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

31 comments

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That’s a fair analysis. I’d just say one thing – we should ask who was advising these plans? Also, what were the credible qualifications of the trustees managing them and what were the incentives for the plan trustees?

It’s fair to say these were badly managed situations. In digging a little into the bad advice that consultants and investment managers have over time passed on to pensions, I think you’d agree that it’s fair to say that is a facet of the problem – definitely not the whole problem as you’ve said.

Posted by yankeehotelfoxt | Report as abusive

Well argued. My concern is that while the risk is ostensibly more transparent in a 401K, that transparency only matters if the worker is actually schooled in the nature of the market enough to understand what is good or bad for them. Its a personal responsibility, instead of a collective responsibility. I agree DB plans have some serious flaws, but rather than simply calling for everyone to move to a 401K model with its own pretty serious flaws, perhaps we should come up with a new retirement model?

Posted by gallen89 | Report as abusive

38% of private sector workers had a DB pension in 1980? If 401k’s were just ginning up then what were the other 62% of private sector workers doing? I’d like to see a bona fide citation.

Next ‘most people in the private sector finance an account they manage themselves. If the account is up when they retire they get a richer retirement. If it is down they get a poorer one.’ Sounds like she’s talking only about stocks. I can’t emphasize enough how unwise it would be to trust stocks nowadays, in the self-regulated environment. I also think the statement is a gross oversimplification.

Lastly, legal constraints ‘kept them from contributing the full amount.’ Is really sounds @ss-backwards. What I know of public pension funds is that legal stipulations hold public entities’ feet to the fire. I fail to understand how ‘constraints’ would force municipalities or other organizations to fund current budget realities yet conveniently stiff contributions that are also legally required. At least the payouts are required. If public orgs fail to pay into funds but have signed contracts for payouts you would think retirees could win a suit for financial malfeasance.

Too much letter of the law and not enough horse sense.

Posted by Mac20nine | Report as abusive

I think any of these retirement schemes are doomed to fail in the long run for country. Managing your own retirement doesn’t spread the risk. To many people are not capably or willing to save for their future. The DB plans are far to easily corrupted and dependent on employer to manage your future. I think the USA got it right with Social Security, but failed to keep it form being corrupted by our politicians. Perhaps we should kill two birds with one stone and combine the Federal Reserve and Social Security into a single organization, private but under constitutional restraints and regulations.

Posted by tmc | Report as abusive

Allison, I beg to differ with your assessment that Matt Taibbi’s recent article in “Rolling Stone” blames the pension crisis all on Wall Street. It’s the fault of numerous factors, with Wall Street being just one of them. I suggest you reread the article more carefully and I hope your readers read it in its entirety.

Posted by pcwizard | Report as abusive

Pensions are a negotiated part of total compensation. The part that does not work is that in the public sector the people doing the negotiating (politicians) are not accountable–they don’t answer to shareholders, they do not have to manage the funds, nor do they have deliver the expected returns. In fact, those managing the funds “on behalf of the workers” get paid their fees even if they do not hit the objective.

All public sector pensions should be cashed out with the funds distributed and the workers should convert to a self-directed IRA or Roth plan. From there they can buy guaranteed income annuities, self manage, or have a bank/brokerage manage their funds. That way, they assume some personal responsibility vs. putting the burden on some future (unknown) tax payer who has to cover the “promise”.

Besides, whatever remains in their IRA is part of their estate, which they can pass on to their heirs. Government should not be in the pension business–not SS, CALPERs, not the federal government. It is merely a political mechanism by politicians to fund their campaigns, secure votes and to pad their wallets.

Anyone who relies on any politician to tell them what is good for them, without any personal accountability, is a fool. See Stockton, San Bernardino, Calpers, Detroit, Illinois Pension fund, NY pension fund…..at what point does the light go on when your pension fund tells you they are only 80%, 70%…funded?

The fact you have a “contract” or a promise does not mitigate reality.

Posted by COindependent | 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. The manipulation of LIBOR did the same thing. All of this caused public pension funds limited to investing in triple-A instruments that were actually crap to lose billions of dollars.

As far as public employees “voting against their own self interest”, most were forced into unions with management whose self-interest did not align with that of their members. I remember as an employee of the State of California being forced into the SIEU without even an opportunity to vote for union leadership, much less provide any input on how union funds were spent including millions of dollars sent to campaign funds of political candidates I would never support.

Posted by ptiffany | Report as abusive

Actually we can blame wall street. The very idea that there should be any risk in a pension account at all is due to wall street’s push to get cash from retirement accounts into their casinos. It’s difficult to find fault with finance if the argument begins by accepting the world view advocated by financial institutions.

Posted by brianpforbes | Report as abusive

The article is interesting, but as is so often the case with economists, it fails to consider the political dimension. I find the argument that says public sector pensions are a problem because of unions to be convincing, because the people running for office and receiving payments from unions for campaigns are also the employees’ bosses. But I suppose she does get at this, sort of, in a roundabout way.

Posted by Calfri | Report as abusive

Why even bother talking about public sector pensions? They are a small fraction of the population and undoubtedly will be taken care of quite well one way or another. The debate should start with should there or should there not be a government operate pension system like Social Security or only private sector based. Talking about unions is just a distraction from the real problem.

Posted by tmc | Report as abusive

This is generally a fair assessment of the problem.

The one thing I would disagree with strongly is the author’s idea that we should just turn everything into defined contribution plans. All the research I’ve seen suggests such plans deliver substantially lower returns over time (1-2% depending on the size of the account, with lower returns for individuals with less money) with higher fees (typically 1% or more, again, higher for individuals with less money), and moreover with much higher volatility for the individuals involved. Well managed pensions have to be part of the retirement mix for people. Otherwise we will simply be fleeced by the asset managers — which is presumably why they like defined contribution plans so much.

Posted by ericksonpb | Report as abusive

The real reason is unions run by people who could not give a rat’s a** about their membership or the people their members are supposed to serve. They irresponsibly bargained and ignored how unrealistic promises are to come to fruition. What happens is let’s promise the moon so everyone feels good and ignore hard choices.

Posted by keebo | Report as abusive

Is it really the fault of the union when a politician is too cowardly to bargain in good faith for their constituents? If the state or the city or any level of government doesn’t have the money, then they should open the books and be done with it. The problem is that they still want all the money that their pet projects require, and will take from the future to make that happen. This is not the fault of the workers. Escrow accounts, fully funded by law, would solve this in one day; but interests (not the worker’s unions), are busy exploiting every level of the system. (read: finance & corporate welfare)

This is a very simple concept called Pay Yourself First, and it should be the bedrock of politics. That we don’t or can’t demand it shows how weak ‘the people’ are against corporate interests.

Posted by Benny27 | Report as abusive

Farnkly it seems that the author is bending over backward to NOT place the blame on a very convenient villain: Wall Street. It is no coincidence that it is convenient…they are in large part, at fault!

Oh and I love the collective advice that everyone get a personal investment account and try their hand swimming with the sharks, er, managing their own money. The USA has such a can-do attitude! Why don’t we all fix our own cars, cut our own hair, grow our own food, develop our own drugs, teach our own children, and study law to represent our selves in legal cases. It is a ridiculous argument that there will be less risk when individuals are “free” (read: forced) to pursue their own amateur dreams in a world of professionals.

Posted by Benny27 | Report as abusive

haha frankly not farnkly

Posted by Benny27 | Report as abusive

frankly you are very pretty

Posted by barenski | Report as abusive

Wall Street has always done everything it can to make stock-market returns look better than they really are, and also (surprise) to shift pensions into vehicles – such as 401k’s – which maximize financial commissions. The financial industry has a lot of political power, which it uses to maximize its profits. The industry also uses personal influence, otherwise known as graft. So generally Wall Street does deserve a lot of the blame for the current state of pensions. Increasing its role by privatizing pensions is not the solution. Actually this has been tried and it hasn’t worked.

Posted by skeptonomist2 | Report as abusive

COindependent is so right. I think this article and the idea of political entities setting up pensions – is fraught with conflicts of interest. Wall Street is only too happy to sell you a dream but politicians are all to eager to pump up the dream – it is a promise they are making to themselves with their constituents tax dollars. When a city has to maintain contributions to the pensions – it becomes a future politician’s problem. He will fight to maintain them in hopes that he will retire with the same deal. No business can survive – paying up to fifty percent of its budget to pensions. Everyone wants a golden parachute – but the reality is municipalities cannot afford 20 to 30 years of pensions paid to individuals based on their highest three years of pay. These pensions were doomed to fail upon inception – but I think politicians wanted the benefit regardless of the risk or unsustainable financial burden on the City. That is like blaming the drug dealer for your addiction…..You really don’t care about side effects – you just want the drug.
The City official/employees should not promise themselves – these monies. You notice that there is no clause in the pension that says the burden to the City shall not rise above a certain percent of the budget. I am sorry that so many people were sold a fairy tale retirement…shame on the all parties involved.

Posted by xit007 | Report as abusive

” well-structured individual account can offer better diversification and is always fully funded.” —- an individual account is “always fully funded”? How do you figure that? All individual accounts carry risk, including individual defined benefit plans carefully crafted by qualified third party administrators. As a matter of fact, individual plans are exposed to the very same risks as large pension plans. An overly conservative plan exposes participants to a very real inflation risk, while the more aggressively invested plans have more obvious risks. A professionally managed retirement plan is probably best for the average worker, who lacks the knowledge and the temperment to manage his/her own retirement nest egg.

Posted by Hairry | Report as abusive

brianpforbes, you want to blame “wall street”? Why not blame your elected officials, who threw out Glass-Steagall when Bill Clinton signed into law, the bill that allowed banks to take on excessive risk? Mr. Forbes, we need banks, we need brokerage firms and we need our government to regulate their activities. You don’t care to invest your money with “wall street”? Fine. Bury your money in the back yard. Fifteen years from now, it will be worth 4o cents on the dollar due to inflation.

Posted by Hairry | Report as abusive

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