Look Out For These Pension Gimmicks

State public pension plans are the future, and often current, greatest liabilities that state governments must tackle. Promises made to employees in the past, and politicians kicking the problem further into the future have made the problem spiral out of control. Economists agree that the current discounting of liabilities leaves much to be desired. State Budget Solutions has long been an advocate for using fair market valuation.

But it isn’t just discount rates that cause these pension liabilities to climb. Here is our guide to some of the other popular tricks used by politicians and actuaries that hide the true cost of delaying pension reform.

Outdated Life Expectancy Assumptions
When public pension funds were first established, the average life expectancy was much lower than it is today. The problem is that some pension funds have not adjusted for this change. The calculations for determining liabilities take demographics into consideration. If this is not updated, it means that the pension fund is planning to pay out benefits to retirees for a shorter time. TheInternational Monetary Fund recognized this issue, concluding that “if everyone lives three years longer than now expected–the average underestimation of longevity in the past–the present discounted value of the additional living expenses of everyone during those additional years of life amounts to between 25 and 50 percent of 2010 GDP.”

  • California: CalPERS has been assuming that government employees, especially police and fire personnel, are more likely to die on the job. This allowed the system to require smaller contributions into the system. But it isn’t true, because government has expanded that definition to include several causes of death that are not directly related to the job, such as heart attack. The result is that CalPERS actuaries are now asking for a 10% increase in contributions to make up the difference for the faulty assumption.
  • New Study: How Will Longer Lifespans Affect State and Local Pension Funding?

Inflated Discount Rates
The discount rate is used to determine the amount of funding necessary in a public pension fund today in order to reach the predicted funding needed in the future to provide retiree benefits. Most public pensions use the expected investment rate of return as the discount rate. This rate is often 7-8%, and sometimes higher. This means that pension fund managers must be willing to take greater risk in order to match the discount rate and ensure that there is sufficient money in the fund at a later date. This also requires that the necessary contributions are made every year, and also requires that all actuarial assumptions are accurate. Pension benefits, however, are considered guaranteed assets to the retirees who are vested in the system and therefore must be paid. This obligation puts taxpayers on the hook for trillions of dollars if the discount rate is not met.

A study by Moody’s Investor Services showed that from 2004-2012, the top 25 public pension funds were “on-target” for rate of returns but still accrued nearly $2 trillion in unfunded liabilities. This is because using the rate of return in lieu of a market-valued discount rate is not a proper reflection on the liabilities. The discount rate should reflect similar liabilities, such as those paid out in government bonds yields. The State Budget Solutions annual report on public pensions showed that if public pension funds used a more appropriate discount rate, the collective unfunded liability of all state plans would be $4.7 trillion.

Overly Aggressive Investment Assumptions
Legislators are tempted to assume a higher annual rate of return on investments, meaning that they can put fewer dollars into pensions in the current budget. Although related to inflated discount rates, this issue is an independent problem.

Underfunding Pension Contributions
An underfunded state pension plan has more liabilities than assets. By continually underfunding pensions, pension accounts become less stable, and there is less assurance that the state can effectively cover distribution amounts when pension benefits become due. The Annual Required Contribution (ARC) is the amount of money required to sustain the pension fund based on the discount rate and other assumptions. When the ARC is skipped, or even reduced, that means that pension funds will need to make up for the lost expected growth, as well as the actual contribution in today’s dollars. This compounds the unfunded liabilities.

  • New Jersey: Governor Chris Christie has made a habit of underfunding the state pension fund, repeating the sins of many of his predecessors. Most recently, Christie’s administration is arguing that its own reforms to the pension system, which required full contributions each year, are unconstitutional. Courts have said that he must follow the 2011 law.

Pension Obligation Bonds
As more states recognize the whopping unfunded liabilities in public pension funds, some policymakers have opted to borrow money now in order to make up the difference. When interest rates are low, the logic follows that if a state borrows money today at a lower rate, it can invest that money, have a greater rate of return, and be able to pay off the bond debt and also assist in paying down unfunded liabilities. But this maneuver also allows the state to automatically assume that this new funding will hit the higher rate of returns, often at 7-8% annually. That means that even less money needs to be put into the pension funds now, or at least according to this accounting trick. Another challenge is when a state issues pension obligation bonds, they underfund the annual required contribution in the budget and in some cases (i.e. Illinois) use the pension obligation bonds to “balance” the current budget and thus not put the money into pensions.

  • Kansas: Kansas has approved a $1 billion pension bond that will put cash directly into the coffers of the system to be used for investment. Because of the investment assumptions, the state has also decided to lower the contribution to the pension plan by $64 million over two years, which will help “balance” the budget.
  • Illinois: “In just ten years, the Illinois General Assembly pushed the burden of billions in government spending onto Illinois’ future generations. Official estimates put Illinois’ unfunded pension liability at $85.6 billion. But that amount does not take into account the $25.8 billion in pension obligation bond (POB) payments still outstanding, which have a net present value of approximately $17.2 billion”

Rolling Amortization and Smoothing
In order to make the contributions by the employer–the government–more stable and predictable year over year, pension funds engage in actuarial gimmicks that allow contributions to remain low. The spirit of this idea is admirable, as it intends to ignore the potential volatility on Wall Street and still ensure proper contributions into the pension fund. In reality, the result has been the opposite. This tactic has allowed pension funds to ignore their incorrect assumptions on investment returns and discount rates and maintain contributions that do nothing to meet the true liabilities.

Liberal Vesting Requirements
In order to receive a pension benefit, government employees must meet certain requirements regarding their employment, including length of service. In some cases, state and local governments have made it easy for employees to meet those requirements, known as “vesting.” If vesting is easy, then too many retirees will be receiving benefits in the future, straining the system. Vesting requirements may also be expanded by the courts, adding greater liabilities to the pension plans. These liberal vesting requirements also make reforms more difficult. The more employees that are considered to be vested while employed, the more limited the reforms can be as it is often the case that vested employees may not have their benefits altered.

Not Planning For The Future
It is so easy for legislators to promise benefits tomorrow but not pay for them today. This is the essential flaw in the current public pension system that allows for defined benefit plans. Those who control the levels of benefits are politicians who must worry about re-election. This is not a system that rewards future planning over present results. If politicians were divorced from the process and employees and retirees had control over their retirement, a good number of these gimmicks would not be necessary to have a sustainable system.

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About the Authors:

Joe Luppino-Esposito is the editor and general counsel of State Budget Solutions. Joe’s current research focuses on public employee pensions, Medicaid expansion, state debt, budget gimmicks, and many other state budget reforms. Prior to joining SBS, Joe was a researcher for Berman and Company, and previously served as a Visiting Legal Fellow at the Heritage Foundation, specializing in criminal and constitutional law.

Bob Williams is President of State Budget Solutions. He is a former state legislator, gubernatorial candidate an auditor with the U.S. Government Accountability Office (GAO). Bob is a national expert in fiscal and tax policies, election reform and disaster preparedness. Because of his unique experience and expertise, Bob is a frequent guest on talk radio and at public forums. His commentary on state budget solutions appears frequently in newspapers, journals and online publications.

This article originally appeared on the website of State Budget Solutions and is republished here with permission.

12 replies
  1. Equal Time says:

    Pension fund finance utilizes estimates for all variables, from average age at retirement, average life spans,average compensation at time of retirement, and several other factors. Whenever a factor is estimated, critiques can argue that a different estimate should be used, It is a never ending opportunity for leveling criticism, but eventually the pension fund governing boards have to decide on each assumption. They usually rely upon actuaries to make a recommendation on them, and that is based on experience and trends going forward. A whole industry seems to have developed of think tanks, writers, fellows and claimed pension experts in this and that who are making a living leveling criticism at one factor or another. Terms such as “gimmicks”. “politicians’, “greedy”, “unsustainable” and “liberal” are interjected in the written critiques to inflame and incite. This article is one example of the products of that industry.

  2. Ed Ring says:

    Equal Time – if you are suggesting that this post has a point of view, you’d be right. But in keeping with your name “Equal Time,” you are invited to read the guest editorial that this post is responding to. More constructively, you might actually compare the merits of the two points of view, and explain which perspective you think is more accurate, and why. One of the primary points of this post was this: Anyone who is collecting a pension of $183,690 per year has scant credibility when it comes to conducting an objective and dispassionate debate over whether or not pensions are too generous, financially sustainable, or fair to taxpayers.

  3. Equal Time says:

    The purpose of my post was to report that an industry has developed of organizations and people who write about the ills of public pensions for a living, not to debate the entrenched views held by that industry. Anyone who is building a political reputation and/or earning a living by writing for an organization with entrenched pension views has scant credibility when it comes to conducting an objective and dispassionate debate over whether or not pensions are too generous, financially sustainable, or fair to taxpayers.

  4. Ron Knecht says:

    Equal Time: Your post is in its essence an ad hominem attack on the author and others. It’s fair to question or impugn the motives of an author (think tank, whatever) only after you demonstrate error (of fact, logic, etc.) on the part of the author, but not really fair or productive to do so before such a demonstration. From your petulant answer to Ed Ring, I can only assume you can’t muster a significant substantive critique, let alone any showing of error on the part of those you criticize. So, you just fast forward to the inappropriate personal attack. Prove me wrong by actually bringing something of substance re: this author.
    — Ron Knecht, Nevada State Controller

  5. Equal Time says:

    Mr. Knecht, since you are using your public office title I wonder if the patrolling of the Union Watch site is in your view a legitimate public policy purpose? As for me, I believe getting into the weeds on topics such as pension reform with those who have entrenched views, especially those professional writers being paid to write them, is a waste of time. No one’s mind will be changed. You should have learned this from the gyrations of the Nevada Legislature in the last couple of months on the topic of pension reform. You would better serve the citizens of Nevada if you focused on retirement security for our children and grandchildren vs. being part of the industry perpetuating the scam that 401(K’s) are the best vehicle available for achieving retirement security.

  6. Ed Ring says:

    Equal Time – you are spending a lot of words impugning the motives of anyone, apparently, who is critical of unreformed, unsustainable government worker pensions. And while you may be correct that there are now a handful of people across the USA who are paid, at least in part, to examine the sustainability of pensions and propose potential alternatives, you are missing two key points:

    (1) The “industry” that promotes pensions, as they are, unreformed and unsustainable, is far bigger and more powerful than any movement for reform. The only reason reform has any chance is because these pensions – for the reasons cited in this article – are financially unsustainable.

    (2) The solutions promoted are not restricted to individual 401K plans. Financially sustainable retirement security can be achieved while retaining the defined benefit, especially if these benefits are not based on the “pension gimmicks” described in this article. And in any case, Equal Time, if individual 401K plans were adopted, they would still be managed by the pension systems. There isn’t any chunk of new business out there for reformers. CalPERS, for example, already administers individual 401K accounts for many participants in that system.

    So if you really would like to have a constructive dialog on these issues, your response to each of these so-called gimmicks might be a good place to start. Each of these points offers ground for serious debate by anyone who is concerned about preserving retirement security for government workers, along with everyone else:

    – Outdated Life Expectancy Assumptions

    – Inflated Discount Rates

    – Overly Aggressive Investment Assumptions

    – Underfunding Pension Contributions

    – Pension Obligation Bonds

    – Rolling Amortization and Smoothing

    – Liberal Vesting Requirements

    – Not Planning For The Future

  7. Equal Time says:

    Interesting response Mr. Ring, but you might use the words unreformed and unsustainable a bit less as that seems to have become redundant (I know, I know, key words intended to elicit a response). Sounds like your backers have designed the 401K alternative they wish to have implemented. When might you roll out the entire proposal so people might digest it? Transparency ya’ know.

    As to having a constructive dialogue on this site I do not seek one because I do not believe it possible as I said to Mr. Knecht.

  8. Ed Ring says:

    Equal Time – California’s state and local government worker pensions are largely unreformed. While PEPRA offered up some real, albeit incremental, reforms, these reforms have been systematically and successfully challenged in court up and down California by, you guessed it, government unions. These pensions are also financially unsustainable. To call them unreformed and unsustainable is to state a fact, not to use “key words intended to elicit a response.”

    As for our backers, I don’t think any of them have suggested we advocate individual 401K accounts. And as a matter of fact, our organization is on record, repeatedly, advocating restoring financial sustainability to defined benefits, not abandoning them. Moreover, even if reform turned out to involve individual 401K plans, they would still be administered by the pension systems such as CalPERS who already administers 401K plans for some agencies. So there isn’t any business that any backers – not ours, as stated – could even get. The idea that the pension reform movement is motivated by the desire of financial special interests to acquire new business is a myth.

    Finally, to reform the defined benefit and make it financially sustainable, two things have to happen. First, the investment assumptions that the pension systems are permitted to use have to be made more conservative, and they have to stop investing in private equity and shift more of their investments out of stocks and into low-risk annuities such as high-grade bonds and treasury bills. Second, they will have to lower the benefit formulas – going forward – to the levels they were prior to 1999 when all the formulas began to be enhanced. That’s what it’s going to take, Equal Time.

  9. Jambo says:

    An interesting read is the history of 401ks. Its actually very short, this is from the guy that invented them – Ted Benna;

    “I knew it was going to be big, but I was certainly not anticipating that it would be the primary way people would be accumulating money for retirement 30 plus years later,” Benna, now semi-retired.

    And this gem,

    “Most of what I was doing was working with business owners,” he says. “Their main interest was, ‘how can I get the biggest tax break, and give the LEAST to my employees, legally?'”

    And so the 401 was born. Now we are at a point where a pension is the devil and so are public service workers. But if it is so lucrative why aren’t all of you critics in these great jobs???

  10. Equal Time says:

    Very interesting,jambo. I just wish those devoting so much money and time to attacking the current public sector DB structure would instead devote their energies to attacking the problem of retirement security becoming a fleeting hope for more and more people. I earnestly believe that the future society our children and grandchildren face, with large numbers of formerly working class elderly without an adequate means of support, is a scary picture of America in the future.

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