In years with Presidential or Congressional elections, we typically turn our attention to public policy at the national level. But many of the most pressing problems are occurring at the state and local level. An example is the underfunded status of many defined benefit pension plans for state and local public sector workers. According to a recent study by economists at Rochester and Northwestern universities, state-sponsored pension plans have unfunded liabilities of over $3 trillion and municipal plans have unfunded liabilities of over $500 billion when properly valued.
There is nothing inherently wrong with the design of defined benefit pension plans, but the way they have been sponsored shows some of the challenges of implementing programs that defer compensation over long periods of time. A defined benefit pension is a promise to pay income in the future in exchange for work done today.* To honor that promise responsibly, the plan sponsor needs to fund it adequately in the time interval between when the promise is made and when it is kept. Simply put, that hasn’t been happening in many large private sector plans and public sector plans. I conjecture that the problems are worse in the public sector because voters don’t pay as much attention to the financial bottom line as shareholders do and because the accounting standards are sharper for private sector plans than public sector plans.
For many years, elected officials have been making promises that future (now, near-future) taxpayers may not want to keep. In contrast to prior years, the debts will not just be outstanding – they will be coming due. Resolving these debts will be a major public policy challenge that plays out in different ways across the country over the coming decade, as Baby Boomers continue to make the shift from their working years to their retirement years. Looking ahead, it is almost unavoidable that there will be “cram down,” defined by columnist Daniel Gross in a 2005 article in Slate as:
It’s what happens when stakeholders who have met their obligations are nonetheless forced to accept returns or compensation that are far less than they were promised. Frequently, cram downs occur because the entity charged with managing the investment has screwed up—it frittered away cash or went bankrupt. And this is the theme that is defining personal, corporate, and government finances this decade.
Gross went on to chronicle examples of cram down in the private sector at the time the column was written. That cram down was on the horizon for public sector employees has been anticipated for many years. New York Times reporter Mary Williams Walsh has been on the case, providing excellent coverage of pension underfunding and related issues.
As in many problems of default, a third party is often asked to intervene to avoid both the cram down to the employees and the tax increases to the local taxpayers. The most likely third party in this case is the federal government, with a bailout to the state or local government sponsor. A recent editorial in The Christian Science Monitor makes a very good point. To the extent that the federal government wants to get involved, it should offer loans -- not bailouts -- to avoid encouraging similar behavior by plan sponsors in the future. To support that goal as well as to protect the federal taxpayer, I would add that ideally, these loans would have the highest seniority in the borrower’s capital structure and be made at penalty interest rates.
At the Rockefeller Center, students can study issues of interest to state and local governments in Public Policy 45 and Public Policy 48, respectively, and conduct research on the challenges facing policy makers in New Hampshire and Vermont in the Policy Research Shop.
The alternative to a defined benefit plan is a defined contribution pension plan
, in which funding is not an issue but the adequacy of future income is typically less certain than if it were specified by a formula and sponsored by a responsible employer. For more than two decades, the growth in pension plans has been of this form, including 401(k) plans, so unlike analogous funding challenges in Social Security and Medicare, the challenge with employer-sponsored pensions will not get worse over time. In past research
, my colleague Jon Skinner and I showed that the projected distribution of retirement income under defined contribution plans was at least as good as that under the defined benefit plans they supplanted.
Andrew A. Samwick is the Director of the Nelson A. Rockefeller Center for Public Policy and the Social Sciences, the Sandra L. and Arthur L. Irving '72a, P'10 Professor of Economics at Dartmouth College, and a research associate of the National Bureau of Economic Research. In 2003 and 2004, he served as chief economist on the staff of the President’s Council of Economic Advisers. Since joining the Dartmouth faculty in 1994, his scholarly work has covered a range of topics, including pensions, saving, taxation, portfolio choice, and executive compensation. Professor Samwick has been published in American Economic Review, Journal of Political Economy, Journal of Finance, Journal of Public Economics, and a number of specialized journals and conference volumes. He graduated summa cum laude with a degree in economics from Harvard College and received his Ph.D. in economics from the Massachusetts Institute of Technology. He blogs about economics and current events at Capital Gains and Games.