When it comes to severe fiscal difficulties spurred by public pension mismanagement, Illinois and New Jersey receive the most attention. These two states, however, are hardly alone:
According to an authoritative study by professors Robert Novy-Marx and Joshua D. Rauh published in the Journal of Finance, pensions in 21 states were funded below 40 percent in 2009. Indeed, according to this conservative estimate, the aggregate "funding gap" faced by states amounted to $2.5 trillion. Since then, assets have gone up in value, as have liabilities, so the net is likely to be roughly the same.
A 2015 report for Mississippi's Public Employees Retirement System said the plan was just over 60 percent funded. PERS says that under its current funding policy, which assumes a 7.75 percent rate of return, it will be 80 percent funded by 2042.
Shoring up state and local government employee pensions is crucial, but conventional legislative fixes are virtually impossible due to strict state legal and constitutional protections for public pension benefits in most states. It's time for a new approach, and one within reach: Give states and cities the option to offer voluntary buyouts to retirees and older workers.
To appreciate the urgency of the issue, some background on retirement plan trends will be helpful.
Many state and local pension plans are simply not sustainable without substantially increasing contributions beyond the capacity of citizens. Another study by Novy-Marx and Rauh, published in the American Economic Journal, found that state and local governments contribute an average of 5.7 percent of their annual revenue to pension plans. To fully fund them, they would need to contribute 14.1 percent -- or an extra $1,385 per year from the average taxpayer. The shortfall is more than $2,000 per taxpayer in five states.
The legal protection most states grant to government workers' pension benefits effectively blocks reform. The desire to protect benefits is understandable -- workers should, after all, receive what's been promised to them. But today these laws protect a system that places workers in a perilous position.
Some bankrupt municipalities have succeeded at reducing their pension obligations in federal court -- not the most desirable outcome, though necessary for recovery. Yet for states, bankruptcy is not an option, and appropriately so.
Other pension scholars, recognizing these facts, have made proposals for modest voluntary pension reform at the state level to supplement a federal bailout of state and local pension plans. These proposals would likely result in hundreds of billions of dollars in new federal spending. Moreover, bailouts like this are unfair to the majority of taxpayers, states, and municipalities who have acted more responsibly and don't require them.
A federal bailout is also highly unlikely. Retirees in Detroit lost significant cash and health care benefits in that city's bankruptcy, and there was no federal bailout to lessen the blow. Under a new federal law, some retirees are receiving notice that their multiemployer pension plans are approaching insolvency, and their benefits will be cut. In this case, Congress, on a bipartisan basis, soundly rejected a federal bailout.
Poor decisions by state and local officials, and the politically charged collective-bargaining environment they work within, are to blame for the crisis. It's up to these policymakers to work with pension-plan beneficiaries and their representatives to solve it.
The following plan would alleviate some of the financial pressure on public pension plans and satisfy retirees who are willing to opt-in -- and it is politically viable:
First, require state and local governments to file a report each year with the U.S. Treasury breaking down each plan's participant demographics and funding status, using realistic, standard actuarial assumptions, as is done in the private sector. Plans must also be required to give this information to beneficiaries in plain English, in order for them to have a realistic understanding of the finances of the pension plans, again as is done in the private sector. States and municipalities that do not comply must lose federal tax exemptions for the interest on their bonds.
Second, allow (but don't require) state and local governments to offer retirees below age 80, as well as some older workers, a buyout of their pension benefits. The size of the buyout should be based on the funded percentage of the pension plan, but include a bonus for the beneficiary. Specifically, calculate the buyout by first taking the present value of an individual's accrued retirement benefits. Then discount it by 100 percent less the funded percentage of the plan, and then add 5 percentage points.
For example, if a retiree had accrued a pension stream valued at $300,000, and the state pension plan was 45 percent funded, then the retiree would be offered a buyout of $150,000 -- assuming that a 5 percent kicker was given as a bonus to encourage take-up of the offer.
Because the discount is based on a plan's funded status, the plan would not become insolvent if many retirees opt for the buyout. Meanwhile, the 5 percent bonus provides a significant incentive for participants to accept it. Studies, such as one by professors Saul Pleeter and John T. Warner published in the American Economic Review, indicate that many of them would take the deal.
Quick action, rather than further delays, will spare much long-term pain for retirees. This proposal presents an unfortunate, but necessary, reform option, and a voluntary one at that. It would give retirees more flexibility and financial certainty, and provide a fresh start for many troubled state and local governments struggling to pay for needed public projects and benefits to the poor.
Mark J. Warshawsky is a senior research fellow with the Mercatus Center at George Mason University, where he co-wrote, with Ross Marchand, "The Extent and Nature of State and Local Government Pension Problems and a Solution."