will bear the brunt of such
deferred maintenance are often too young to object
at the ballot box.
We can expect bond-rating agencies to examine
such practices more closely than they have in the
past and the states themselves to disclose them more
fully under pressure from the recently revised GASB
accounting standards, which require the unfunded
liabilities of public-sector defined-benefit plans to
be placed on the balance sheet of the public entity
sponsoring the plan. In addition, GASB will require
most pension costs to be recognized over shorter
durations than is now the case.
The funding problem is so acute that some have even
proposed a role for the federal government in underwriting states’ and cities’ pension costs. One need not
look further than the Pension Benefit Guaranty Corporation and its billions in deficits from guaranteeing
portions of private-sector defined-benefit pensions
to see that such guarantees seem to introduce moral
hazard. Deficits within Medicare and Social Security,
on top of the deepening national debt, pose risks of
their own. We are on an unsustainable trajectory that
requires immediate and comprehensive action for the
sake of future generations.
The decisions in certain states to adopt pay-as-you-go funding can also be affected by legal opinions or policy practices
that such benefits can be unilaterally modified if not discontinued immediately. Some believe that prefunding would
confer legal rights on these same benefits, thereby making it more difficult to modify such arrangements.
Based upon the most recent actuarial valuations from June 30, 2009, to January 1, 2012.
Using the market value of assets.
See n. 1 above.
See http://le.utah.gov/interim/2010/pdf/00001430.pdf, executive summary, finding no. 6.
See http://jsg.legis.state.pa.us/publications.cfm?JSPU_PUBLN_ID=48, p. 20.
This is the ratio of a plan’s current assets to the present value of earned pensions. Detailing the variations in the
definitions of assets and liabilities are beyond the scope of this paper.
See http://benefitcommunications.com/upload/downloads/2011MercerSurvey.pdf, p. 87.
See n. 1 above.
p. 9, table 1.
See http://www.mackinac.org/17128, p. 26.