Pension Pinch

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First it was a time bomb. Then it was a python. Warren Buffett calls it a gigantic tapeworm. Three scary metaphors for the underfunding of U.S. public pensions. While corporate America has largely shifted to employee-funded plans — just 10 percent of companies offered defined-benefit arrangements in 2011 — more than three-quarters of state and local government workers have traditional coverage. The problem? The financial crisis caused asset prices to shrink and governments to skip scheduled contributions as they grappled with budget shortfalls. Liabilities skyrocketed while plan investments failed to keep pace. The 25 largest pensions alone face an estimated $2 trillion gap between what they promised and what they’ve saved. What seemed like a simple solution to labor negotiations — offer better retirement packages in the future instead of salary increases today — is poised to give lawmakers headaches for years. For the baby-boom generation with its scant retirement savings, it’s one more thing to worry about.

The Situation

Detroit’s record bankruptcy that ended in December had taxpayers pitted against pensioners as the city sought cash for public services. The biggest unions negotiated deals to reduce pension cuts and urged members to vote for them, while bondholders took unprecedented reductions. In California, Stockton protected all pension promises as it moved through bankruptcy. Their struggles don’t bode well for Chicago, where pension payments are set to increase by 135 percent in 2016, or for states like Illinois and New Jersey, where promises to retirees are forcing cutbacks elsewhere. The Windy City’s prospects dimmed in May when the Illinois Supreme Court ruled that a 2013 bill to trim pension benefits violates the constitution. Moody’s Investors Service cut Chicago’s bond rating to junk. Illinois is its lowest-rated U.S. state. In New Jersey, Governor Chris Christie’s decision to scale back pension fund payments has led to a record nine downgrades and left state pensions $83 billion short of what’s needed. Rhode Island Treasurer Gina Raimondo wrote one of the few success stories in overhauling public pensions, gaining passage of a measure deemed ambitious and courageous by some, and illegal and infuriating by others. She was elected governor in 2014.

Source: Wilshire Consulting
Source: Wilshire Consulting

The Background

Thirty years ago, large companies were like states and municipalities, with more than 75 percent of workers participating in defined-benefit pension plans. Then executives realized the arrangement put all the investment risk on them. Defined-benefit plans give workers a pre-determined payout in retirement based on years of service and final salary. It creates a future liability that’s tricky to predict because it relies on assumptions about salary growth and life expectancy. The long-term obligation must be matched with investments that grow at a sufficient pace — a tall order after the recession as stock prices plunged and interest rates reached record lows. Private pensions have problems too; just 5 percent of those at Standard & Poor’s 500 companies are fully funded, though it’s deemed a manageable expense. Public plans outside the U.S. also tend to be underfunded, with some better and some worse than American ones. Public pension benefits in countries including Australia, France, Germany and Hong Kong are more generous than those in the private sector, as in the U.S.

Source: Wilshire Consulting
Source: Wilshire Consulting

The Argument

They may be surrounded by ticking snakes and worms, but there are optimists. For 2014, the value of pension assets grew to 78 percent of liabilities, the highest since 2009. That provides ammunition for those who think the problem is overblown and will resolve itself as the economy improves, stock prices increase, interest rates rise and states and cities can put away enough revenue for pensioners. Others say there’s no way to make good on promises without at least scaling back benefits to new workers. Raimondo’s plan in Rhode Island delayed retirement, suspended cost-of-living increases and offered workers employee-financed plans.

The Reference Shelf

  • A Pension Benefit Guaranty Corporation primer on defined-benefit plans.
  • Bloomberg list of most underfunded state pension plans.
  • Report from Brown Center on Education Policy at Brookings, “Are Public Pensions Keeping Up With the Times?”
  • Employee Benefit Research Institute’s frequently asked questions on trends in retirement plans.
  • Morningstar Inc. report, “Determining the Aggregate Per Capita Pension Liability.”
  • The Pew Charitable Trusts report, “A Widening Gap in Cities.”
  • Natalie Cohen, head of municipal research at Wells Fargo Securities, described in a Bloomberg Briefs interview how pension obligations crowd out other government services.

First Published March 10, 2014

To contact the writer of this QuickTake:

Brian Chappatta in New York at bchappatta1@bloomberg.net

To contact the editor responsible for this QuickTake:

Jonathan I. Landman at jlandman4@bloomberg.net