Tick tock goes the pension bomb
Whether they are private pension plans, such as Ford Motor Company’s plan or public plans like the Retirement Systems of Alabama, the defined benefit pension model is unstable and has its origins in an earlier, less sophisticated era in American history. The inherent instability was made obvious this week when Ford Motor and Verizon announced they would have to add $5 billion and $1.7 billion respectively to their pension funds to cover rising liabilities. The steps being taken by major American companies to shore up their pension plans are the norm in the defined benefit world because the plans treat the world as static, ask too much of administrators, and get bogged down in internal disputes and politics.
The stories about Ford and Verizon are just the tip of the iceberg in what will be another tough year for defined benefit pensions. In fact, a few weeks ago in Illinois, the state’s credit rating was downgraded because of massive unfunded liabilities. Illinois’ downgrade could soon be followed by Kentucky and New Jersey; in many other states, including Alabama, public pensions will be forced to add billions of dollars in new, unexpected contributions in 2013.
The call on workers and taxpayers for extra contributions has become commonplace across the country when it comes to public pensions, and the call for more funds should be met with outrage and serious reforms. Among the reforms people should be demanding, here are a few that make sense:
• Greater clarity about assets and liabilities
Public pension investments are treated with a great deal of secrecy. Determining the positions held by public pensions requires a tremendous amount of work for the individual; it’s far easier, in fact, to discern the holdings of rich individuals like Warren Buffet or large mutual funds like Vanguard than it is a public pension fund. Since taxpayers are the ultimate stakeholders responsible for public pensions, more information about assets, liabilities, and risk should be made available to members of defined benefit plans and the general public.
• Be honest about the future liabilities and worst case scenarios
The estimates of future unfunded liabilities for public pensions across the US range from about $1.5 trillion to $8 trillion. If we assume low discount rates for the future, unfunded liabilities for the RSA, for example, unfunded liabilities rise to $30 billion; the official reports from administrators, meanwhile, say RSA has about $5 billion in unfunded liabilities. Both numbers are big, but $30 billion of liabilities means far more drastic actions should be taken now when compared to $5 billion. The same goes for the broader conversation about pensions: an $8 trillion hole will require different solutions than a $1.5 trillion deficit; perhaps we should be planning for the bad outcome!
• Let’s get serious about the assumed rate of return on assets
Even though financial markets have been experiencing a “new normal,” which has been characterized by lower real returns and slow economic growth, pension plans across the US assume about 8 percent returns on assets. Assuming 8 percent returns masks the size of unfunded liabilities. If, for any long period, returns fail to hit or exceed 8 percent, workers and taxpayers are on the hook for more contributions.
• Start thinking “outside the box”
At the end of the day, defined benefit plans are struggling because the model is flawed. The trend in the private sector has been to shift away from defined benefit programs in favor of defined contribution plans, which are portable and allow individuals to control their own assets. Defined contribution programs are viewed more positively by their members than defined benefit; they are more stable for companies and taxpayers; and they shift responsibility to the individual.
Given the serious pension liability problem we face—one which will only grow as we move forward—radical solutions, such as shifting from defined benefit to defined contribution, should be on the table. A few states, such as Michigan and Utah, have done this in recent years, but states like Illinois are digging their heels in, rather than thinking big about how to protect retirees and taxpayers in the future.
In the absence of some of the reforms mentioned above, the pension problem will plague us for years and years to come. The clock is ticking on this problem, and huge tax increases and layoffs await us if reform waits. Even in the short-run, businesses and taxpayers can look forward to higher costs, and everyone had better be braced for unnecessary uncertainties.
Scott Beaulier is Executive Director of the Manuel H. Johnson Center for Political Economy at Troy University.