Daniel Sutter: The perils of pensions and prosperity
During the city of Detroit’s bankruptcy, the state-appointed administrator sought to cut pension payments for thousands of retired city workers in violation of Michigan’s state constitution. City retirees eventually accepted a 4.5 percent cut in benefits, in part to prevent possibly larger cuts. Many private sector pensions are also shaky; the Federal pension insurance agency is currently assisting a record number of multi-employer plans. Pensions are complex contracts, on which employers can try to take advantage of workers. Timing presents a challenge for pensions: employees work before receiving a pension. Markets involve voluntary exchange to mutual benefit. But when one party must act first, the second can always refuse to perform as promised. In a simple deal like, “I’ll scratch your back if you scratch mine first,” I could fail to return the favor. Reneging on a promise converts an exchange into a one-sided rip-off. Complex business arrangements enable prosperity. We will likely do business only with people we trust, like close family and friends, if we cannot contract successfully with strangers. But you cannot run a national or global business with only trusted associates. Fortunately, many solutions for tough contracting problems now exist. For instance, you and I might take short turns scratching each other’s back. A pension, however, must be paid after workers finish working. The problem is worst for defined benefit pension plans, where the plan accumulates contributions to pay benefits according to a formula. If the plan is underfunded and cannot pay the promised benefits, a worker cannot take back her years of work. The danger is not as pronounced for defined contribution plans, because workers will see on their quarterly statements if contributions are not being made and then can look for a new job. Government employers can also renege on pension promises. Indeed, the problem may be worse because our elected representatives cannot force future representatives to appropriate funds to the pension in say 2025. Tax dollars that should go to the pension can be spent on other services. States have taken a variety of measures to protect public sector pensions. A new study from the Center for Retirement Research at Boston College examines how such measures affected public sector pension reforms since the 2008 recession. Several states protect promised benefits for current workers in the state constitution, while two states offer no legal protections. The remaining states (including Alabama) rely on contracts affording workers some legal protection. Have stronger measures better protected promises? The answer is yes for state constitutional protection. Furthermore, fewer states have either reduced benefits or increased contributions for current employees than they have for new employees. For example, 60 percent of state pensions increased the years of service to retire for new employees, versus only 4 percent for current employees. This is significant because only current workers or current retirees have truly been promised pension benefits; reducing benefits for workers not yet hired does not renege on a promise. Reneging on promises others rely on is never good, but some context can help us understand why this occurs. Illinois has perhaps the nation’s worst-funded state pension plan, thanks in part to the “Edgar ramp” plan. Illinois’ state pension was already in bad shape in 1994 when Governor James Edgar and the legislature agreed on a schedule involving fifteen years of modest contributions followed by steeply escalating payments. Meeting scheduled contributions in 2016 would have required over one quarter of Illinois’ general fund tax revenues. Any Illinois state legislator or voter under age forty today was not eligible to vote when the Edgar ramp was adopted. We can understand why they might balk at slashing spending for schools or prisons or raising taxes to honor a promise which they did not make. We do not live in a world where everyone’s word is their bond. Underfunded employer pensions result in part from a timing dilemma plaguing many types of exchanges. Fortunately, legal and constitutional guarantees for public employee pensions have limited politicians’ reneging on their promises. ••• Daniel Sutter is the Charles G. Koch Professor of Economics with the Manuel H. Johnson Center for Political Economy at Troy University and host of Econversations on TrojanVision. The opinions expressed in this column are the author’s and do not necessarily reflect the views of Troy University.
Alabama state pension fund paying $370,000 in bonuses
Alabama’s state pension fund is paying a total of $370,000 in incentive bonuses to 14 employees. The bonuses were approved this month by board directors for the 2015 fiscal year. The head of the Retirement Systems of Alabama, David Bronner, says the bonuses help him keep strong employees in a competitive profession. The pension system earned a 1 percent return on its $32 billion in investments for the year that ended Sept. 30. That’s below its long-range target of 8 percent. But Bronner says the bonuses are based on performance relative to the markets, not the overall target. State Treasurer Young Boozer says the incentive program is “fair and reasonable.” A legislative committee is studying the state pension system and might recommend changes in 2016. Republished with permission of the Associated Press.
Daniel Sutter: Mickey Mantle, pensions and safety nets
Employer-provided pensions across the U.S. are changing. The old standard, the defined benefit plan, is rapidly disappearing. I suspect that this change will have significant consequences. Pensions typically take one of two forms, defined benefit and defined contributions. A defined benefit plan guarantees annual payouts in retirement, typically based on earnings and years worked, and employer contributions plus returns on investments pay these benefits. Under a defined contributions plan, employers contribute a specified amount to an employee account, and the accumulated contributions plus investment returns, however much this happens to be, is the employee’s retirement. The proportion of salaried, private sector employees covered by defined benefit plans fell from 38 percent in 1990 to 20 percent in 2008. Over this time, private sector workers with defined contribution plans increased from 8 percent to 31 percent. Most public sector employees currently have defined benefit plans, like the Retirement Systems of Alabama. But this is slowly changing; Michigan and Utah have switched new state employees to defined contribution plans. The form of the plan affects who bears pension risks. One risk is that contributions and investments will fail to yield sufficient funds for retirement. This could happen because of lower than expected investment returns, or because of mistakes in pension accounting, which is described as more of an art than a science. The potential also exists for someone to outlive their retirement funds. Employers bear these risks with defined benefit plans, versus employees with defined contribution plans. Both private and public sector defined benefit plans are often underfunded. Fewer than 10 percent of Standard & Poor’s 500 index firms with defined benefit plans, for instance, have fully funded pensions. Companies must make up the shortfall from an underfunded pension out of current revenues, which can drive an otherwise successful business into bankruptcy. Defined contribution plans avoid pension-induced bankruptcy, but result in people without funds for old age. As more companies and governments shift to defined contributions plans, this problem will only worsen. The life of baseball great Mickey Mantle illustrates the potential danger. I was in diapers when Mr. Mantle retired, but I learned early about his greatness as a player, and later about his famous carousing and drinking. Mr. Mantle often said that if he had known he was going to live so long (he died at age 63), he would have taken better care of himself. The progress and prosperity of our economy have supported modern medicine and a significant extension of life. Life expectation increased by 20 years between 1930 and 2010. Based on how economists estimate the value of years of life, living an extra 20 years is equivalent to a $2 million benefit for the typical American. I hope that progress in life extension continues, and even accelerates it if possible. We form expectations about life based on experience and available information. Mr. Mantle’s expectation was not unreasonable based on life when he was growing up in the 1930s. Before 1930, men did not on average to 60, and men in the Mantle family rarely saw 50. Many Americans never reached retirement age. Progress creates an imbalance between life plans based on yesterday’s world and a different, albeit better, future. For the lengthening of life, this imbalance takes the form of persons without funds for old age. Defined contribution pensions exacerbate this problem by placing the risk on people likely to make mistakes and possessing little ability to afford the consequences. Millions of persons without money for old age could lead to demands for a much expanded government safety net, perhaps an expanded Social Security designed to provide full retirement income. Ironically, defined benefit pensions provide a voluntary, contractual safety net. Pensions allow the sharing of risks involved in planning for old age. These pensions reduced the potential for people to save too little and voluntarily transferred wealth to those who live unexpectedly long lives. I do not know if defined benefit pensions will disappear. But if they disappear, I suspect that we will miss the market-based safety net they have provided for Americans as progress extended our life spans. Daniel Sutter is the Charles G. Koch Professor of Economics with the Manuel H. Johnson Center for Political Economy at Troy University and host of Econversations on TrojanVision. Respond to him at dsutter@troy.edu and like the Johnson Center on Facebook.
Robertson/Barth/Jahera: Legislators step up to tackle Alabama’s underfunded pensions
On November 9, a newspaper in North Alabama published an editorial suggesting that any legislative interest in our state’s public pension system would inevitably spell “disaster” for retirees. The editorial also claims that legislators may be plotting to “shore up” the General Fund through the “cash cow” of Alabama’s public pension system. In reality, a handful of Alabama legislators are undertaking the mammoth task of ensuring that our state can fulfill the obligations owed to current and future public retirees. This is no small task, as Alabama’s public pensions are underfunded by at least $15.2 billion. To put this number into perspective, every household in Alabama would need to contribute $8,274 to fully fund the system. To the casual observer, an unfunded pension liability is about as abstract a concept as the national debt. Many taxpayers may wonder why it even matters–will the bill ever really come due? Politicians in both cases often get away doing nothing, because they know that they won’t be around when the bill does come due to future generations. And every year that these problems aren’t dealt with, they worsen. Alabama’s public pensions, unlike most private sector pensions, are based on a defined benefit formula. This means that state employees pay into their retirement accounts, as do their state employers, and the Retirement Systems of Alabama (RSA) invests that money with a guaranteed return of 8%. Whether or not the investments actually return 8% matters little to state employees, who will receive the same contractual benefit no matter what. How is this possible? Because the Alabama Legislature-led by the same individuals now being wrongfully accused of trying to raid the pension system–has been faithfully paying a large sum of taxpayer dollars to RSA each year to cover its shortfalls. This year alone, legislators sent RSA nearly $1 billion. And they didn’t have to. The state is not legally required to pay the “annual required contribution” (known as the ARC), yet the legislature has never failed to make that payment–even when it has been painful to do so, as it was this year. The ARC is the yearly amount needed to fund current and future retirement benefits and liabilities. Why has the legislature made this payment? To keep the system solvent for our public retirees. Legislators in states like Illinois, New Jersey, and Pennsylvania chose not to fund the ARC, obligating taxpayers to further subsidize these drastically underfunded pensions. What Alabama’s legislators have begun to realize, however, is that it’s getting harder and harder to make that substantial annual payment to RSA, especially with no end in sight (it’s expected to increase by 3.4% this year). The legislature’s pension study committee, led by Senator Arthur Orr and Representative Lynn Greer, is taking this concern seriously. The reforms that the committee is contemplating will have no impact on the benefits of any current retiree or state employee; however, these changes would aid in protecting the retirement that these individuals have already earned. To do so, the rise of our unfunded liability (which has increased by an astounding 625% since 2003) must be halted. The defined benefit plan exposes the State of Alabama (the employer) to the maximum risk of future funding shortfalls. As long as we continue to add new employees to this plan, we risk going even deeper into pension debt. To avoid this situation, the legislative study committee is looking at pension options for future employees that would reduce the state’s long-term risk of pension underfunding and allow Alabama to pay down its current pension debt. It’s a painstaking task, but one that could have a sizable and lasting payoff for state employees and taxpayers alike. Over the years, a number of state leaders have tried but failed to accomplish pension reform for many of the same reasons that congressmen have given up on fighting debt limit increases. For instance, there’s a great deal of misinformation surrounding the debate that heavily clouds the merits and necessity of reform. Some will argue that the $15 billion pension debt isn’t even problematic. The general public is largely apathetic to the plight of state employees, who have better retirement benefits than many Alabamians, and state employees are led to believe that reform efforts signal that someone is after their retirement. In spite of these troubling realities, a few key legislators have decided to roll up their sleeves and attempt to deal with this critical issue. They should be applauded–by state employees, for working to safeguard their retirement funds; by their colleagues, for taking on a weighty assignment that nobody else wanted; and by taxpayers, who may not care much about public pensions, but have been and will continue to be called upon to “shore up” Alabama’s retirement system unless reforms are made. Katherine Green Robertson serves as Vice President of the Alabama Policy Institute. Dr. James R. Barth is the Lowder Eminent Scholar of Finance and Dr. John S. Jahera is the Lowder Professor of Finance at Auburn University.
Katherine Robertson: Legislature can still finish strong
The Alabama Legislature caught its share of grief after adjourning the Regular Session without passing a budget. The alleged infighting between the House and Senate and the bickering over how to solve the shortfall dominated the headlines in early June as the session wrapped up. Yet nearly eight weeks later, it’s easier to examine the full body of work and praise a great deal of what has been accomplished. Heading into next week’s Special Session, Republicans should focus on preserving their record over the past five years and on finishing strong. A brief reminder of how this Session began: the governor sent over a budget that relied almost entirely on tax increases to close the General Fund shortfall. Rather than being able to make a few tweaks here and there, legislators opposed to tax increases were forced back to the drawing board with far fewer resources, particularly staff, to aid in their research and decisionmaking. It was hardly surprising that they chose to close the gap with cuts, as the base of the Republican super majority rightfully refused tax increases that would, by and large, ask the people to hand over more of their hard-earned money to fund Medicaid and prisons. While the budget quandary remains unsolved, the Legislature tackled several complex policy matters that will have a positive long-term impact on the General Fund. For instance, managed care reforms to Medicaid that passed in 2013 were duplicated for long-term care services in hope of slowing perpetual increases in Medicaid spending. The Senate also declared its opposition to Medicaid expansion, recognizing that the state’s required obligations through expansion would ultimately add a 10 percent increase to state money spent on Medicaid (not including unknown administrative costs). In another act of legislating for the long-term, the comprehensive prison reform bill was signed into law. Corrections spending accounts for 4.3 percent of all state spending and a whopping 21.4 percent of General Fund expenditures. Along with Medicaid, this spending has increased by 25 percent over the last 20 years with no signs of slowing. Aspects of the prison reform law do require additional front-end funds; but, over time, this investment should help to level out corrections spending as the strains of overcrowding are eased. On the last day of the session, a bill was passed to reform judicial public pensions. Public pensions are an oft-overlooked aspect of state spending, but this year alone, the state put almost $1 billion — nearly five times the amount of the shortfall — into the pension system. The estimates for 2016 are no better. The Judicial Retirement Fund has the worst funding percentage of the state’s three pension systems, and the reform passed this session addresses the state’s liability in this regard. It will result in immediate cost-savings with an even greater savings impact expected over time. Despite some flirting with the governor’s proposed tax increases, most were dead on arrival, as was gambling. Instead, new legislative study committees were established on issues such as tax reform, structural pension reform, and proposed privatization of the state’s ABC Board. This indicates an ongoing willingness to deal with fundamental problems in Alabama’s state government, rather than abdicating this duty and opting for budget gimmicks and quick fixes. Republicans should take pride in these accomplishments and refuse to agree to proposals that would taint their record. There is no denying the pressures that they face from various positions of leadership, powerful special interests, and bleak budget spreadsheets. Still, legislators are sent to Montgomery to make tough calls. This group campaigned on a commitment to govern with the best interests of the people in mind — not to make their decisions on weekly polls or chances at personal gain. U.S. Sen. Jeff Sessions made headlines in Alabama this week with remarks he hoped would embolden Republicans. He said, “We don’t need to be timid. We need to do the right thing. We need to do the bold thing. The government can’t do everything for us. Our values are good values … and we need to define those values. We believe in limited government and lower taxes.” When legislators return on Aug. 3, they will be given another opportunity to take the senator’s advice and finish strong. Based on the grit of those legislators we work with behind the scenes, I, for one, still have faith that they will. Katherine Robertson is vice president for the Alabama Policy Institute (API), a nonprofit research and education organization dedicated to the preservation of free markets, limited government and strong families.
