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Rethinking the Public-Pension Punching Bag

Mention pensions and—until recently—most people pictured a secure income in old age, possibly including happy thoughts of leisurely trips and visits from grandchildren. Assuming they were lucky enough to have a pension, their eyes would glaze over if the conversation steered toward years-of-service formulas, funding ratios, and other aspects of the arcane and obtuse inner workings of pension funds.

No more. The deteriorating condition of many state and local government pension funds has grown into an impassioned topic for cable talk shows. The financial meltdown and economic downturn have made obvious what many experts long knew: Too many state and local governments routinely underfunded their pension plans while the future cost of their retirement payout promises swelled.

Take Illinois, which has funded only 54 percent of its public pension liability, according to the Pew Center on the States. This financing gap translates into a $54.4 billion bill that is more than three times as large as the payroll for current workers participating in the state's pension program. The generosity of many public pensions is an incendiary topic, with taxpayers potentially on the hook for billions and billions in unfunded promises. "These are structural issues and not just a reflection of where we are at in the economic cycle," says Joshua Rauh, economist at the Kellogg School of Management at Northwestern University. Adds Robert Clark, economist at the Poole College of Management at North Carolina State University: "The next decade will be one of fundamental reform in public sector pensions."

Reforming won't be easy. The harsh fiscal reality is that in most cases, public pension obligations in states and cities can't be changed for existing workers. Those workers will continue to earn their promised pension benefits throughout their government career, although a number of state governments are trying to tinker at the margin, such as by changing cost-of-living payments. Municipalities in Chapter 9 bankruptcy can renegotiate pensions. (In sharp contrast, companies can freeze promised benefits to-date for their workforce, then modify the plan's future returns). As a consequence, public pension reform will mostly affect new hires. In the current political discussion, it is said that if the 401(k) is good enough for private sector workers, it must be fine for the public sector.

Why Go to "the Lowest Common Denominator?"

Yet three decades after the 401(k) was launched, its own drawbacks are becoming increasingly apparent. "There is certainly 'pension envy' and the answer is, 'let's go to the lowest common denominator,'" says Alicia Munnell, director of the Center for Retirement Research at Boston College. "That doesn't make sense."

Indeed, the heated rhetoric is obscuring the fact that pressure for change offers a real chance at designing a better 401(k)-type pension. Pension experts agree that unlike the current generation of private-sector 401(k)s, public-sector plans should feature a very limited menu of broad, low-fee investment options; mandatory worker participation; a required employer match; and low-cost inflation-hedged annuity options to guarantee a fixed income in retirement. It's an approach the private sector may eventually want to emulate.

"I have grown increasingly frustrated that this is boiling down to a debate of taxpayers versus government workers," says Jeffrey Brown, professor of finance at the College of Business at the University of Illinois at Urbana-Champaign. "The public pensions are ripe for reform and it's a real opportunity for everyone."

A majority of government employees are covered by "defined-benefit" pension plans. To most of us, these are the blue-chip pensions from days past, by which the employer bears all the investment risk and commits to a fixed payout of money based on a salary-and-years-of-service formula. Many more private-sector employers used to offer defined-benefit plans, but they are costly to run and carry onerous obligations toward retirees.

The Age of Defined-Contribution Plans

Companies ended up embracing comparatively cheaper defined-contribution plans, especially the 401(k). In these, employees decide how much money to invest and where to invest it, depending on the limits established by law and the choices offered by the employer. The company might kick in a matching contribution, but employees bear all the investment risk. For instance, according to a June 2010 survey by consultants Tower Watson, 58 of the 100 largest American companies offered new employees only a defined-contribution pension—vs. 10 in 1998—while only 17 of the companies surveyed had a defined-benefit plan, down from 67 in 1998.

To be sure, most public employees have the option of participating in a defined-contribution plan at work, usually as a supplement to the core defined-benefit pension. The 401(k) is the bedrock savings plan in the private sector. Increasingly it's the only option available.

It is now becoming apparent that the future tab for state and local defined-benefit pension plans is even bigger than expected. On average, most public plans assume that they'll earn 7 percent to 8.5 percent on their investments. Yet finance economists argue convincingly that a more realistic range for such a fixed obligation might be 3 percent to 5 percent. The lower number swells the amount state and local governments might have to kick in to pay retirees. For example, assuming that all state pension liabilities were frozen as of June 2009, Northwestern's Rauh and Robert Novy-Marx of the Simon School of Business at the University of Rochester estimate that unfunded liabilities swell to $3 trillion at a more conservative rate—almost double the $1.8 trillion shortfall under standard public-pension practice. "It isn't a viable funding model," says Olivia Mitchell, an economist at the University of Pennsylvania's Wharton School.

One complication of just replacing pensions with 401(k)-type plans for new government employees is that many state and local workers aren't part of Social Security. They weren't included when Social Security was created in 1935; while growing numbers have been brought into the system, about a third still don't participate. "If you have Social Security, you have a floor, and the private sector would have had a much more difficult time making the shift from defined benefit to defined contribution without Social Security," says Rauh. "If the only thing workers have is a 401(k) plan, they have a great deal of risk."

Social Security or Deep Cuts?

The solution seems to be either to bring all new state and local workers into Social Security or keep public defined-benefit plans for those workers, dramatically slashing the payout until it essentially mirrors the income-replacement ratios of Social Security.

With a base consisting of Social Security or a truncated, fully funded pension plan, the 401(k)-like portion could be modeled after the federal government's Thrift Savings Plan. This is a voluntary 401(k)-type plan open to all federal employees. Fees are a razor-thin.028 percent—28 cents per $1,000 of investment. However, any state and local government version would have to mandate both employee participation and an employer contribution.

Another widely admired model could be TIAA-CREF for higher education, which similarly offers a limited number of broad-based investment options and low fees. Employees are automatically placed in the plan with mandatory contributions from employer and employee. Perhaps most important, the TIAA portion of the plan offers savers the option of easily transforming some or all of their money into a low-cost guaranteed annuity with a 3 percent minimum annual interest rate. Building into the plan the option of an annuity-like product with a strong inflation hedge could well combine the best of defined contribution and defined benefit plans, says Zvi Bodie, finance economist at Boston University School of Management.

Right now, the prospects for a reasoned overhaul of public pensions seems remote. There is almost a pension panic sweeping state houses and municipal headquarters, hardly an environment conducive to reform. Yet public officials have an opportunity to create a better retirement savings plan that might spark a different kind of pension envy. If this were done right, it could inspire the private sector to follow the public sector's lead.

Farrell is contributing economics editor for Bloomberg Businessweek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace.

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