Before the invention of the 401(k), most businesses in America gave out long-term retirement plans in the form of a pension. A pension is a combination of contributions from an employee and the employer.
Employers who offer pensions invest employee contributions and guarantee payouts to retired workers to be used as a supplement to Social Security. In the 1980s and ’90s, however, many firms moved away from a defined benefit plan and started 401(k)s. This was a way to still offer benefits to retirees, without the long-term costs or liabilities associated with a defined benefit plan. Yet, while the private sector transitioned away from these pension plans, federal, state and local governments did not.
The result has been that most public pensions today are underfunded and lack the capital to pay out benefits down the road. Historically, the growth of this money helped minimize the underfunding of the plan. Yet in today’s environment, with lower expectations for returns, we could be in for a rude awakening.
In the past, the expected return was roughly 8 percent. But the last 15 years have included not only the meltdown in tech but also the financial crisis. The return expectation has not nearly been met, and pensions likely average 3 percent below previous expectations. If the actuaries of these pensions lowered the return bar, they might have a better chance to keep the liabilities at bay. However, this would also demand a higher contribution into the plan to maintain any semblance of financial solvency.
According to data from the American Enterprise Institute, the state pension market is underfunded by roughly $3 trillion.1 The federal government shortfalls are hard to determine, which makes assessing underfunding difficult. However, the bottom line is this: Federal pensions are underfunded!
It is time that the Fed and the states do what most of the private sector has already done: freeze the public pension option and instead create a 401(k) plan for the future.
Almost every state and municipality is running a deficit. Additionally, and on average, they are 43 percent underfunded, which makes it unlikely that they can fully fund the promises made to their public employees. Meanwhile, the politicians continue to “kick the can down the road,” bringing no solutions to the table.
While it is important to have these programs available, it is time that the Fed and the states do what most of the private sector has already done: freeze the public pension option and instead create a 401(k) plan for the future. This will not make the problem go away. However, at a minimum, it will help government entities in the future.
The unions will push back on such a move, but the current environment is unsustainable and will cause large shortfalls. In the next decade, the flux of retiring baby boomers will only increase deficit spending for state and local governments. That makes the need all that more urgent: It is time to buckle down and create a path forward, not to look behind and ignore the warnings.
1Rich, Robert F., David Merriman, Darren Lubotsky, Laurie Reynolds, and J. Fred Giertz. Public Pension Policy in Illinois: An Introduction to a Crucial Issue. Chicago: University of Illinois, Urbana–Chicago, The Institute of Government and Public Affairs (IGPA), 2011.
This article was originally published in the December/January 2016 issue of Worth.