The Public Employee Pension Crisis Explained

The threats to America’s fiscal stability are numerous and well-known-the country is more than $17 trillion in debt, with a projected deficit of $649 billion in fiscal year 2014, and it has a social security system that will be paying out more than it takes in by 2018.

But another serious danger looms in the form of several trillion dollars in unfunded public employee pension liabilities, which are crippling our states and sometimes driving cities toward bankruptcy, forcing massive debt onto the backs of future generations, and threatening the financial solvency of the country.

But what exactly are unfunded pension liabilities, and how do they come about? This article aims to simplify and explain the public employee pension crisis in a plain-language fashion that is accessible and easy to understand.

Pensions Explained

In the simplest terms, a pension is a fixed amount of money paid to a person upon retirement from service to an employer or other organization. A pension is often paid on a set schedule, such as a monthly payment, but may also be paid in other intervals, such as block payments. Different types of pensions exist but this explainer focuses on the ubiquitous defined benefit plan, in which a retired government employee receives a set annual payment for life according to a formula based on factors like salary and number of years worked.

Here’s a typical example: The fictitious City of Odyssey pays retired employees 1.6% of their final salary for every year that employee worked for the city. Bob worked for the City of Odyssey for 30 years and was earning his top salary of $84,000 per year when he retired. Thus, Bob receives an annual pension of $40,320 (1.6% x 30 years x $84,000). Easy enough, right?

Why Do Governments Provide Pensions?

Local and state governments, and a dwindling number of private companies, offer their eligible employees pensions as a benefit of employment beyond salary, just like health insurance and paid vacation. Employees know they will receive a fixed amount of income to use during retirement. This perk can be used to attract potential employees to the government workforce.

How Is a Defined Benefit Pension Different From Other Kinds of Retirement Plans?

In a defined benefit system, the employer promises to pay its employees a fixed and predetermined sum of money upon retirement for the rest of their lives. This is a big, legally binding commitment and employers are responsible for ensuring there is enough money available to pay out the promised benefits. Most public sector retirement systems across America are defined benefit pensions.

In a defined contribution retirement plan, such as a 401(k), the sum of money employees receive in retirement can vary and employers aren’t required to pay a specified amount to employees upon retirement. Rather, employers and/or employees contribute a certain amount to a retirement investment account and the amount of money retirees receive depends on how well the investments perform. Most private sector retirement plans are defined contribution.

Who Pays for Public Sector Pensions?

Employers-for our purposes, state and local governments-pay for most of government worker pensions by annually contributing to a pool of assets that will be used to pay out defined benefits, or to individual retirement accounts for defined contribution plans. But since governments are funded by taxpayers, it is the taxpayers who actually pay for the bulk of public employees’ pensions. Most government workers typically contribute a small percentage of their pay into the pension plan as well.

How Do Pension Funds Get their Money?

It is important to note that governments don’t use a “pay-as-you-go” system in which checks cut to retirees today are paid directly by the government out of the current operating budget. For one thing, employers wouldn’t be able to afford to make pension payments purely out-of-pocket. Instead, governments with defined benefit plans figure out how much to save and contribute to the pension fund each year to pay out future pension benefits, and put that money into a collective pot. Then pension boards with members appointed by elected officials invest those assets to generate the rest of the funds needed to pay retirees. Pension managers can invest in the stock market, land purchases, bonds, and other investment vehicles depending on their risk strategy.

Ideally, based on these contributions and investment returns, the pension fund should grow large enough to payout the promised pension benefits in the future.

How Do Employers Know How Big Their Pension Funds Need to Be?

Actuaries calculate how much money will need to be paid out in pension benefits each year, factoring in things like employees’ life expectancies, the number of employees expected to retire in a given year, employee turnover, and any changes to the employer’s pension formula. This figure is an estimate and relies heavily on assumptions about the future.

In our earlier example with Bob and the City of Odyssey, we determined he would receive an annual pension of $40,320. Now let’s assume he retired at age 65. If actuaries estimated the average employee’s life expectancy to be, say, 75 years, the employer would expect to pay Bob $403,200 in total. But people are living longer these days so what if Bob lives to be 80? The employer would have to pay him $604,800-$201,600 more than anticipated. That is a big difference, one that the taxpayers are legally obligated to cover.

For defined benefit retirement systems, actuaries estimate the life expectancy for the whole group of retirees and bank on some people living shorter than expected in order to pay the benefits for those who wind up living longer.

Likewise, actuaries may assume that a certain percentage of the workforce will retire in a given year. Some employees are choosing to work longer but in some cases employers are encouraging early retirement. So if more people than expected retire, the pension fund will have to start paying pensions earlier than intended and they won’t get all of the investment returns they were expecting. This can drive up pension payouts over expectations.

How Do Employers Aim to Make Sure Their Pension Funds Are Big Enough?

Actuaries estimate the expected rate of return on the employer’s pension plan investments-a critical figure that we’ll discuss in more detail shortly.

Pension plan managers also invest the pension’s assets, presumably with the goal of maximizing returns and growing the account.

Once the actuaries estimate how much the pension plan needs to pay out in benefits and how much the account is expected to earn in interest and other returns, they can determine how much money the employer will need to contribute to the account that year. This is another critical factor in the pension equation, which we will touch on shortly.

How Public Pensions Work in a Perfect World

Let’s look at an example in a perfect world. Let’s say that in 1989 the City of Odyssey hired a group of employees and enrolled them in a defined benefit plan that would provide annuity payments worth $100 million right at the time they retire. To keep things simple we’ll assume all of these employees stay working for the City and retire as a group 25 years later-this year.

The City estimated the rate of return it would earn investing pension assets between 1989 and 2014, when they would have to pay out the $100 million in benefits, would be 7.5%. Most state and local governments were using that rate as well.

Based on those assumptions an actuary determined that every year the city should pay about $1 million into the pension fund and city workers would be asked to chip in about $350,000 collectively as well so the total annual contribution would be about $1.35 million.* The money was strategically invested with the goal of achieving an average return of 7.5% annually.

In this perfect world scenario, we’ll assume the City of Odyssey made 100% of its annual contribution every year. Employees are required to make their full annual contributions, so we know they did. We’ll also assume the City achieved their expected average annual return of 7.5%.

So by 2014, the City has grown its assets to $100 million, enough to cover its pension obligations for its group of employees retiring this year.

[* To exactly earn a future value of $100 million, the precise annual contribution is slightly more than $1.35 million, but we’ll round the numbers to make this easier to follow.]

Why Are Employer Contributions to Pensions Important?

In order to work, defined benefit pensions must be pre-funded. That means that every year, the pension account should have enough money to cover all of the benefits earned that same year. Over time, relying on investment returns alone isn’t sufficient to cover payouts so employer contributions are required.

The pre-funded nature of the defined benefit pension systems is in contrast with the Social Security system, which is not required to be pre-funded. In the latter system the government collects tax dollars from the working population and uses the money to pay for retiree benefits, rather than maintaining sufficient funds to pay for retiree benefits in a given year. The young pay for the old on the condition that the generation behind them will do the same.

But in defined benefit pension systems, when employers don’t pay 100 percent of their annual required contributions and/or investments don’t generate their hoped-for returns, the pre-funding mechanism fails and unfunded liabilities are created.

Importantly, pension funds are only really pre-funded if the actuarial assumptions that guide annual contribution determinations pan out. So if pension fund actuaries underestimate the rate of return on investments, or the number of employees retiring in a given year, or the average retiree’s life expectancy, unfunded liabilities result.

Most pension systems in America have unfunded liabilities, either from under funding their system, or from relying on overly optimistic actuarial assumptions. Therefore, in addition to the annual cost to pre-fund pension liabilities, actuaries determine a schedule for paying off the unfunded liability (which is technically pension debt), and governments add a debt payment to their normal annual contribution. More on this below.

Why Is the Rate of Return on Investment a Critical Factor?

The rate of return has a huge effect on how much money the pension fund earns. If an employer estimates its pension fund’s assets will earn a 7.5% return but they only yield a 3% return, the pension fund will have less money than anticipated, but still has to pay the same amount of benefits. The difference between those two figures is an unfunded liability.

In the perfect world scenario above we assumed the City of Odyssey achieved its estimated investment return of 7.5%. But what if the average return is only 3%? Then the City will only have around $51 million in assets at the end of the 25 year time period, and the difference would be a $49 million unfunded liability.

What Happens When Pension Funds Fall Short?

In general, pensions are guaranteed, at least from a political perspective. This means that even if a pension fund doesn’t have enough assets to pay all of its pension benefits, those benefits still have to be paid and the fund goes into debt. So who is stuck footing the bill for public sector unfunded liabilities? Taxpayers.

There are many ways a pension fund might fall short of the money for promised benefits. Investment assumptions could be overly optimistic. People could live longer than expected. Or a government could fail to pay its total annual contribution to the pension fund.

Actuaries can determine whether a pension fund is in debt well before it runs out of money by adding up the total amount of assets in a pension fund and comparing it to the total amount of pension benefits promised. Because pension systems are supposed to be “pre-funded” these numbers should be equal. If the assets are lower than the promised benefits then the system has unfunded liabilities.

Governments pay for these unfunded liabilities-i.e. debt-by siphoning money that could otherwise be spent on other services, or used to fund lower taxes. Each year actuaries determine a payment schedule to get rid of the debt and if a government is being responsible it pays at least the minimum amount of this amortized debt payment.

How Pensions Work in the Real World

In our perfect world example, the City of Odyssey lucked out. Its actuarial assumptions about life expectancies and retirement dates were on point, its optimistic assumptions about investment returns came to fruition, it made its required annual contributions, and it was able to fully fund its pension obligations.

But in the real world, public pensions don’t often function so well and politics play a big role in that. If the City of Odyssey were like many cities, counties, and states across America, the decision for how to manage pensions would not just be a fiscal decision; it would be a political one.

Politicians are faced with choices like whether to use scarce taxpayer resources to build additional school buildings or pay off pension debt; to fix an aging bridge, or pay the full annual cost of pre-funding pension benefits. In a practice known as “crowding out,” politicians often decide that putting less than the required annual contribution into the asset pool for pensions is a worthwhile trade off for funding some other public good.

And those required contributions are based on the assumed investment rate of return-the higher the expected rate, the lower the required annual payment. If the assumed rate is wrong then future taxpayers will be forced to cover the cost. In the meantime, politicians are incentivized to assume high rates of return to free up money now, as they won’t be around to deal with the consequences of the problem years later.

In practice, the most frequent failing is government not paying the annual amount the actuaries say they should, and instead spending that money on other things. Sometimes governments instead assume too high returns on investment. Sometimes they do both. And sometimes they do this over many years, so that a serious problem is allowed to develop.

Let’s apply some of these pension realities to the City of Odyssey and see what could happen.

In 1989 the City began making its full annual contributions but after 15 years, in 2005, it decided to pay just 75% of its pension payment, or $750,000. Since then it has made all of its other payments, but that one-year of underfunding created more than $500,000 in unfunded liabilities. That’s because the actuaries had assumed that the missing $250,000 would have earned 7.5% in interest in each subsequent year. In the absence of that additional $250,000 investment, those assets were not available when it came time to pay out pension benefits.

The City of Odyssey also saw its unfunded liability increase because investment returns did not meet the average assumed rate of 7.5%. The financial crisis caused major losses for the City’s pension assets invested in the stock market, and the fall in land prices also hurt returns. After the crisis, there were some years where returns were in double digits, and other years where returns were less than 2%. On average the City only earned a 4.5% return over the 25 years that our group of employees was working for the City. Instead of the $100 million the City needs to pay the promised pension benefits from 2014 onwards, their pension fund has only $63.4 million.

In other words, because of overly optimistic investment return assumptions and failure to make its full annual contribution just one year, the City of Odyssey faces $36.6 million in total unfunded pension liabilities. But the promised benefits still have to be paid, and the money to do so has to come from somewhere. This spells bad news for the citizens and taxpayers of Odyssey.

How Big is the Pension Problem?

The scenario we created for the City of Odyssey is not pure fantasy. In our actual real world, the collective 50 states have reported $520 billion in unfunded liabilities, according to fiscal year 2013 reports. However, this may be an understatement of the problem. Using different assumed rates of return, research groups and economists have estimated the states’ combined unfunded liability at anywhere from $1 trillion to $5 trillion.

What’s Next?

Now that you have a basic framework for how pensions work, the factors that impact pensions, and the size of the problem, we invite you to explore pension issues-and concrete, proven solutions-in more depth. Reason Foundation offers a variety of resources online, including case studies that look at reform efforts in various jurisdictions, commentaries that apply this understanding of pensions to breaking news stories, research papers that cast new light on the depth of the pension problem and the efficacy of proposed solutions, and monthly newsletters that keep readers up-to-date with the latest developments and the sharpest thinking in public employee pension reform. Lawmakers and officials seeking Reason’s help should contact our pension reform help desk at pensionhelpdesk@reason.org.