Let’s stack the deck
Deficits at state-pension funds are the real monsters threatening municipal stability. Estimates of shortfalls at these funds range from $1 trillion from the Pew Center on the States to $3 trillion from Orin Kramer, the former chairman of New Jersey’s State Investment Council.
There are numerous strategies thatÂ individual pension-plan sponsors are using to stabilize their funds, including:
- Reducing benefits
- Increasing employee contributions
- Making additional public contributions to “top up” the fund
- Trying to increase returns for the fundby increasing investment risk
- Changing to a defined contribution plans
The excellent graphic above, provided by the Pew Center on the States, shows how many states are adopting the first and second strategies listed above. The upside of these methods is they stabilize fund assets immediately.
As most pre-existing pension plans are defined benefit plans (think standard public pension), the fifth strategy of changing to a defined contribution plan (think 401K) has been the focus of much discussion. Unfortunately, this change shifts almost all of the risk for providing benefits to the retiree.
An excellent report from the Center For RetirementÂ Research defines the risks:
The defining characteristic of defined contributionÂ plans is that they shift all the responsibilities and allÂ the risk from the employer to the employee.
In termsÂ of responsibilities, the employee must decide whetherÂ to join the plan, how much to contribute, how toÂ allocate those contributions among different investment options, how to change those allocations overÂ time, and how to withdraw the accumulated funds atÂ retirement.
Under a defined benefit plan, the sponsorÂ retains these responsibilities. Â The plan requires participation, sets contribution rates, invests the assets,Â and pays an annuity at retirement.
Leaving the responsibilities in the hands of employees means that they are exposed to the risks ofÂ saving too little, losing funds when financial marketsÂ fluctuate, seeing the value of their retirement incomeÂ eroded by inflation, and outliving their resourcesÂ since payment is generally not in the form of anÂ annuity.
Not to be harsh, but generally people with low incomes lack experience in managing financial assets and can be misled easily by complex financial product disclosures. Or, to put it more simply, they are easy prey for Wall Street.
The most interesting idea I have read comes from the Center on Retirement Research report cited above and proposes a “stacked”Â benefit plan. This would provide a base defined benefit for income up to $50,000 and then “stack” a 401(k)-type program on top for higher-earning employees.
A better approach to limiting taxpayer risk isÂ to cap the income covered by the defined benefit plan. Â Such a cap would prevent the situation where the typical taxpayer, earning $50,000, is forced to pay higherÂ taxes when the stock market plummets to coverÂ benefits for highly-paid public employees, such asÂ university presidents.
Therefore, the proposal wouldÂ be to limit coverage under the defined benefit plan toÂ earnings below, say, $50,000 (indexed for inflation). Many public sector workers would still be covered inÂ full under the defined benefit plan.
In the last few years Georgia, Michigan, and Utah have adopted such “stacked” plans for new hires, and nine more states are discussing adoption. See the Center on Retirement Research report for more details.