PrintPublic employee pensions are in jeopardy of being undermined by those who want to privatize pension plans and cut benefits
By John D. Abraham
Public employees are special types of workers. They teach our children, keep our cities and towns clean and safe, and are among the first responders to fire and other emergencies. Even though they see their budgets cut by headline-seeking politicians, they continue to do their jobs each and every day.
They do not take jobs in education, health and safety, nursing or highway maintenance to “strike it rich.” They take these jobs out of a desire to serve others, to make our communities better than they are today. In exchange for this commitment to public service, society has established a social compact that provides for public employee healthcare and retirement needs.
However, this social compact between public employees and the public is being undermined by privatization ideologues whose goal is to shrink the size of government by shifting as many public services as possible to the private sector. They believe that by reshaping public employee benefits to match those in the private sector (which they would also like to weaken), the shift to privatization will be simplified.
One example of this move toward privatization is the recent drive to take away traditional pension benefits from public employees and replace them with private savings accounts. Currently, over 20 state legislatures (see box) are considering or have implemented proposals to limit or cap traditional pension plans in favor of a radical change that will likely lead to lower retirement benefits.
Traditional plans provide security; private accounts create uncertainty
Traditional public pension plans provide a guaranteed monthly benefit for the life of the retiree based on a formula that considers a worker’s earning and public service. A typical school secretary or public health worker can expect to receive a benefit of more than 50 percent of final pay after 30 years of work. Pension benefits are usually coordinated with Social Security benefits and private savings to provide the retired public employee a good chance of maintaining his or her standard of living through his or her senior years. This is how the “three-legged stool” concept came into being.
In private savings accounts, employers and employees make a percent-of-salary contribution to employee accounts. Each account holder is then required to invest the contribution in a menu of choices typically provided by the employer. There is no guaranteed benefit available to the employee at the end of his or her career. Private accounts provide a savings vehicle for wealth accumulation, but there is no attempt to coordinate the benefit with Social Security or other private savings.
Other differences from traditional pension plans
Traditional plans typically provide a disability pension for those no longer able to work due to a physical or mental impairment. They also provide a death benefit for survivors of public employees who die abruptly during their work careers. Both provisions typically pay out a guaranteed lifetime monthly benefit to help affected families cope with the financial loss associated with disability and/or death of a breadwinner. In the private account world, no special consideration is provided to disabled workers or survivors of the deceased.
“Vesting” grants the participant a legal right to a pension benefit at retirement. While private account supporters claim these savings plans vest faster than traditional plans, there is no legal requirement for this. Vesting rules vary from state to state. In West Virginia, for example, the traditional plan calls for 100 percent vesting after five years of service. The private account option has a step-rated vesting schedule that requires 12 years of service to fully vest the account.
Traditional plans also permit employees to buy back prior service earned in other jurisdictions. Most plans also permit retiring employees to use part of their unused sick leave to buy back past service or add to their service record. Both provisions give employees an opportunity to enhance their final retirement benefit. Private account sponsors do not provide for such enhancements.
Understanding the debate
At the heart of the current debate is the purposeful misuse of an actuarial concept called “underfunding.” The mathematical formula for calculating the level of underfunding is quite simple: assets in the pension plan divided by the liabilities for benefits earned by plan participants as of a specific date (assets/liabilities). When a pension plan’s assets are equal to its liabilities, it is said to be 100 percent funded, which typically means that if the plan were terminated on the date of that calculation, it would have enough assets to pay benefits for all previously performed work. When a plan is more than 100 percent funded it is deemed to be “overfunded.” When a plan is less than 100 percent funded, it is regarded as “underfunded.”
And while the aggregate dollar amount of underfunding sounds staggering when taken out of context (about $293 billion for FY 2004), this represents a total shortfall for the 127 plans in the Public Fund Survey of only about 12 percent (Brainard, Public Fund Survey Summary of Findings for FY2004, Sept. 2005). Public pension plans have already amassed 88 percent of the assets needed to pay promised benefits. At this level of funding, virtually every plan has enough money on hand to pay all of its promises to all vested employees and retirees for years to come.
Spreading fear through misleading rhetoric
Not surprisingly, the champions of privatization have adopted the same misleading rhetoric used by those who claim Social Security is “underfunded” and no longer affordable. Rather than look at the positive position public pensions are in, privatizers try to spread fear by drawing attention to the unfilled 12 percent of the glass. They take this position at the urging of anti-tax, anti-government groups who want to privatize as many public employee jobs as possible and the financial services industry who stand to reap huge payoffs if the $2 trillion of traditional pension assets are replaced by private accounts.
The causes of underfunding are well-known. Either the liabilities grow faster than expected, or the value of the plan assets drops.
Plan assets decrease in value whenever an actuarial assumption is not met. One typical maneuver is to overestimate the rate of return the plan will earn on its investments. As a 1 percent change in the earnings assumption (e.g., 6 percent to 7 percent) can change the annual contribution up or down by 20 percent to 30 percent, some states purposely use higher assumptions to lower their current contribution. When the higher earnings figure is not realized, an actuarial loss is created and an underfunding liability results.
As many of today’s state and local lawmakers focus only on reducing government spending, the ability to manipulate actuarial assumptions creates a “moral hazard” for elected representatives. When lawmakers control pension funding assumptions, they can force the use of high and unrealistic interest rates, and be rewarded by anti-tax groups for their control of government spending. As the liability is pushed out to the future, these elected representatives can meet their constituencies’ need for lower taxes, and place the true funding cost on future legislatures and plan participants.
One other obvious way an actuarial underfunded liability can occur is when the value of the plan’s assets fall. We observed the unprecedented run-up in the value of stocks in the late 1990s and the following downturn that led to three years of negative returns. As most pension plans are funded on a five year rolling average basis to smooth out the ups and downs of the market over time, it will take several years of positive returns to offset the negative returns of 2000-2002.
The goal of pension funding is to make sure that the employee’s benefit is fully paid by the time of retirement. The plan’s actuary makes assumptions about how much interest the plan can earn on its investments, active employee and retiree demographics, turnover rates, future wage increases and other factors to determine the employer’s contribution for the year. Actuaries try to estimate the smallest contribution that can be made each year that, when combined with compound interest, can reasonably achieve the promised pension benefit at retirement. Public plans have been so good at using this formulation over the last 50 years that about 75 percent of the pension benefit is derived from employee contributions and compound interest. Governments effectively leverage their 25 percent contribution into a modest but stable lifetime benefit (estimated to be about $19,000 per year) for all plan participants. Taxpayers ought to feel good about the efficient use of their contribution.
John D. Abraham is deputy director of the AFT research and information services department, and the union’s pension specialist.
