The Pension Bomb

 

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Of those three choices, the one that does the greatest damage to the economy is cutting public spending. We were willing to agree to some delay in paying into the pension fund because it’s better than budget cuts in this kind of economy. So we have said that, sure, in general slowing down the payment to the pension fund is not a good idea, but compared to the two other choices, borrowing a little money from the pension fund is probably second-worst. The best is to raise taxes on those most able to pay.”

A common analogy equates funding a pension plan to a mortgage. “Having a mortgage in and of itself is not a financial problem for an individual, but if you borrow more than you can afford, then it can become a problem,” says Keith Brainard, research director at the National Association of Retirement Administrators. “If I have a mortgage of $100,000, that sounds like a lot of money, but when you consider it’s something I’m going to pay off over 10 or 15 years, it’s not that big a deal. Similarly, an unfunded pension liability really depends on how big it is and the fiscal condition of the plan’s sponsor.”

Connecticut’s unfunded pension liability is large, but ultimately manageable in normal times. But as Moody’s points out, the state’s fiscal condition is under extreme duress: “Connecticut compares unfavorably with other states on measures such as debt ratios that are among the highest in the nation, pension funding levels that were among the lowest in the country even before the market turmoil is factored, and other post-employment benefit liabilities that are larger than the size of the state’s annual operating budget.” Citing the state’s efforts to solve its budget crisis, Moody’s warns, “These solutions create future structural budget gaps and leave the state with significantly reduced flexibility to address additional fiscal pressures that may arise due to a delayed and/or weaker than expected recovery from the worst economic recession since the Depression.”

Nappier quickly points out the glaring weakness in the mortgage analogy: “Unlike a mortgage, a pension plan is never fully paid for because there will always be new plan participants working toward their retirement.”

How do we get out of this mess? An improved economy with fewer unemployed taxpayers and a bull market would certainly help. So would a group of influential legislators that makes the situation a priority. To get there, however, one has to cross a field planted with political land mines that include some combination of increasing state employee contributions, adjusting cost-of-living increases, tightening practices that inflate salaries used to calculate pensions, raising retirement ages, increasing taxes, or adding even more long-term debt to the state’s books by issuing pension-obligation bonds.

Another widely touted solution is switching from a defined benefit plan that pays a predictable sum on retirement to a defined contribution plan—one familiar to most of us working in the private sector—that requires employees to set aside money each payday and build a less predictable nest egg for withdrawal in the future. As for health care, the state and its public employee unions have taken a small step forward by requiring new hires to contribute to a retiree health-care fund, although the state is in no position to contribute to that fund beyond the $10 million it used to seed the fund.

“To reduce the cost of the pension plan means that you look at a plan design that will lower the costs. And that can be very controversial and sensitive to employees,” Nappier says. “Some plans in other states are redesigning the plan for new hires. It stops the bleeding. The other option is to increase the amount being contributed by all those that contribute, the employee and the employer. Maybe it’s time to rethink that.”

Perhaps, but the unions are unlikely to agree to major adjustments in the plan. “We have a very moderate pension benefit structure in the state and it’s one the state can easily afford,” Livingston says. “It’s not something that we’re unduly concerned about because it’s a moderate benefit structure and there is a system to pay off the unfunded liability over time.”

Issuing bonds in the amount of $9 billion to make up for the unfunded liability in just the state employees’ pension would increase the state’s already massive $18 billion debt burden by 50 percent. In 2007, the state issued $2 billion in bonds to make up for a shortfall in the teachers’ pension fund. “The idea is that you’re going to borrow money at  a rate lower than what you’re going to earn on it and that you’ll come out ahead,” Brainard says. “Evidence that I’ve seen indicates that most pension bonds issued in the last decade are under water.”

Switching new state hires to a defined contribution plan, which works like a 401(k) plan, is probably not a panacea, either. “You’re not relieving yourself of the liabilities that already exist in the plan,” Brainard says. “Simultaneously, you are restricting the payroll base used to pay off those liabilities. Generally, analyses in other states have found that changing new hires to a defined contribution plan takes years, at least a decade, to generate any savings. Then, at that point, the savings are relatively meager.”

Such a changeover also requires labor to go along, which is a doubtful proposition. The state already offers an alternative retirement plan in which workers put in 5 percent of their pay, with the state’s match at 8 percent of salary. But, as Sal Luciano, executive director of Council 4 of the American Federation of State, County and Municipal Employees and a state pension board member, observes, many of the workers who opted for that plan are having serious regrets.

“August ’08 hits and their nest egg is gone,” he says. “You have people who’ve been in there for 25, 30 years and thought they were going to retire. Then they looked at the balance sheet and said, ‘I can’t retire.’”

Ultimately, the executive and legislative branches will have to muster the political will to honestly account for liabilities and address ways to contribute consistently to the fund. “In my view, the way to go about it is to make adjustments to the pension plan,” Brainard says. “You have to embrace and engage the problem. Paying into the pension fund is not sexy. It doesn’t get many votes. But it’s a core responsibility of leaders to pay that.”

The Pension Bomb

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