Private employers have been steadily reducing traditional pension coverage for their workers. In 2013, only 18% of private workers were covered by a pension, down from 38% in 1980. These “defined benefit plans” (the payments into the plan are not specified but the pension benefit payments are guaranteed and determined by a specific formula that considers years of service, salary and age) have largely been replaced by “defined contribution” plans (the payments into the plan, by both the employee and employer, are determined by a specific formula but the eventual value of the plan is dependent on how the individual’s account is invested).
Public workers (employees of states, cities and other jurisdictions), however, are still by and large covered by pension plans, with 78% enjoying the benefit. This is great for the employees but the financial status of these plans is a growing concern.
A recent report by the Pew Charitable Trusts found that state pension systems had a $968 billion shortfall in 2013 between projected benefits and the funding available to meet those obligations. (The report acknowledges that strong stock market returns in 2014 helped reduce this shortfall, but stock markets have been slightly negative in 2015 and over-reliance on positive investment results has been a big contributor to the shortfall over time.) When local pension systems are included, the shortfall exceeds $1 trillion.
Plans use economic and demographic assumptions to estimate the expected cost of benefits earned for the current year, and the required contribution includes this amount and an amount to reduce some of the accumulated funding shortfall. In 2013, state pension contributions totaled $74 billion, but this was $18 billion short of the required contribution total. Only 24 states made at least 95% of their self-determined requirement in 2013 (kudos to Vermont, Missouri and Indiana for making contributions far in excess of the requirement) while 16 states made less than 80% of the requirement (New Jersey winds the booby prize at only 47% of the requirement)
The worst overall funding levels are Illinois (only 39% of projected liabilities) and Kentucky (44%). Despite the economic recovery only 21 states improved their funding status from 2011 to 2013 (34 states actually fell further behind and the others were flat). On average, these state pension plans are only 74% funded.
(Arizona has contributed 100% of its requirement from 2003 to 2013 and its overall funding level in 2013 was 72%; estimates show this funding level going over 81% in 2014.)
States can improve their plans’ status by adopting steady, level payments rather than allowing payments to fluctuate or deferring larger payments to future years. New accounting standards beginning with reporting for 2014 will make it easier to evaluate the plan’s fiscal health as well the ability of funding policies to reduce pension debt. The plans will have to clearly report the cost of new benefits earned that year by employees and to disclose investment returns under consistent guidelines. Unfunded pension liabilities must be included on government balance sheets.
There are a number of reasons public pensions have gotten themselves into this mess. Benefits formulas were changed to increase payments during the heydays of the 1990’s. Contributions to pension plans have often been cut during times of budgetary crisis. And most states have some provisions that expressly prevent the reduction of benefits that participants expected at the time of employment. Seven states (including Arizona) have constitutional guarantees that the benefit cannot be taken away and many others protect benefits under the contract clause of the US constitution. That leaves the only options for most public pension plans to either change pension benefits for new employees or cost-of-living adjustments, neither of which can fully address the shortfalls.
Private employer pension plans operate under much different regulations. The Employee Retirement Income Security Act of 1974 (ERISA) protects accrued benefits but allows employers to change pension terms going forward. ERISA also created the Pension Benefit Guaranty Corporation (PBGC), a government entity that insures private pension plans. PBGC is funded by per-participant premiums from the pension plans. It requires that plans use interest rate assumptions that reflect current rates and it also requires pension plans to send participants annual statements on the plan’s funding status. Perhaps most significantly, if a pension plan becomes insolvent and PBGC must step in to make pension payments, individual benefits are capped at $60,136 a year. (The maximum benefit is far less, at $12,870, for multi-employer pension plans established through collective bargaining by unions.)
But things aren’t so great in PBGC land either. Since 1974, PBGC has assumed responsibility for over 4,700 failed plans covering more than 2 million individuals. As of 2014, PBGC’s unfunded liabilities (that is, its projected payments for plans that are insolvent or expected to become insolvent in excess of its assets) were $61.8 billion, up sharply from $35.6 billion in 2013. The federal budget compromise in 2013 sharply increased the premiums plans pay to PBGC over the next several years, but this may accelerate the trend of healthy plans eliminating any further pension risk by offering participants a lump sum payout or purchasing an annuity from an insurance company to make payments.
A traditional pension is unquestionably a great benefit for employees and a valuable supplement to retirement. Hopefully, both private and public pension plans will be fiscally responsible so all taxpayers don’t find themselves on the hook to support those benefits.