As state and local governments grapple with pension and retiree health care liabilities, this compilation of articles by academics, actuaries, pension consultants, and research institute associates will be a helpful resource. Public pension funds, predominantly defined benefit plans, face the double whammy of low interest rates and recent poor stock market returns. Facile comparisons of public and private employee compensation have riled up politicians in search of budget savings. This readable book could not be better timed to assist legislators, labor union leaders, and taxpayers in understanding public pensions.
The book has three main divisions. Part 1, Costs and Benefits of Public Employee Benefit Systems, explains the primary issues in valuation methodology of plan assets and liabilities in the public sector. Part II, Implementing Public Retirement System Reform, includes chapters on the current status and proposals for reform of public pension plans in Germany, Canada, and Japan. This section also includes a chapter on recent state reforms in the US, and concludes with a chapter on best practices for defined contribution plans that are the sole retirement plan. Part III, The Political Economy of Public Pension Reform, includes chapters on the political nature of pensions, social activism on the part of the investment committee of a fund, and issues relating to political support for defined benefit plans in the public sector. In what follows, I focus on a set of chapters that could constitute a quick-start primer for those seeking background and guidance on current pension problems.
Are public employees paid more than private sector employees? Chapter 6, ‘Benefit Cost Comparisons between State and Local Governments and Private Industry Employers,’ illustrates that simple comparisons of compensation are off the mark. While state and local workers cost employers substantially more on average in wages and benefits, there are explanations for the differences – unionization among them – but key are different participation rates, and differences in occupation and industry mix. For example, facile comparisons of the service industry wages compare less skilled restaurant servers, cleaning and business services with public sector skilled and risky jobs such as police and fire fighters. This chapter does not cut the data by education levels; a recent report also indicated that college-educated public sector workers do worse, and high school graduates do better, than in the private sector.
What is the cost of a defined benefit plan? Is an actuarial or market-based measure of pension costs the relevant one? While the corporate sector is required to mark-to-market in reporting their assets and use market-based approaches to valuing liabilities, there is ongoing disagreement about whether actuarial or market-based approaches are appropriate in the public sector. This is of more than theoretical interest, since restating pension liabilities by discounting them at something closer to a risk-free rate than the commonly assumed 8% could lead to a political crisis that may affect the viability of these pension systems. The message of the first section of this book is that full and economically accurate information will allow plan fiduciaries to act appropriately.
Chapter 2, ‘Estimating State and Local Pension and Health Care Liabilities,’ details the range of assumptions allowed in public sector accounting that draws a comparison across plans a crude approximation at best. Even with the current (likely to understate) practice, state and local pension and health liabilities are estimated at close to $2.4 trillion, while dedicated pension assets total less than $2 trillion. Chapter 3, ‘The Case for Marking Public Plan Liabilities to Market,’ illustrates the funding differences that result using actuarial versus market-based methods for four defined benefit plans from different regions of the US.
The heart of the argument is contained in the very readable Chapter 4 titled ‘Between Scylla and Charybdis: Improving the Cost Effectiveness of Public Pension Retirement Plans’. First, the author explains that maintaining the defined benefit form as the primary plan is desirable for a variety of reasons. In particular, defined contribution plans, without a high mandatory contribution, will not provide adequate retirement income. But, the use of current accounting and reporting practices obscures the actual defined benefit cost from fiduciaries. Further, the common practice of smoothing returns hides the fact that the liability fluctuates with changes in the interest rate. If the liability were allowed to fluctuate naturally, the fiduciaries would feel compelled to hedge the liability. Since the volatility is hidden, he argues that pension plans could not be much more exposed to interest rate risk than if they tried intentionally. Further, cost information is hidden when newly awarded pension benefits are amortized rather than immediately recognized. This chapter argues for a gradual reduction in the assumed interest rate until it reaches the long-term government bond rate.
Much of the smoothing would be unnecessary if investments were selected to minimize volatility. Chapter 5, ‘Public Pensions and State and Local Budgets: Can Contribution Rate Cyclicality Be Better Managed?’ illustrates how particular plans have handled contribution rate volatility due to higher investments in stocks. Volatility due to benefit or demographic changes cannot be immunized, but the volatility due to declines in the capital markets could be eliminated if plan sponsors chose to. There is unanimity among the authors that the discount rate used to value defined benefit obligations must come down. It is no longer clear to me, however, that the risk-free rate is the appropriate discount rate. Given the fiscal difficulties states are facing currently, promised health benefits and possibly pension benefits are no longer guaranteed, riskless cash flows. It may be more reasonable for state pension plans to use a rate that is a couple of percentage points higher than the long-term bond rate. But moving from a discount rate of 8% to even 5% will dramatically increase reported pension liabilities.
One danger of full information in this shock therapy form is negative legislative reaction and possible termination of defined benefit plans, once legislators are told that the true value of benefits promised is higher than previously understood. But if liability valuation is not accurate, the danger is that underfunding may get progressively worse until the localities look for bankruptcy options or emergency management legislation that allows contracts to be broken.
Going forward, legislators may decide to lower the value of future retirement benefits in a new plan, and so they will also need to understand how co-existing defined benefit and defined contribution plans can balance the sharing of investment risk and longevity risk between risk-averse employees and the risk-neutral state. Chapter 12, ‘Redefining Traditional Plans: Variations and Developments in Public Employee Retirement Plan Design’, illustrates how several sponsors have incorporated defined contribution elements into or alongside the primary defined benefit structures to redistribute risks or costs, enhance benefits, or promote longer employment.
There are significant advantages to retaining the defined benefit structure particularly for long-term and/or lower-paid employees even with reduced benefits. This volume will be a useful reference tool for all stakeholders during the public pension reform process.
