A pension system that swings with investment returns

September 19, 2013

Although the media is full of hair on fire stories about the level of funding in public pension funds some of the funds are in great shape. State run pension systems like the North Carolina Local Government, Wisconsin Retirement System and numerous Washington state funds have extremely high funding levels, near 100 percent in the latest figures from 2011. Each plan has different state funding requirements, retiree benefit schemes, asset mix and projected investment returns. But each plan has been prudently managed, and, most importantly, excessive benefits have not been promised to retirees.

Almost every public pension has a “defined benefit” structure, which means that the benefits promised to an employee upon retirement are a fixed amount and may also have mandated annual inflation increases. The pool of assets that these benefits are paid from fluctuates in value from year to year and state and local governments are responsible to make up any funding shortfall in the plan. This structure, where the government is responsible for all shortfalls, is what has caused large and accelerating government contributions to make up for investment losses from the 2001 and 2008 financial crises. And when governments have to unexpectedly increase pension contributions it crowds out funds that would have been used for education or other social services. Or taxes must be raised.

Unique among state pension funds, the Wisconsin Retirement System is structured as a “defined contribution” fund where everyone, taxpayers, employees and retirees share the risk that the fund will not achieve the returns necessary to fully fund pensions. Wisconsin is structured like a giant 401(k) for its members with steady contributions from the government and employees but the annual payout to retirees varies according to how well the fund is performing. Institutional Investor describes it:

Designed decades ago and unique among the 50 states, the ninth-largest public pension system in the U.S. features a mechanism that insulates Wisconsin from wide swings in funding by balancing both cost-sharing and risk-sharing between employers (that is, taxpayers) and employees.

The general criticism of public pensions is that retirees usually bear no risk of not receiving their full benefits. This differs from most of the private sector where retirees rely on their personal investment savings and likely draw income at different rates depending how their investment savings are doing.

Public pensions are basically insured by taxpayers who carry the risk of having to pony up more money when financial markets crater. The Wisconsin pension lays off more of this risk to the retiree but also rewards pension holders when financial markets are strong. More from Institutional Investor:

Wisconsin’s multi-levered retirement machine also awards pensioners an annual bonus or dividend, when asset prices are rising that has reached as high as 17 percent (during the bull market in 1999). Retirees can also rest assured that their pensions are secure for the long haul despite any short term gain or pain, because the adjustability feature keeps WRS close to 100 percent funded. For their part, taxpayers can take comfort in knowing that they won’t get hit with an increase because of a shortfall in the pension trust fund.

Public pensions will be fought over for at least the next ten years and Wisconsin’s model may not be appropriate for all governments but it should be an option for newly hired employees and offered as an alternative for situations where retiree pensions are being restructured like in Detroit’s bankruptcy. All pension funds have substantial swings in annual investment returns as the chart above shows. But a professionally managed “jumbo 401(k)” pension plan like Wisconsin’s is very likely to have better annual returns than what an individual employee would achieve in their self-managed 401(k) plan. Public employees and retirees should consider sharing the taxpayers risk as a creative solution to get the weaker pension funds into stronger shape.

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