In Search of State Pension Reform

Recently, the public debt crisis in Puerto Rico has sparked widespread discussion about the need for public pension reform. The island territory is already $72 billion in debt, with shortfalls in the public pension fund of up to $30 billion. Without major changes in government spending patterns, Puerto Rico is in danger of becoming insolvent, sending the already brittle economy into a death spiral. While many on the left call for the immediate restructuring of Puerto Rico’s debt, the island’s plight is just the latest example of a state or territory misusing and abusing their public pension system, demonstrating the dire need for reform.

The debt crisis in Puerto Rico follows a long line of states and localities tearing away at their public pension system by overcommitting and underfunding. For years now, liberal cities and states have been expanding benefits included in public pensions, yet never seem to address how these new benefits will be funded. As a result, many high profile bankruptcies have been declared due to irresponsible pension expansion. In California, retroactive benefit increases forced the cities of Stockton and San Bernardino to declare bankruptcy. Similarly, in Illinois, the public pension fund hasn’t been properly funded for years, as many fear another high-profile default in Chicago. Finally, in the country’s largest case of bankruptcy, the city of Detroit has long struggled with funding its pension liabilities, though some of these pensions are particularly generous given the city’s financial state. Indeed, Puerto Rico is just another example of a financial epidemic sweeping the nation.

There are a number of reasons why these public pensions are so regularly underfunded, all of which can be reformed to encourage fiscal responsibility. One such reason is the method through which state governments calculate their liabilities. Since these pension funds are measured in the long run, states are often allowed to pay less than the total liability in the beginning, with expectations that increases in the bond market will increase the available money in these funds and cover the rest of the liabilities. However, this process of “discounting” pension payments isn’t always tied to the rate of return on safe, long-run investments, like treasury bonds. Instead, some states say they expect returns of around, for example, 8 percent of their investments, even when long-term bonds often only produce return rates of around 3 percent. As many states have guaranteed that their pension promises will be met, states should be using the 3 percent figure to calculate how much they can avoid paying up front; however, by using the 8 percent figure to avoid more payments, states are mishandling pension funds and misinforming taxpayers about how their tax dollars are being spent.

Another problem facing many state pension systems is the type of pension promised to their public employees. For years, states have predominantly been offering “defined-benefit” pensions, which determine a set-level of benefits to be paid to the retiree, no matter the changes in costs imposed on the state by future adjustments. This is in contrast to “defined-contribution” pensions, which have become the typical model in the private sector. These defined-contribution pensions, like a 401(K), set a consistent level of contributions that an employer can make, rather than guaranteeing a consistent level of benefits. This 401(K) model expects employees to contribute to their pension fund, but also gives them more freedom in retiring, as the pension plans can be transferred to accommodate career changes. Defined-contribution plans are a significantly better pension option than defined-benefit plans, as they save the state much more money on liability funding while also benefiting the employees with more mobility and opportunities to invest as they see fit.

Considering these two problems are some of the primary reasons why pension funds are in danger across the nation, there is much that can be done for states to reform their pension system and prevent debt crises like that facing Puerto Rico. States can take on more fiscal responsibility by being clear and transparent in the rates of return they are realistically expecting on their pension funds, preventing these governments from short-changing the taxpayers. Furthermore, states can begin to switch out their defined-benefit plans for defined-contribution plans for new public employees. This would save the states money and offer more freedom to employees in handling their investments.

In fact, many states are already making the change to adopt defined-contribution pensions. For example, in 2011, Utah adopted a hybrid system of pension plans, allowing employees to choose a defined-contribution plan with a guaranteed 10% contribution by the state. More recently, Oklahoma completely revitalized its pension system in 2014 by making all public pensions for new employees follow the defined-contribution model. This change allows the state to address the $11 billion in previously unfunded liabilities, guaranteeing more fiscal security for the state.

More and more states have begun adopting these hybrid and defined-contribution plans, so the pressure is on for the rest of the states to reform their pension systems. Such reforms can mitigate any looming debt crises, as that currently facing Puerto Rico, with more fiscal responsibility, as well as benefit public employees with more workplace freedom and opportunity for growth.

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