Without Pension Reform, Retirees Lose
My mother, who recently passed away, spent the last seven years of her life in assisted living facilities. Such care is quite expensive, but fortunately she had a generous Maryland state pension from her many years as a teacher and guidance counselor. Although current teachers and other government employees in many states have been promised similarly generous pension benefits, many of them won’t be so lucky.
The cold, hard accounting tells us that some will face financial hardship when their government employers are unable to pay what’s been promised. The sooner states act on pension reform, the fewer promises will be broken.
Most state pension plans, including Maryland’s, have large unfunded liabilities. State governments have not been contributing enough each year to cover the cost of benefits owed to workers later on in retirement (given reasonable expectations of what the money invested by their pension funds will earn between now and then). In 2015, total unfunded liabilities of state pension plans were approximately $5.3 trillion, equal to about 35 percent of Americans’ collective annual personal income.
Some states have been closing the gap between assets and liabilities, but others have not. Between 2014 and 2016, the shortfall increased in 27 states, with the increased gap averaging 3 percent of state government worker payroll. This increase in unfunded liabilities makes it even harder to pay promised benefits in the future.
States with increasing unfunded liabilities could eventually find their reserves fully depleted. At that point, they would have to pay benefits out of current tax revenues. John D. McGinnis, a member of the Pennsylvania General Assembly, estimated that it would take more than 50 percent of his state’s annual budget to pay all pension benefits owed in 2032. Although most other states have smaller unfunded liabilities than Pennsylvania, having to balance a shortfall by cutting state spending by even one-third would be a devastating blow.
Even states with better funded plans have a long way to go. Taxpayers are on the hook for an average of $7,601 per citizen in the state with the best funded pensions (Tennessee) and $45,689 in the state with the worst funded pensions (Alaska).
In many states, it is simply unrealistic to expect taxpayers to close the gap between retirement assets and liabilities on their own. Short of draconian cuts to state services like education, it would require a large tax increase. Neither option is politically feasible most of the time in most states.
That leaves another option that, while also easier said than done, is necessary: lasting state pension reform.
Ideally, reform should not keep states from providing the benefits they have already promised to current workers and retirees. A few states have taken the approach of reducing benefits only for workers hired after a certain date. Unfortunately, continuing to promise the same benefits to all existing workers for each year they work until they retire will not reduce costs enough to save most plans.
Take Pennsylvania, which recently reformed its pensions to create a hybrid plan for newly hired workers without reducing its promises to existing workers. This is expected to save taxpayers between $8 and $20 billion dollars, but that is much less than the state’s unfunded liabilities of over $200 billion.
Much more progress could be made if states substantially reduce the amount of benefits promised for all future work, as opposed to just reducing benefits for workers hired in the future.
An even better approach would be to switch to private-sector-style defined contribution plans for work performed after a certain date. Employers and employees each contribute a specified amount to an investment plan and the proceeds belong to the employee. Gone is the incentive for governments to exaggerate future investment returns to make today’s numbers look better. Today, many states compound the problem by doing just that.
While future retirees will probably receive less than past retirees (with or without pension reform), well-designed reform can also increase generational equity. Taxpayers and workers can set aside sufficient money now for future retirees, rather than passing those costs along to future generations. The status quo, meanwhile, risks serious inequity between employees who are near retirement and those who retire after a future crisis forces benefit cuts.
In truth, it may already be too late to save some of the most underfunded state pension plans from eventual default. For the rest, timing matters. Every year we delay reform increases the burden future taxpayers will have to bear. And since many of those future taxpayers will not accept steep tax hikes, delay also increases the likelihood of default.
Such a crisis would be tragic for retirees like my mother, who depended on pension benefits to pay their living expenses. The more underfunded a plan is now, the more important it is that the state provide more in funding each year and make more realistic promises.
Tracy C. Miller is a senior policy research editor with the Mercatus Center at George Mason University.