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.