Pension tension

For decades, state and local government employees across the U.S. knew that when they turned 65, they could safely retire without becoming destitute. Years of public service had earned these workers the promised pillow of a pension to pad their purses as they eased into their golden years.

These days, however, receiving a fully-funded pension upon retirement isn’t necessarily a guarantee.

In fact, it’s tough to overstate just how underfunded public pensions in the United States are. Last year, Moody’s Investors Service estimated that public pensions were underfunded by $4.4 trillion, according to an article from The Wharton School at the University of Pennsylvania.

$4.4 trillion. That’s 20 percent of the national debt. To illustrate further, it equals the size of the German economy, the world’s 4th-largest economy, according to Investopedia.

Clearly, many pension plans cannot continue to be administered as they have been. But modifying them involves a tug-of-war between satisfying employees and realistically maintaining city coffers and taxpayer obligations.

“Pensions are complicated, no question about it,” says Olivia Mitchell, the International Foundation of Employee Benefit Plans professor at the University of Pennsylvania’s Wharton School. “But it’s a very simple matter to say, if you want $1,000 a month for the rest of your life, from the time you hit 65, that’s very, very expensive.”

“It takes millions and millions of dollars, and you’re either going to have to pay for that or you’re going to get less, or you’re going to have to work a lot longer, which is possibly also going to happen,” she adds.

While the Great Recession is an oft-cited culprit of many recent financial woes, one must look farther back than 2008 to truly comprehend how pensions became so underfunded, says Jean-Pierre Aubry, associate director of state and local research at Boston College’s Center for Retirement Research.

“The way I see it is more like, in 2000, we were ahead of the game. Now, it’s all back to where we should be,” he says.

How did we get here?

Most public pension plans in the U.S. were started between 1920 and 1950, Aubry says. They were the financial security guarantee that employees needed to retire before their productivity and utility declined. Pensions also served as a human resources (HR) tool — they helped control employee turnover and rehiring, while also yielding a predictable HR policy.

When they were first introduced, pension plans were paid out from general revenues, Aubry says. In the 1970s, pre-funding pensions arose as a practice, with governments setting aside money before employees retired to later help fund their benefits. Pension liabilities arose at the same time since governments would estimate how much they would owe someone in the future to put funds away in the present.

Promising money since 1920 and not putting money towards the promises meant that there was a large number of guaranteed pension funds by the 1980s, Aubry explains. Not every pension provider’s pre-funding plan was flawless, either — some providers either miscalculated pre-funding or they began it late.

Over the past 40 years, investment specialists convinced public plan fiduciaries more and more to invest more in equities, hedge funds, alternatives and other areas, Mitchell explains. The 1980s and 1990s brought abnormally high returns, which yielded decreasing costs, Aubry says. Many believed that the high returns of this period would continue indefinitely.

The dot-com bust and the Great Recession, however, caused costs to jump. Aubry says that this returned pension funding “back to where we probably would have been had the 80s and 90s not been as good as they were and were more like what would’ve been expected.”

The stock market isn’t the only culprit in underfunded pensions. “Cities and states frequently choose not to contribute everything they should have contributed to fully fund the plan[s] because they had other uses for the money, especially in the aftermath of the Great Recession,” Mitchell explains.

Pensions aren’t universally underfunded, though. A lot of variation exists among public pension plans. Many cities and states have instituted pension reforms that will take time to work through the system but that will ultimately fulfill costs, Aubry says. As such, he notes that he’s hesitant to call underfunded pensions a wholesale crisis per se.

The entirety of state and local pension systems can be roughly split into thirds in terms of their funding, says Josh Franzel, president/CEO of the Center for State and Local Government Excellence (SLGE). About one-third are doing relatively fine in possessing the assets needed to fund pensions now and moving forward. One-third has lower funding margins but will probably be OK in funding pensions in the future. The final third is comprised of severely underfunded pension systems.

“That bottom third really needs to re-evaluate what they’re doing,” Franzel says. “In order to get them on decent footing, they need to go well beyond what we typically view as standard benefit reform.”

What can be done?

Mitchell notes that many solutions have been proposed to tweak pension plans to meet favorable outcomes.

A notable strategy involves combining the two major pension plan types — defined benefit plans (DBs) traditional to government and defined contribution plans (DCs) more akin to 401(k) plans — to form hybrid pension plans that contain elements of both, Mitchell says. Because of the DC component, these better accommodate employees who don’t spend their entire careers in government.

Other strategies include increasing employer or employee contributions, reducing or eliminating cost-of-living adjustments (COLAs), reducing disability pensions, re-examining a pension plan’s investment portfolio and increasing requirements for retirement plans’ eligibility, according to Franzel and SLGE Senior Research Associate Gerald Young.

Reports and briefs about pension funding from organizations like SLGE, Boston College’s Center for Retirement Research and the Pew Charitable Trusts abound with data and explanations of how cities and states have applied these strategies to remedy their pension-related issues. But because the pension issues that cities face can vary widely, no one-size-fits-all approach truly exists for pension woes.

“I think any action that a city or a state is going to take regarding their pension plan is something they are going to have to consider in light of their own circumstances, their own demographics and their own relationship not only with their plan administration but with their legislature and how these things work together,” Young says.

While conceptually plausible, implementing any of these solutions isn’t necessarily a straightforward feat.

“You’re dealing with people’s money, you’re dealing with people’s retirement, it gets to be an emotional issue,” says Fort Worth, Texas, City Manager David Cooke, whose city successfully changed its pension plans in February to address underfunding. “You can think it’s all about facts and math, but not necessarily all the time.”

Fort Worth, Texas: A preemptive strike

Around 2015, poor investment returns had ensured a growing unfunded liability for Fort Worth’s pension program. Though pension funding wasn’t an immediate issue, Fort Worth’s elected officials began addressing the problem around this time to avoid a future financial catastrophe.

“We’re not going to run out of money in the next five, 10 years, right? So, when we say [the pension system was] unsustainable, this thing was going to run out of money, but not in the immediate future. And so, sometimes it’s just easier to forget that and make that somebody else’s problem in the future,” Cooke says

The city was especially spurred into action when rating agencies downgraded the city or put it on a negative outlook, Cooke says. Officials assembled a pension task force comprised of police union and fire union members, a representative for general government employees, a financial advisor, representatives of the employee retirement fund and community members. The city also hired a consulting firm to work with the task force.

“The first two years of that group meeting was just trying to convince everybody that we had a problem that needed to be solved,” Cooke says.

The chief part of the debate occurred between August and December 2018 and concerned strategy. Cooke was adamant about taxpayers not completely being on the hook to fund the city’s pensions — the solution had to be shared. Past decisions had also protected retirees at the expense of younger employees.

Ultimately, the task force decided on a solution that involved the city contributing more money, employees contributing more money and the city making changes to the actual benefit, Cooke says.

The city council voted in favor of the new plan in December 2018, and the task force then spent four to six weeks meeting with employees about the pension plan’s changes. Cooke estimates that 40 meetings — in-person and online — were held across a three-week period on the subject.

“I do think we did a good job educating the employees that, either we can solve it, or it’s going to get solved by the [Texas state] legislature in Austin, and they’ll be able to control that outcome,” Cooke says. “So, at least we can control this outcome if we can get the employees to vote, and they did.”

In February, 74.47 percent of Fort Worth’s 6,589 employees cast their votes, with over 50 percent voting in favor of the changes, according to numbers given by the city.

For Cooke, being clear on the problem to be solved, identifying the decision-making criteria and not letting people believe the process would be easy were key in implementing these sustainable pension reforms in Fort Worth.

Young echoes this point, noting that when he’s encountered pension reform scenarios that go well, effective communication among all stakeholders has been universally valued in the process. It indeed proved essential to Cranston, Ri., whose police and fire pension reforms withstood a full legal challenge in June.

Unlike Fort Worth, however, Cranston, was already in extremely hot financial water when it began enacting pension solutions.

Cranston, R.I.: A crisis averted

When Allan Fung assumed his current role as mayor of Cranston in 2009, he inherited a city that at the time, was “a fiscal nightmare,” he says. Cranston was financially distressed on many fronts, and Fung’s administration took multiple steps to relieve the city’s condition.

However, a municipal analysis of the city’s pensions revealed that by 2011, unfunded accrued liability of the city’s pension plans had reached $256 million, according to Rhode Island Supreme Court documents. By the next year, the pension plans were funded at just 16.9 percent.

After meetings with stakeholders and running numerous actuarial scenarios with outside help, Fung’s solution manifested as two ordinances in 2013 that enacted 10-year COLA freezes for the city’s police and fire pensions, court documents show. Two local retiree associations promptly sued Fung and the city.

“There was a lot of anger,” Fung recalls, noting that when he put forth the pension ordinances, he had to move hearings out of the council chambers into a high school auditorium to accommodate union members and retirees.

Fung’s administration had to then figure out how to fully fund obligations to actuaries, the pension and other post-employment benefits (OPEB) while doing right by retirees and union members, he says. Many union members and retirees came forward, and they joined Fung negotiating to settle, he says.

Officials were able to compromise with many members of the associations in December 2013, according to court documents. The settlement specified that COLAs would instead be frozen in alternate years during the initial 10-year period, among other stipulations.

“I have to definitely applaud a lot of our public safety union members and also the retirees because… many of them stepped up to the plate, came to the table,” Fung says. “I outlined the math that we were steering at as a city, not just with the plan, and many of them worked with us to kind of right the ship so that the funds will be there for them and their beneficiaries in the future.”

However, 72 police and fire retirees refused to settle, and they continued to push the lawsuit, which ultimately reached the Supreme Court of Rhode Island, Fung says. In a historic decision, the court ruled in June that the city’s narrowly-tailored solution served a significant and legitimate public purpose to remedy the city’s dire financial straits and problematic pension plan, following the consideration of many other options, Fung says. Because of this, the city was able to modify contractually-vested benefits, and the plaintiffs were given the original 10-year COLA freeze, Fung says.

Cranston also moved new non-public safety city employees from traditional, costly DB plans to DC plans, Fung says. That deal too, was hammered out with unions at the bargaining table.

“We still have a very good relationship with the unions because we did it the right way: sitting across the table, negotiating with them, providing the facts and data, and just being honest with them,” Fung says. “So, I think that was a big key factor.”

What lies ahead?

Cranston general employees’ move from DBs to DCs underscores a belief of Fung’s that governments should “get out of the pension business going forward.” He adds that DC plans give employees more control over their retirement dollars, which he sees new employees wanting.

For Cooke, pensions appear to still be attractive for public safety employees, but not so much for other government workers today.

Concerning pensions’ place in modern government as a whole, Cooke muses, “if we were sitting around a table today deciding how to recruit and retain employees, we wouldn’t even be having that conversation.”

Mitchell believes the DB model itself might be outmoded, as it doesn’t take rising life expectancies into account. Given this, she believes that pensions of today don’t recognize the inability to provide enough money for people to retire young and live several more decades. However, fixing that may require a redefinition of retirement as a whole.

Mitchell’s argument echoes Aubry’s belief that reforms too often focus more on the pension yield rather than the age at which the employee begins receiving that benefit. But while shifting to DCs will stop the accrual of future promises, Aubry adds that it cannot do anything about existing liabilities, which will drive governments’ costs for the next 25 to 30 years.

Over those 25 to 30 years, retired government employees across the U.S. will continue to rely on pensions to help finance their golden years. And regardless of the pension model, state and local governments will continue to owe these people decades-old promises that they’re obligated to make good on.

“DB or DC at the end of the day is the selection of the public employer, but it needs to be well-funded, and it needs to provide adequate retirement benefits once the individual decides to retire,” Franzel says.