The Public Sector Ponzi Plan

Commentary

The Public Sector Ponzi Plan

Pension misunderstanding and misinformation are alive and well in Wyoming. Talking about pension reform raises both hopes and hackles. While many worry about the legacy of pension debt, the resulting tax hikes and service reductions imperiling future generations, others drag out the litany of common, but incorrect, objections to reform. Presented below are a few of the favorite objections, to which we’ve responded.

Claim: Offering new employees a defined contribution retirement plan (DC) instead of a defined benefit plan (DB) and raising their salary would not save taxpayers money. You simply switch costs: salaries versus retirement.

Fact: A widespread argument against moving new government employees from a defined benefit pension (DB) to a defined contribution pension (DC) plan is that little real savings would result because salaries would be increased to make up for reduced benefits. Salaries are already rising without the shift to a DB plan. The last thing taxpayers can afford are both higher salaries and the unknown future cost of unsustainable benefits. However, the fundamental principle forgotten here is that today’s taxpayers have a moral responsibility to pay for what they voted for. Higher salaries are paid by today’s taxpayers, who ratify the lawmakers’ decisions by voting for those who promise higher salaries. Separating salaries from egregious pension benefits – as happens in pension reform – ensures that higher pension debt is not offloaded to future generations. Our children and grandchildren – people who have no way to protect themselves from profligate politicians – should not be saddled with a future tax liability that they had no say in deciding.

Claim: If the Wyoming Retirement System (WRS) has to administer two totally different programs the administrative costs will skyrocket, so less goes to the retirees but more to run the system for little or no savings.

Fact: The WRS already administers two entirely different programs: the defined benefit and the defined compensation program. True, adding a defined contribution plan would entail an additional cost because these types of plans are individualized according to the personal requirements of each member. According to a report by the Center for Retirement Research at Boston College, the average administrative and investment costs for DB plans and DC plans were 0.43 percent and 0.95 percent of assets, respectively. However, depending on the formation of the DC system, these costs could be minimized by requiring the use of index funds or adopting a collective DC structure. More importantly, moving new employees to a DC plan would eliminate the possibility of billions of dollars of new unfunded liabilities. As an aside, the cost to run the WRS has already skyrocketed. Between 2004 and 2013, WRS administration costs as a percent of total assets rose by more than 200 percent. Skyrocketing costs at WRS are another issue entirely.

Claim: DC plans require each worker to become their own investment specialist and as a result, their retirement fund is significantly lower than what a DB plan would provide. Additionally, there is no protection should the retiree outlive his or her funds. These retirees would then become recipients of other welfare programs such as food stamps and Skilled Living Centers.

Fact: As the majority of private sector employees participate in DC plans, options in the market have increased tremendously and costs have declined. Looking at Wyoming’s colleges and universities, around 40 percent of the faculty and staff elect a defined contribution system (currently administered by TIAA-CREF) and it’s not evident that there is a problem in investments or retirement security for our educators. Indeed, only when one holds their own money in their own account can they be sure they will have an income in the future.

With the use index funds, workers don’t need to be “investment specialists” to earn reasonable returns from their pensions. Most professional investors and mutual funds do not beat the market. This means that non-expert individuals could outperform most active fund managers by putting their pensions in low-cost passive index funds. A DC plan, therefore, could minimize workers’ sophistication risk by setting a simple 60-40 stock-bond index portfolio comprised of domestic stocks, foreign equity, and municipal bonds as the default asset allocation. Additionally, the risk of outliving pension assets can be dealt with by purchasing annuities.

Given that some cities, such as Central Falls, Rhode Island, Pritchard, Alabama and Detroit, Michigan, are reducing the pension benefit to existing retirees, and according to hedge fund Bridgewater Associates, 85 percent of public pension funds could go bankrupt in three decades, perhaps we should be more concerned about what state employees still in the plan will do should the state renege on its pension promises.

Claim: We take out 30-year loans to buy a house. Retirement systems project in 30 year cycles too. Wyoming has close to 80 percent of the funds necessary to get us through the tough times.

Fact: A DB plan is analogous to a 30-year mortgage in the following way. Imagine that you take a 30-year mortgage, but this kind of mortgage is not paid for every month. Rather, the mortgage will be paid off at the end of year 30, by a lump sum amount. You have two ways to prepare for that lump sum payment. One way is to put aside, for instance, $5000 a year in a safe bank account earning 3 percent interest, so that after 30 years, that bank account will have enough money to pay for the mortgage. Another way is to put aside only $2000 a year in an investment portfolio comprised of stocks, bonds, real estates, etc. and hope that that portfolio will consistently earn 8 percent a year in 30 years to pay for the mortgage in the end. You choose the second way. During 30 years, however, you don’t save $2000 a year consistently. Also, your portfolio falls short of the 8 percent target. Eventually, you don’t have enough money to pay for the mortgage, so you force your kids to make up the shortfall.

The above analogy aptly describes the situations of many public DB plans. Many states/cities assume unrealistically high rates of return and fail to make annual required contributions, resulting in unfunded liabilities. The funding ratio of a pension plan, quite simply, is assets divided by liabilities. Currently, the funding ratio of Wyoming’s state pension plan is approximately 77 percent, meaning it does not have enough money to pay its promised benefits to those contributing into the system. Not consistently putting aside money for the “mortgage” means that lawmakers are consistently underfunding the system and it will be very difficult to account for all liabilities in the future. If all the funding assumptions were met and contributions made, the plan would not have an unfunded liability.

Again, thinking that this liability could be paid off in 30 years, much like a 30-year homeowner loan, presupposes that the plan sponsor makes their full required contributions and that the assumed rate of return (and other actuarial assumptions) will be realized. Which do not happen in many public DB plans, leaving the burden of payment to future generations.

Claim: The legislature has done a very good job of tweaking the system to improve its future and is projected to reach 100 percent funding in around four years if we can survive any significant downturns.

Fact: Making any fiscal plan contingent on surviving significant downturns is highly irresponsible and short-sighted. This also implies that pension funds are invested in riskier assets to provide for higher returns, which usually depend on economic bubbles. In a brief flurry of feigned fiscal responsibility, Wyoming’s legislature made a very significant tweak to the pension system when it eliminated the cost of living (COLA) adjustments in all but the Fireman A pension plans. While a step in the right direction, the main goal of this reform was to delay, but not eliminate, the collapse of the retirement system. Politicians are interested in ensuring the plan remains in place during their tenure in office. What happens once they are gone is of little concern.

In addition, COLA elimination and plan contribution increases mean the plan might, should all assumptions (AKA crystal ball gazing) pan out, be fully funded not in four years, but in 30 years-2043 according to the WRS.

A concerned Wyoming Public Employees Association member did make one good point after a recent expression of the above litany. He decried politicians’ proclivity for corporate welfare, the use of hundreds of thousands of dollars to create tens of jobs in the state. This misuse of tax dollars could potentially leave retired state employees waiting at their mailbox for a pension check that never comes.

If we want less political gamesmanship with our state’s pension funds, we should remove the temptations from elected officials to play with our money, and give the benefits our public servants deserve to them to manage, just like they manage all of their other bills. It is time for state bills to be paid for when they are incurred, not left for future taxpayers to fund.

Maureen Bader is an economic analyst for the Wyoming Liberty Group. Read more about her at wyliberty.org

Lance Christensen is the former director of Reason Foundation's Pension Reform Project.