Public pensions are the Trojan horses of US entitlements

Public pensions are the Trojan horses of US entitlements
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As hollow as the giant wooden horse of legend, America’s public pension plans have lulled participants into the false belief that their pension check will never bounce.

The nearly 25 million Americans expecting their retirement to be funded by state and local pensions deserve to be told what their plan can realistically afford to pay them.

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Total unfunded liabilities at U.S. state and local public defined benefit pension plans are about $1.4 trillion — more than three times their pre-financial crisis level. After a decade of strong investment returns, the funded status of public pension plans continues to worsen.

The next economic downturn will deliver the coup de grâce to some public pensions. As the probability of defaulting on promised benefits increases with falling asset prices and bloated pension liabilities, retirees nationwide will face the grim prospect of receiving greatly reduced benefits during their golden years.

Public pensions issue annual member statements indicating the annual pension payments that participants can expect to receive at predetermined retirement ages, reinforcing the perception that those payments are fully guaranteed and funded.

Sure, the financial health of public plans is described in great detail in their comprehensive annual financial reports and actuarial valuations, but these arcane documents are often several hundred pages thick.

Say you are a hardworking member in the State Employees’ Retirement System of Illinois, whose funded status stands at around 34 percent and your recent annual member statement promised you an annual pension of $30,000 at age 65.

Truthfully, the plan can afford to pay you only $10,000 per year. The number is probably closer to $5,000 if more realistic investment returns are assumed and if projected benefit payments are discounted at a sensible rate.

What to do? First, asset class return assumptions should be identical for all public plans with the same discount rate applied to all plan liabilities, no matter a pension’s funded status. Stop allowing public pensions to calculate the present value of their liabilities using the expected rate of return assumed to be generated on their assets.

Require public plans to follow U.S. generally accepted accounting principles that call for a discount rate based on the yield of high-quality bonds just as private-sector pensions do.

Application of this lower, market-based discount rate would cause reported liabilities to balloon, worsening the funded status of most plans. But at least participants would see a truer picture of their retirement income.

In addition, underfunded public plans should clearly disclose to participants the extent to which their benefits are or might be impaired. If your pension plan is vastly underfunded (i.e., you happen to be a teacher in New Jersey, a police officer in Chicago or even worse, a firefighter in Kentucky), the plan sponsor should be required to quantify the likelihood of a reduced payment.

This would be comparable to the information already contained in the annual funding notices sent to participants in private-sector pensions but personalized for individual members.

Younger workers could adjust their spending and saving habits if they know that the pension plan that promised them a secure retirement is almost broke.

For some, that could mean saving more, purchasing insurance or annuities, downsizing their home or altering the asset mix in their personal investment portfolio. For others, it could mean delaying retirement or making substantial changes to their planned retirement lifestyle.

Intergenerational equity, a basic tenet of the social contract that binds workers and plan sponsors, has been given short shrift. Today’s retirees are receiving their promised pension benefits but, for the majority of public plans, the scheme is financially unsustainable.

With public plan liabilities exceeding their assets, these Trojan Horses of America’s entitlement system create a structural imbalance that cannot be solved without reducing pension benefits.

Public pension trustees and chief investment officers face the difficult task of informing Paul that the ruse is up and Peter will no longer stand for being robbed of his retirement livelihood. Plan sponsors and participants will be forced to ante up with higher contributions.

Those already drawing a pension will shoulder their share of the financial burden too. Pensioners will almost certainly be faced with reduced payouts, potentially putting their ability to afford the basics of life — food, housing and health care — in serious jeopardy.

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What’s worse, there is little or no safety net in the event a pension becomes insolvent. Benefits are not insured by the Pension Benefit Guaranty Corporation and state and local government employees can see their Social Security benefits reduced — if they are eligible for them at all.

This is a deep-rooted and complex financial predicament with potentially calamitous economic, social and political ramifications. For all stakeholders, the cure may be worse than the malady in that all potential solutions will involve some degree of prolonged financial sacrifice and suffering, especially for those least prepared.

The employees of America’s state and local governments are undercompensated for the many essential services they provide throughout the 50 states; often risking their lives to better our communities. They deserve to be told the truth, however painful, about the size of their pension check.

Sean Holland is a principal at Comave Advisors. He previously was manager of private equity-international for one of the largest U.S. public pensions, the New York State Teachers' Retirement System (NYSTRS). James Laurie is a Portfolio Manager at RBC. Both Holland and Laurie are alumni of New York University Stern School of Business' MS in Risk Management program.

Note: Sean Holland's biography has been updated to clarify his title at the NYSTRS.