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Budget & Tax News

Public-Sector Pension Crisis Worsens

Billions in unfunded liabilities should worry taxpayers

Adam Summers
March 1, 2006

While private-sector pension terminations and freezes are grabbing headlines, the situation is every bit as grave for government pension systems.

Like many of the remaining traditional defined-benefit pension plans in the private sector, government pension plans are swimming in red ink. As of January 25, 2006, the National Association of State Retirement Administrators and National Council on Teacher Retirement reported an aggregate unfunded liability of nearly $296 billion for the 103 pension systems and 127 total plans in their Public Fund Survey. A 2004 analysis by Wilshire Associates put the unfunded liability as high as $366 billion.

Problem Is Nationwide

Pension funding problems are hitting state and municipal governments across the country.

The City of San Diego is probably the worst example of pension mismanagement. The city is now embroiled in its worst financial crisis ever, with an estimated pension deficit of $2 billion threatening to consume as much as one-third of the city's general fund. The city's failure to properly disclose pension liabilities prompted a U.S. Securities and Exchange Commission investigation and led to the suspension of the city's credit rating. So far eight former pension officials have been charged with criminal corruption by the U.S. Attorney's Office and state District Attorney's Office.

In Illinois, taxpayers face a pension deficit estimated at $38 billion—the worst in the nation.

The state of West Virginia faces a $5.5 billion pension deficit and an additional $3.3 billion in unfunded workers' compensation liabilities--a total deficit nearly three times the state's annual $3.1 billion general fund budget.

In California, the teachers' retirement system now faces a shortfall of more than $24 billion, and the state's combined contributions to the public employees' and teachers' plans now exceed $3 billion per year.

Borrowing, Diversions Cause Trouble

In the public sector, politicians and bureaucrats frequently have blamed unfunded actuarial pension liabilities on factors outside their control, such as the stock market downturn that followed the "dot-com" boom of the late 1990s. While sagging returns certainly did not help pension investment portfolios, they account for a fairly small portion of the problem.

Governments have tried to borrow their way out of debt by issuing risky pension obligation bonds, which often end up landing them in even worse financial shape than before, because the bonds must be repaid with interest.

Illinois, for instance, issued $10.1 billion in pension obligation bonds in 2003, hoping annual returns on the invested money over the next 30 years will exceed the 5.05 percent interest rate on the borrowed money. Last year, though, Illinois lawmakers diverted more than $1 billion in scheduled pension payments to other spending. Illinois is diverting more than $1 billion in pension payments to other spending again this year, digging the hole deeper.

401(k)s Offer Solution

In response to their pension funding problems, some governments are following the example of the private sector and switching to 401(k)-style defined-contribution retirement plans, in which the employer and employee each make contributions to a retirement account the employee controls. Numerous states--including Colorado, Florida, Louisiana, Maine, Michigan, Montana, Ohio, Oregon, South Carolina, Vermont, Virginia, and Washington—offer defined-contribution plans to at least some of their state employees.

Defined-contribution plans offer a number of advantages over defined-benefit plans. The chief benefit to the employer is that their predictable costs allow for greater stability and accountability. Costs are known in advance (because they are simply a set percentage of payroll) and don't change much from year to year. This is a sharp contrast to the volatility of required contributions experienced under defined-benefit plans.

For state governments, this is particularly helpful in the budgeting process, because legislators—and taxpayers on the hook for any funding shortfalls--do not have to worry about being surprised by greater-than-expected contribution requirements when the stock market sours and the pension fund's investment returns plummet. This added predictability of government finances eliminates the risk of unfunded liabilities and thus guarantees full funding of the system.

Governments can still offer attractive compensation packages by increasing salaries or the level of the government's contribution, but they must ensure those compensation increases are paid for up front.

Workers Benefit from 401(k)s

Defined-contribution plans offer a number of benefits to workers as well. They are portable, meaning they can be "rolled over" from one employer to the next when an employee changes jobs. This is particularly attractive considering the median job tenure in 2000 was only 4.7 years, and merely 2.6 years for employees aged 24 to 34, according to the U.S. Bureau of Labor Statistics.

Defined-contribution plans also offer individuals the freedom to invest their money as they see fit. As risk levels and investment strategies change with age, defined-contribution plans offer the freedom and flexibility that one-size-fits-all government-managed pension plans cannot.

No Cure-Alls Available

Another important step governments can take to stem the tide of ever-rising pension costs is to enact constitutional or charter amendments requiring voter approval of all government employee benefits. This strategy has helped politically liberal San Francisco keep retirement costs in check while conservative areas such as San Diego and Orange County, California have been brought to the brink of financial ruin by their pension systems.

The conversion of government defined-benefit plans to defined-contribution plans, and the implementation of voter approval requirements, may help to reduce retirement costs, but they certainly are not cure-alls. These solutions will only stop the bleeding. Persistent pension underfunding, sometimes over the course of decades, has led to debts that will have to be paid one way or another.

State governments may minimize the resulting cuts to important government services by adopting strategies such as privatizing or outsourcing certain government functions, selling unused or underutilized assets, consolidating similar government agencies and functions, implementing performance reviews to identify waste and poor-performing programs, and eliminating lower-priority programs.

These actions will be necessary if governments are to return to a solid fiscal position and ensure that public employees' retirement costs are covered without soaking taxpayers in the process.

Adam B. Summers is a policy analyst at the Reason Foundation and co-author of the study The Gathering Pension Storm: How Government Pension Plans are Breaking the Bank and Strategies for Reform. This column first appeared in Budget & Tax News, published by the Heartland Institute. An archive of Summers' work is here and Reason's government reform research and commentary is here.


Adam Summers is Senior Policy Analyst


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