Why most state and municipal pension plans are underfunded and why that could lead to higher taxes and reduced government services. Why participants in state government retirement systems have greater protection against benefit cuts than participants in municipal retirement systems.
In this episode you’ll learn:
- How defined benefit plans work.
- Why there is more subjectivity regarding valuing a pension plan’s liabilities compared with its assets.
- What does it mean for a pension plan to be underfunded, and why are so many public sector pension plans in that situation.
- Under what circumstances can a pension plan cut benefits to beneficiaries.
- Why underfunded pension plans will most likely lead to higher taxes and reduced government services.
Public sector pension plans are offered to individuals who have worked the number of years required for the defined-benefit-style offering by local and state governments in the U.S. While it is comforting for beneficiaries to have their public sector pension plan worry about market risk, inflation risk and longevity risk, there is a crisis emerging that should require participants to keep a close watch. In this episode, David explains how to evaluate the default risk of defined-benefit plans, why the public pension plan crisis is becoming so severe, and how listeners can best educate themselves for wise decision-making.
How the value of public pension plans is calculated affects the projected rate of return
Pension plans are composed of the plan’s assets and the liability involved. Generally, the assets include stocks, bonds, cash and other assets. The value of those assets is easily calculated by referencing the current market value of the assets in consideration. The liability, however, is more difficult to calculate, since it is the current value of future benefits. What discount rate should be applied by public pension plans to the future benefits? How should they translate that future value into today’s dollars? Most public sector pension plans use the expected rate of return on the assets. Currently, the median rate used is 7.25%, which is high given the low yield on bonds.
If the market value and the liability are equal, then the plan is fully funded. If there is a shortfall, however, the liability is underfunded. The higher the discount rate (the assumption of the future rate of return), the lower the liability is. While participants don’t have to worry about the risk that the assets carry, they do have to consider the default risk. How likely is it that the plan will be funded enough to actually fulfill future obligations to beneficiaries. Is there a risk that their pension will be cut? While many public sector pension plans are verbally optimistic about the future health of their plans, the average funding level of most plans is only 69%.
Failing to meet the need upfront leads to future crisis
How did the crisis of grossly underfunded defined-benefit plans happen? David explains that it took a long time to create the current mess of things. The root cause lies in governments’ decisions to not pay upfront the cost of the liabilities. While they continued to offer increasingly valuable pensions, they continued to not meet the upfront financial need—causing a horrendous game of catch-up that is not easily won. As interest rates fall, the expectations regarding rates of return fall as well, increasing the size of the liabilities and the level of underfunding. Lower rates of return increase the gap between what is owed to participants in the plan and what is actually funded, making the crisis even harder to overcome.
Be sure to listen to the episode for David’s example of Kentucky’s public sector pension plan. The state in the worst shape funding-wise, their plan is only 13% funded. The proposed solution will take an estimated 30 years to resolve the crisis. Not all states, however, have such daunting challenges to overcome. Those that planned ahead and consistently paid upfront for their pension plans were able to survive the recession with much less hiccup. Those who put in the amount needed to fund the liability based upon the performance of the assets have nothing to worry about if they consistently keep up their funding practices.
The potential impact of short-falls in the public sector pension plans
Solving the crisis is made more difficult by the fact that most states cannot cut pension plan benefits, and they cannot go bankrupt. Cities are allowed bankruptcy, but states are tied to their initial obligations, with very few allowances.
David explains that even if you do not plan on participating in a public sector pension plan, the current crisis will affect you. Because states are so bound in the types of solutions they have available, higher taxes are a probable segue to funding for defined-benefit pension plans. Reorganization of services and cutting of future pension plan benefits are also solutions. In some local governments, the pension plans have had to rely on outside funding in order to survive. Some governments have even cut staffing in order to avoid raising taxes.
Being involved now can save defined-benefit participants heartache later on
David shares tactics for calculating what types of investments could be affected by the public pension crisis, including municipal bonds. Considering the public finances of where you live or are thinking about living and pursuing a career are also ways to become involved in the crisis management and prevention.
The private sector is not unaffected, either. Be sure to research whether or not your employer’s employee pension plan is part of a multi-employer pension plan or a single-employer plan. Statistics show that multi-employer plans are more likely to suffer cuts and underfunding than single-employer plans.
David encourages listeners to become involved in educating themselves on the state of their defined-benefit plans—public or private. Join the pension committee for your plan, if possible. Research and understand how your state and city determine the rate of return on their assets and liability. Taking the time to obtain the knowledge just might save your retirement.
- [0:18] The crisis of underfunded defined-benefit state and city pension plans.
- [2:32] Calculating the financial value of a public pension plan.
- [4:46] What rate of return should public pension plans use?
- [8:44] Why public pension plans are highly underfunded.
- [11:34] Kentucky’s 13%-funded pension plan raises red flags.
- [13:37] Failing to meet the needs upfront causes a funding crisis down the road.
- [15:33] Why states cannot go bankrupt but cities can.
- [17:52] How do public sector pension plans affect tax-payers?
- [20:18] How states and cities are trying to solve the crisis.
- [21:45] Considering underfunding when deciding what to invest in or where to live.
- [24:09] How private-sector pension plans could possibly affect tax-payers.
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host David Stein. Today is episode 269. It’s titled, “How the Public Pension Crisis Will Impact You.”
A pension scenario
Last week I mentioned a member of Money for the Rest of Us Plus who’s retiring and has the opportunity to purchase into the Nevada State Public Employment Retirement System. She can pay $86,000 and will then receive an additional $550 per month for the rest of her life.
We looked at the economics of the transaction, given her life expectancy of 24.6 years. That income stream, that $550 per month for the next 24.6 years, if she pays $86,000 for that, that equates to a 5.8% internal rate of return. That’s a pretty good return.
What we then have to evaluate is the default risk. What is the likelihood of the Nevada Public Retirement System and the state of Nevada defaulting on that obligation? Could her benefits be cut?
In today’s episode, we’re going to take a closer look at that particular public retirement system, as well as all public retirement systems, because there’s a crisis going on. Most of the state and county and city retirement systems, defined-benefit pension plans are underfunded.
What is a pension plan?
The American Academy of Actuaries points out that pensions are a form of deferred compensation. Participants essentially trade compensation today for future benefits. And just like with this Plus member, this particular defined-benefit plan would offer her fixed lifetime income, assuming she qualified, in other words, had worked a sufficient number of years to do so, and in this case, she did. And now she has the opportunity to actually to purchase additional benefits.
But that’s how a defined-benefit plan works. You work a certain number of years to get vested. And then the longer you work, you get vested in a higher potential retirement amount. And when you retire then you get this fixed lifetime income.
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