With politicians, retirees and city and state governments struggling to find ways to address unfunded defined benefit pension obligations, there’s been plenty of disagreement over all kinds of “facts” surrounding the issue.
Richard Dreyfuss, a senior fellow at The Manhattan Institute of Public Policy, set out to address and debunk what he described as some of the myths and half-truths surrounding public-sector pension reform.
Here are 11 of them:
Myth 1: Many states have adopted comprehensive and sustainable pension reform. According to Dreyfuss, Alaska and Michigan are the only states that have established mandatory defined contribution plans for new hires, which he believes is the first step toward pension reform. Many states have adopted what he calls “pseudo” reform, like issuing pension obligation bonds or borrowing to meet retirement benefit system obligations. Many have offered incentives for early retirement to older workers on more expensive retirement plans, but “in doing so, they enhance already generous benefits while often extending the amortization period — the number of years required to pay off obligations completely — for the unfunded liability of their plan. Other states have attempted to pass the current costs of their pension plans down to future generations. Dreyfuss, for what it’s worth, believes that the only way to truly reduce the cost of a DB plan is to eliminate DB plans.
Myth 2: The best measure of success in reforming a DB plan is a reduction in projected employer contributions after reform. This near-term drop represents acceptable and sustainable reform that will withstand the test of time. Politics and DB plans can be a toxic combination, says Dreyfuss. Projected pension-plan contributions are merely estimates based upon future assumptions, often placing future taxpayers at significant risk. The success of any reform effort often hinges on at least three key assumptions:
a) The achievement of annual asset returns of 7.5 percent or higher. b) No future benefits improvements (often enacted retroactively). c) Contributing the actuarially recommended contributions (ARC).
In most cases, Dreyfuss says, it’s likely that none of these three assumptions will be achieved.
Myth 3: Uniformed public-sector employees require a defined-benefit plan. Those who risk their lives for the community should be afforded significant death and disability benefits, Dreyfuss says. In fact, most states have adopted statutes specifically addressing such contingencies. But, Dreyfuss said, retirement benefits for uniformed employees should be similar to those of non-uniformed employees. If the lack of guaranteed pension benefits limits a government entity’s ability to hire qualified employees, their base pay should be adjusted. Some public safety employees do not participate in Social Security. This can be remedied in DC plans by offering higher employee-plus-employer contributions of 18–20 percent, according to a TIAA-CREF study. Another reason public-sector plans are so costly is that uniformed employees typically retire as early as age 50 because full retirement benefits are based on a set number of years of service, regardless of health or age.
Myth 4: A particular pension plan remains in satisfactory condition based upon the fact that no retiree has yet to be denied a payment. Plans are going through three stages of financial distress, he says:
Stage 1: Plans abandon 100-percent funding targets, legalize financial manipulation and underfunding generally occurring since 2008.
Stage 2: Systemic liquidity challenges; projected higher pension contributions creating budgetary pressures and/or tax increases.
Stage 3: Prefunding is fully compromised; widespread borrowings and more bankruptcies. This will occur over the next five to 15 years.
Myth 5: The unfunded actuarial liability (UAL) is not important, since it assumes that everyone will be retiring today. Under most actuarial cost methods, the UAL is a snapshot of the present value of benefits earned to date, less assets available to pay these same benefits. Some earned benefits are currently in pay status, and other benefits are payable at a later date. Therefore, the UAL does not represent the value of all participants retiring today.
In theory, if a plan were sold to a third party to assume its obligations, the unfunded liability would represent a deficit that would need to be satisfied. Any reasonable observer would find this deficit to be more than that estimated by the plan because plans customarily assume an optimistic annual return rate of 7.5 percent on assets.
Myth 6: New members are needed to sustain DB plans. Without them, plans will incur transition costs that make DB-to-DC conversions unaffordable. Pension systems are designed to be self-sustaining. DB plans, if properly designed and administered, should not need new members to sustain themselves. The claim that a plan needs new members to sustain it is a red flag indicating that basic funding principles have been compromised.
Myth 7: The federal government needs to play a role in state pension-reform efforts. Dreyfuss believes government interference makes things worse when it comes to managing risk. Plenty would agree; others, perhaps less so.
Myth 8: Cash-balance plans offer a route to meaningful reform. Dreyfuss claims this is false because cash balance plans are just another form of defined benefit plan; they just define the promised benefit in terms of a stated account balance, which is more in line with a defined contribution plan. Given that they are DB plans, they are subject to the same political pressures as any other form of DB public-sector pension plan: accounts can be retroactively increased; the plans can be underfunded; and their assets are valued with an assumed rate of return that may, for political reasons, be set too high. Most important, as with any DB plan, a cash-balance plan can generate unfunded liabilities. Only DC plans take politics out of pension arrangements, he said.
Myth 9: “Actuarial soundness” is a well-defined and commonly understood term. This claim is often invoked to pre-empt probing questions regarding a particular plan design or funding approach, Dreyfuss says. “Actuarial soundness,” though, has no rigorous definition. It is a qualitative term referring to whether a debt is ultimately satisfied — not a quantitative term identifying a specific duration with related details.
Myth 10: An “80 percent funded” status is the sign of a healthy pension plan. A plan’s funded ratio is simply the ratio of its assets to its accrued liabilities. The bedrock standard here is that benefits should be funded as they are earned. In such a situation, the ratio of assets to liabilities is 100 percent. Only a 100-percent funded ratio marks a plan that is current in its funding progress toward its ultimate long-term goal.
Myth 11: The average annual public-employee pension is $25,000. Averages can be misleading, Dreyfuss says. For example, the Pennsylvania Public School Employees Retirement System allowed retiring employees to withdraw their accumulated employee contributions in exchange for a lower monthly annuity (a provision that was eliminated for new hires beginning in 2010). Based upon the most recent actuarial valuation, the average pension overall is $25,323. However, the average pension for a full-career individual retiring between the ages of 60 to 64 with 30 to 34 years of service is $45,349. A more meaningful analysis would consider the percentage of income replaced at retirement, including Social Security.