Governance & Decision-Making in Underfunding of Public Sector Pension Plans

Cities and states throughout our country are struggling to meet the financial demands of skyrocketing public employee pension contributions. The immense size of the unfunded liabilities is forcing agencies to amortize these debts over decades, transferring the financial burden to future generations of taxpayers. Forward-looking projections of contribution rates reveal little to no relief for many years to come.

This crisis has prompted government agencies at all levels to call for reform of the public pension systems; but will these proposed reforms fix the problem?

Some legislators and union leaders claim that the economic impacts of the Great Recession are the root cause of the current pension crisis. Yet, a historical look at the financial markets reveal that we have, for the most part, fully recovered from the recession – yet public pension funding levels continue to slide.

In a study recently published in The Journal of Retirement, Michael J. Sabin (2015) takes an empirical retrospective look to identify causes of the current underfunding of public-sector pension plans administered by the California Public Employees Retirement System (CalPERS). Sabin studied six CalPERS plans using actuarial valuation reports from the past eighteen years. It finds, contrary to conventional wisdom, that investment returns played only a minor role in the current underfunding.

This study illustrates clearly that market returns that meet actuarial assumed rates of return are not enough to fix broken pension systems. Sabin writes:

In other words, the explanation for Sunnyvale’s current underfunding lies not with investment performance, but with actuarial forecasting. The forecast underestimated the amount by which pension liabilities actually grew over the 18-year period and calculated a normal rate of contribution that was too low to keep up. Many assumptions go into the actuarial forecast: wage growth, retirement ages, retiree lifetimes, and so on. These assumptions are input to a set of calculations that produce the forecast. The valuations that are the data source for this article do not provide enough detail to make definitive findings about which assumptions or calculations went awry.

While some of this forecast error may be just that – error – there is more of a behavioral issue at work that has its roots in structural governance issues.

The largest issue is the traditional make-up of pension boards that approve the assumptions that are used to create these forecasts. In an overwhelming number of systems, pension boards are comprised of members with direct financial interests in the performance of the plan – employees, retirees, union officials, city/government administrators, and elected officials who were often labor supported candidates – all of whom are advised by plan administrators that are also members of the plan. At first blush, this seems like a good thing, given that those with skin in the game should be making the best decisions for the plan’s performance. But in order for that to occur, there would have to be equal risk for poor decisions.

Both employees and employers fund public pensions. The cost of providing these pensions is broken into two separately calculated costs: normal cost and prior service cost (unfunded liability). You can read a simple explanation of these costs here.

With the current funding mechanisms in place for most plans, risk is not balanced, nor shared. In the vast majority of plans, employees may only participate in partially funding the normal cost – which again, is determined by the actuarial forecasting. (In some cases, by statute or policy, there are artificial caps placed upon either employee or employer contributions.) Any costs related to forecast error are shifted to the unfunded liability and become part of the unfunded liability payment.

Therefore the risk associated with not meeting actuarial assumptions is borne entirely by the taxpayers. Public agencies do not generally have major concerns with budgetary impacts of normal cost contributions, though they may increase in some measure from year to year. It is the amortized unfunded liability payments that have sent contribution rates skyrocketing to unsustainable levels.

Additionally, these unfunded liabilities are generally amortized over long periods of time, spreading the associated costs across generations. This process of amortizing unfunded liabilities over periods of 30 years or longer, raises questions of intergenerational equity. What happens when our children and grandchildren can’t even receive basic governmental services or pensions because all the resources were depleted paying down the exorbitant pension costs of their parents’ and grandparents’ generations?

Stepping back from all of this for a moment, and looking at board decision-making, leads to the point of this being a behavioral issue at work that results from structural governance issues. Nearly every person at the decision-making level benefits from low projected normal costs, and nobody at the decision-making level is harmed by high unfunded liability amortization payments in the short term. In fact, there is an incentive to drive down normal costs through the careful selection of actuarial assumptions. This lowers the employee’s contribution rate, effectively increasing take home pay, and, due to established laws and court precedent, irrevocably transfers the entire risk and debt to the government agency – and therefore the taxpayers – through either higher taxes or lower levels of services. There is neither an incentive for being accurate, nor a consequence for being inaccurate. It is actually a perverse system in which there is a win for the entire membership when pension board trustees are wrong!

Defined benefit pension plans are systemically broken. Throughout the nation, awareness of these problems has increased, and efforts to fix the systems are beginning to take hold. But are the reforms addressing the underlying, systemic causes?

As policymakers pursue meaningful “reform” of pension systems, they will be merely trimming at the edges, unless there is a clear focus on the structural issues and decision-making processes before the fault lines of failed governance begin to show impacts as oversubscribed and underfunded public pension plans reach maturity. This means there must be a concerted effort to address the systemic failures, ensure risk is managed and shared, and prevent intergenerational transfers of debt.