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A solution to our public pension problem
 
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This commentary originally appeared in Forbes on May 2, 2016.

Are American governments making promises that American taxpayers can’t keep? The answer may well be “yes” when it comes to public pensions.

Unfunded pension liabilities, or the difference between what’s been promised to future retirees and what’s actually on hand to provide for those benefits, have grown to absolutely epic proportions. This raises serious concerns about the sustainability of America’s retirement systems and its ability to make good on the promises made.

Last month, Moody’s Investor Services, one of the nation’s top credit rating agencies, estimated that federal unfunded pension liabilities (including civilian and military obligations) had risen to $3.5 trillion, or about 20% of GDP. In addition, Moody’s pegged state and local governments’ unfunded liabilities at roughly the same amount, bringing the total U.S. pension shortfall to 40% of GDP.

Making matters even worse, total U.S. unfunded liabilities that includes Social Security, Medicare and other debts top $100 trillion, according to the website usdebtclock.org.

Regardless, there’s an ocean of retirement-related red ink that, at some point, will have to be mopped up either through massive future tax increases, a substantial reduction in benefits, or some costly combination of the two.

Government is hiding the ball

Part of the reason that things have gotten so far out of hand is government’s penchant for hiding the ball. U.S. Congressman Devin Nunes echoed this frustration when he said: “It has been clear for years that many cities and states are critically underfunding their pension programmes and hiding the fiscal holes with accounting tricks.” Nunes filed legislation recently to help get a handle on the issue.

In Texas, the problems with public pensions are less pronounced but still serious.

The latest figures from the Pension Review Board (PRB), the state agency charged with overseeing Texas’ state and local retirement systems, show that among the 93 systems monitored by the agency, unfunded liabilities topped $60 billion as of February 2016. That’s a spike in pension debt of $2.7 billion since June 2015 and an increase of $7.7 billion compared with two years ago.

Digging further into the data reveals that the funded ratio—a measure of a plan’s current assets as a share of its liabilities—averaged 80% across all plans. It’s generally held that a funded ratio of 80% or more signifies a firm financial footing, something that Texas’ systems are right on the brink of surpassing.

Looking at these plans’ amortization periods also hints at trouble. The PRB’s guidelines for actuarial soundness recommend that a plan’s amortization period ideally range between 15 and 25 years. However, 56 of the 93 plans exceeded that target as of February 2016.

The financial wreckage in Houston

Over a longer time horizon, it’s evident that fewer plans are able to achieve the recommended amortization period. A 2014 PRB report compares the financials of Texas’ 93 monitored plans in 2000 and 2013. The report finds that in 2000 roughly 46%, or 43 of the 93 plans, had amortization periods at or above 25 years. By 2013, however, that figure had grown to 65%, or 60 of the 93 plans.

On a more local level, the city of Houston—which is the largest city in Texas and the fourth biggest in the nation—is seeing its finances wrecked because of public pension problems. Its three major municipal systems, including the Houston Municipal Employees Pension System ($1.8 billion owed), the Houston Police Officers Pension System ($1.2 billion owed) and the Houston Firefighter’s Relief and Retirement Fund ($532 million owed), have unfunded liabilities totaling $3.5 billion. And thanks to a sweetheart setup, the city is limited on what it can do to bring down the swell of debt.

Recognizing Houston’s pension problems, Moody’s downgraded the city’s credit rating in March, citing “large unfunded pension liabilities (among the highest in the nation)” as one of core concerns. Shortly thereafter, Standard & Poor’s followed suit and dinged Houston’s credit rating citing: “the city’s large unfunded pension liability that has been exacerbated by what we consider optimistic rate of return assumptions and a history of lower-than-actuarially determined contributions…”

A fundamentally flawed system

Be it from a statewide perspective or more locally, Texas’ public pension systems are clearly not headed in the appropriate direction. A course correction is needed before the problem metastasizes into something much, much worse.

At the core of the pension problem, both nationally and in Texas, is a fundamentally flawed system—the defined benefit (DB) system. DB-style pension plans promise current and future retirees a lifetime of monthly income, but do so without knowing whether the money will be in the fund.

These types of pension plans suffer from two major deficiencies: generational accounting and excessive expected rates of return.

The first is the issue of fewer people contributing to the pot of retirement benefits compared with the rapid pace of baby boomers receiving benefits that’s often more than what they contributed. Put another way, there are fewer dollars available for retirees. This is a huge burden on DB-style plans.

Another issue is the fact that many plans assume unrealistically high rates of return—like an 8.5% return expected annually by the Houston firefighters fund or an 8% yield assumed by Houston’s other two major pension plans. Houston is certainly not the only U.S. city guilty of being too bullish on future returns. This is a nationwide problem that’s leaving a wider gap in financial solvency over time. Moreover, many plan managers have invested in risky assets to achieve these returns that could come to bite them later.

For taxpayers and retirees, it’s imperative that substantive reforms are put in place. This starts with eliminating DB-style plans and transitioning to a more secure retirement option like defined contribution (DC) plans.

Take a cue from the private sector 

DC-style plans resemble 401(k)s in the private sector and the optional retirement programs (ORP) available for higher education employees in Texas. These DC-style plans put the power of an individual’s future in their own hands instead of depending on the good fortune of government-directed DB-style plans. DC-style plans are portable and sustainable over the long term as they are based on the contributions of retirees and a defined government match.

With DC-style plans, retirees will finally have the opportunity to determine how much risk they are willing to take. They also reduce the risk that the government will default on their retirement or fund those losses with dollars from taxpayers who never intended to use these pensions. By giving retirees more freedom on how to best provide for their family, they will be in a much better position to prosper.

Because of their efficiency, simplicity and fully funded nature, the private sector moved primarily to DC-style plans long ago. For the sake of taxpayers and retirees dependent on government pensions, it’s time for all governments to move to these types of plans as well.

With trillions of dollars in pension problems at the federal level and tens of billions of dollars in Texas, lawmakers at the federal, state and local levels must make changes now. Specifically, they should transition all new employees and those interested into DC-style plans.

If not, our kids and grandkids will be saddled with pension debt and forced into a future of higher taxes and broken promises that could have been avoided.