Unfunded Liabilities of Public Pensions, A Red Herring

Rarely have so many people believed as an article of faith something so fervently that wasn�t true: unfunded liabilities of public pensions are speeding us toward fiscal Armageddon. Unless something drastic is done very soon, we taxpayers will have to bailout overly generous, fiscally irresponsible public employee pension systems. A class war is looming, according to one New York Times columnist, between taxpayers and the beneficiaries of these systems.

But ask most people who believe this what an unfunded liability is and they�re not exactly sure. They only know that it is bad, very bad, and threatening to them.

To understand what an unfunded liability is, it is necessary to look at how most pensions used to be funded, on pay-as-you-go bases. That meant that as contributions from employers and employees came in, they were paid out to retirees. It worked for government pension funds because you could assume that they would always be around with workforces to make contributions, unless one believed in the arch libertarian fantasy of total privatization, a government without government employees.

Without going to those extremes, one could reasonably believe that one day there might be fewer employees supporting more retirees and the fiscal balance would be upset. That possibility plus the reality that private corporations with pension funds might go bankrupt stimulated the call for prefunding of pensions. With a fully pay-as-you-go system, if contributions stop, as when a company goes out of business, pension payments have to stop too and current workers receive nothing for their contributions.

The whole idea of prefunding is to build up enough of a reserve in pension funds so that should contributions stop, there will be enough to keep paying pensions for the rest of retirees� lives and pay off current workers for what they have contributed. That is a good prudent fiscally conservative goal. Any pension fund can be so measured according to how close it has come to achieving it.

Some public pension funds are fully funded, others overfunded�yes, overfunded�and others underfunded, the ones that selectively receive all the press attention and ire. I�m still waiting to see a newspaper article about the many public pension funds that are in very good shape despite the recession.

Being underfunded in itself is not a problem so long as enough contributions are coming in to meet current�as opposed to all current and future�obligations. There is no need to reform the balance between revenues and expenses if there is progress toward full funding.

Even if progress is stalled or going in the other direction, there may be no fiscal need for reform if the condition is temporary, as when a recession decreases revenues from pension fund investments�what is currently beleaguering many public as well as private pension funds.

Reforms are only needed for those pension funds whose balances of unfunded liabilities are growing on a long term basis. In the worst of those cases, slight changes in contribution rates deliver dramatic revenue increases. Such abuses as spiking�the artificial driving up of final salaries with overtime and other means to increase benefits�can and should be eliminated. Employer underfunding by skipping contributions that are not made up can be reduced or eliminated. Early retirement incentive programs that offer workers unearned pension credits can be eliminated.

The real aim of the enemies of public pensions, though, is not prudent stewardship of the funds. It is to eliminate them entirely and replace them with 401(k)s.

Public as well as private pension funds can have unfunded liabilities because their benefits are guaranteed. That requires that they be funded properly. Because 401(k)s have no guaranteed benefits, by definition they have no liabilities, funded or unfunded. Their sponsors are thus completely absolved of any responsibility for proper funding.

If a state skips payments to a public pension fund as a means of making up for revenue shortfalls during recessions, that will come back to haunt it in the form of an increased unfunded liability which must be addressed when the economy improves. If an employer skips payments to a 401(k), it can be done without fear of having to face any future reckoning. All future consequences will be borne by workers at retirement.

It is curious that when 401(k)s began in 1981, they were sold on a promise�but with no guarantees�that they would deliver greater benefits than traditional pensions. Now that that claim has been exposed to be false, the argument has shifted to traditional pensions are too expensive. To sustain the new claim, the proponents of 401(k)s have exaggerated the fiscal problems of public pensions�to manufacture the perception of imminent crises where none exist�and attempted to whip up resentment against those who still have secure pension plans.

It is a manufactured crisis that diverts attention from the real crisis: American retirement security is declining rapidly precisely because 401(k)s have increasingly replaced secure, fiscally sound for the most part, traditional pensions.

–James W. Russell

One Response to Unfunded Liabilities of Public Pensions, A Red Herring

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