The real reasons America’s pensions are hurting

By Allison Schrager
October 3, 2013

State and local pension plans are underfunded, in many cases dramatically. Enough so that, in the next decade, many states will have to cut benefits or services, raise taxes, or receive some form of a bailout. Matt Taibbi’s latest in Rolling Stone blames the situation on a convenient villain — Wall Street. But it’s far more complicated than that. State and local plans are underfunded because of terrible accounting standards, local governments who underfunded their plans, and plan trustees who gave away sweeteners that robbed plans of their assets. That is the inherent problem with traditional pensions, or any type of compensation that is back-loaded (payments pledged for the future). It’s too easy to over-promise today and not set enough money aside, but either retirees or taxpayers eventually have to pay up. It’s tempting to blame Wall Street, but that does not solve the problem. It enables public employees to lobby against their own long-term interests.

Traditional pensions, called Defined Benefit (DB) plans, are supposed to protect workers. Workers are promised that a fraction of their highest salary will be paid to them upon retirement and for the remainder of their lives. Around their peak of popularity, in 1980, about 38 percent of private sector workers had a DB pension, but today fewer than 15 percent do. Nearly all public sector employees still have a DB pension.

By contrast, most people in the private sector finance their retirement with an account they manage themselves. They decide how much to contribute and bear the investment losses. If their account is up when they retire, they get a richer retirement. If it is down, they get a poorer one. The advantage of DB plans is that they spread investment risk across different cohorts. High-return cohorts subsidize the low-return ones. Everyone is protected from a poorer retirement by giving up the upside. If you adequately fund the plans it can be an efficient form of risk sharing.

The recent revelation of why Detroit’s plans ran into trouble is an example of how this can go wrong. When returns were very high retirees and workers were given bonus money. But this undermines the risk-sharing aspect of a DB plan. You can’t have certainty and upside without paying for it.

Giving away upside for free isn’t unusual in public DB plans. Wisconsin state employees and some Illinois teachers are offered two options when they retire. They can either take what they were promised, based on salary and tenure, or they can take what they would have earned if their contributions earned a market return (or in the Illinois case, the return plan trustees hoped to earn). According to pension economist Jeff Brown at the University of Illinois, when returns were high, many other plans increased the generosity of promised benefits. The problem is plans don’t cut benefits when the fund does poorly. This asymmetry undermines the health of the plan.

The pensions are also underfunded because states did not contribute enough to them. Each year public plans must make contributions to finance new obligations and part of their underfunded pre-existing promises. Even pre-crisis, just before May 2008, only about half of plans paid in what they were supposed to. About 44 percent of governments that underpaid did so because they faced legal constraints that kept them from contributing the full amount. It’s gotten worse since the financial crisis. When a municipality has more pressing concerns than paying pension benefits in ten years, the plans don’t get the money they need.

In spite of this, many plans claimed good financial health before the crisis. More recently, one-third of state plans claimed they have enough assets to pay 80 percent of their promises. But these estimates rely on the assumption that pension assets will earn at least 7 percent to 8 percent each and every year. All DB plans are supposed to smooth risk across retirees, but public DB plans are special because the taxpayer is on the hook if there’s not enough money. That extra guarantee has value. We pay insurance companies premiums to ensure we are paid no matter what happens. Taxpayers provide that same certainty, but the pension funds assume it’s free.

The guarantee from the taxpayer isn’t free because plans typically need money when the market is down. But it’s more expensive to raise capital or taxes in a bear market. If you account for the true cost of paying benefits in all states, the public plans’ underfunded liability may be as high as $3 trillion, three times what states currently estimate.

True, the finance industry had a major role in causing the financial crisis. Following the crisis, plans’ assets fell in value and the recession undermined the health of municipalities. But that’s precisely why it’s so important to put enough money aside when the economy is strong.

DB plans have the potential to be very valuable to workers. But in practice they create a number of bad incentives. Managing a successful pension requires long-term thinking, and an ability to both sacrifice for the future and account for risk. Many state and local plans try in good faith to do this, but others are tempted to offer up short-term gains and underfund. Private accounts have been demonized for exposing savers to more risk, but at least the assets are yours and the risk is transparent. For that reason they may be a better alternative for public employees. We learned from Enron that investing all your 401(k) assets in company stock is a terrible idea because the fate of your employer and your savings are tied together. But in some ways DB plans have the same problem. A well-structured individual account can offer better diversification and is always fully funded.

Public employees are counting on what they’ve been promised. Many of them don’t have Social Security to fall back on because workers in some states, often police and firemen, don’t pay payroll taxes and participate in the program. Their pension was presumed to provide adequate security. Blaming the financial industry instead of taking a hard look at what these plans really cost undermines the financial security of public workers. Because eventually some plans will run out of money and workers will face a poorer retirement.

PHOTO: Protesters carry a banner calling for Detroit’s debt to be cancelled as people enter the federal courthouse for day one of Detroit’s municipal  bankruptcy hearings in Detroit, Michigan July 24, 2013.   REUTERS/ Rebecca Cook


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Many folks want to blame “wall street” because our elected “representatives” deflected blame toward “wall street”, when it is really our government who is to blame for relaxing important banking regulations that were put into place during the “great depression”. By the way, this deregulation was a bi-partisan effort that occurred under Bill Clinton. You can blame “wall street”, you can blame George W Bush, you can blame the “commies” if you want to, but you would be wrong. I blame our education system for hatching multiple generations of dogmatic lemmings who are quick to latch onto easy, but often incorrect, answers. People who ran up credit card bills and second motgages, who made foolish investment decisions… people who want the government to take care of them and who would blame others rather than take personal responsibility.

Posted by Hairry | Report as abusive

“The article fails to mention that most of these public pension plans such as the California Public Employees Retirement System (CalPERS) and the California Teachers Union Pension Fund were heavily invested in triple-A rated toxic mortgage-backed financial derivatives. These credit rating agencies – Moody’s (owned by Warren Buffett), Standard & Poor’s and Fitch – to issue fradulent high ratings to entice institutions like pension funds to invest in crap. The Wall Street Casinos were bailed out, the Plutocracy’s gambling losses were covered, but the pension funds got screwed. ”

–OK, I’ll bite: how much did pension funds lose in the debacle?

Posted by Tinmanrc | Report as abusive

Benny27…I have a 401k and I manage how the money is invested. When I first started out I knew absolutely zero about investing. So there is a bit of a learning curve. Mutual Funds are predominately what you find in most 401k plans. So instead of swimming with the sharks…you riding with them. The diversity of mutual funds greatly reduces risk. Plus the plans provide a lot of information regarding these funds. Most important is how they have performed over long periods of time. And in times of market stress you have the option of moving your money to the money market. It won’t grow there…but it’s virtually 100% safe. I have A LOT more money in my 401k than me and my employer have put into it. It’s easy to find a mutual fund that has an average annual return of 8% or more over 10 years. It’s the compound of that return along with continuing to add to the 401k that can generate an “eye popping” amount of money.

Posted by xyz2055 | Report as abusive

Tinmanrc – of course, we now know that those derivitive assets were high-risk junk, but it is the responsibility of the auditors to expose weakness in assets. The credit rating agencies did not have accurate information. “Garbage in, garbage out”. So who is to blame? The investment banks that created the junk assets, the banks and pension plans who did not understand those arcane derivitives, but who added them to their portfolios anyway, the auditors who did not understand them, but who did not raise warning flags and our elected officials who did not provide even minimal regulatory oversight.

Posted by Hairry | Report as abusive

well, folks work and they have no time to look at those mutual funds booklets, I remember I just threw mine into recycling, most people simply can’t make informed decision about this. Lets have human resource department do all that, wth are they doing over there anyways besides handing out pay checks

Posted by barenski | Report as abusive

barenski – The US Dept of Labor requires 401k sponsors to provide employees with education and information resources sufficient to make wise decisions. Ask your HR dept where you you go for more information about the investment alternatives available to you in your 401k.

Posted by Hairry | Report as abusive

xyz, you’re technically correct when you say “in times of market stress you have the option of moving your money to the money market. It won’t grow there…but it’s virtually 100% safe” BUT…

That’s what too many people do at the bottom, locking in their 50% loss and missing the 100% rally. Sure, you can say it’s a personal responsibility thing but that’s cold comfort when millions are thrown on public assistance.

Posted by Tinmanrc | Report as abusive

to Hairry – this idea , of blaming
“People who ran up credit card bills and second mortgages, who made foolish investment decisions…”
is not correct. Consider credit cards ; it is the responsibility of the credit card company to determine if the individual will be able to pay back the loan they’re offering. However, with the advent of credit default swaps, financial institutions were able to transfer risk off their balance sheets (at the cost of increased systemic risk), which effectively relieved them of the need to adhere to such risk models. It’s not on the investor that banks decided they could take infinite risk and swap it on the market.

Posted by brianpforbes | Report as abusive

brianpforbes – Well no. Credit card issuers are in the business to make money. They’re unconcerned whether you are making a wise personal decision to obtain a credit card and then run a balance in it. I’m unsure how you tie credit default swaps to personal responsibility. (I blame our education system) Thank you for your comment.

Posted by Hairry | Report as abusive

Good Points made here, I just wanted to add that I direct my own retirement savings also, and it is pretty hard. Mutual funds are no panacea, the fact that you can move around in response to the market is probably the largest factor in under-performance of self-directed accounts. How can we be expected to do as well as professionals? Especially professionals whose mandate is conservative, such as the trustees of national pension funds?

I began young and have good lessons learned from my parents but the financial services sector spend sall their time muddying the water so that “trading” comes out the same as “investing”, when these two actions are almost polar opposites. People cannot understand the risk they are taking almost all of the time, especially now when many “businesses” are really hedge funds. See: energy companies

Posted by Benny27 | Report as abusive

Many of the comments are correct. Even the above-average intelligence person is unable to effectively manage his 401K or IRA. However, that is what banks and mutual fund managers are for. But one must be aware of the fees charged as they severely deplete the long term returns. And, many companies sign on with 401K managers that have exorbitant fee structures that most employees are not even aware of. If you keep fees low, the returns can be quite positive with low downside risk.

The issue is the same whether you’re in defined contribution, defined benefit, or self-directed plan–it requires education. That education (learning, meaning personal effort) is the responsibility of the the individual. Companies and 401K managers offer these education seminars but typically less than 50% of the employees attend–they cannot be bothered. Anyone who leaves their financial future to the discretion of any manager deserves exactly what they (do not) get.

As for Benny’s comment, regarding competing with the professionals. Do not try to compete with them–look for a balance between lower risk and return. Do not compare your reduced-risk returns with the 18% the hedge funds claim–(as one year returns do not make a trend) as their clients are typically people who can afford to lose that single investment.

One only has to look at CALPERS and their “alternative investments”–some of which have not returned a dollar in literally five years–but CALPERS continues to invest with them. But CALPERS thinks they need those investments as it’s the only chance of hitting the 8% returns they forecast for their portfolio of billions. They cannot diversify further into the stock market since the are already fully invested there.

Competing with the hedge funds is no place for the individual investor to play. Most importantly, an individual does not ever have to compete with the hedge funds to secure their financial future.

Posted by COindependent | Report as abusive