The City and State Pension Crisis Has Only Just Begun

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America has recently experienced a wave of municipal bankruptcies significantly fueled by underfunded pension and retiree health obligations to retired city workers, including policemen, firemen and teachers. The bankruptcies of Detroit and some California towns, the massive pension shortfall in Illinois only partially addressed by recent legislation, and the tense situation in Chicago with the mayor asking municipal workers for give-backs are just the beginning of difficulties that will appear across the country. Asset returns have come up short of what has been assumed. Generous unfunded retirement benefits with early retirement dates and expensive cost-of-living adjustments were doled out to government workers years ago by politicians who are no longer around to be held responsible for their dereliction of prudence and duty to taxpayers who now are expected to pay for these shortfalls. By the best estimate, the total pension underfunding for state and local government is $4 trillion.

Two problems have become increasingly apparent and immediate: the legacy obligations promised to retirees and workers just about to retire, and the funding and nature of retirement benefits being accrued now and in the future by younger and future state and local government workers. The first problem is larger in size and concern because those retirees and long-service workers are legitimately worried that their retirement benefits promised by fiscally challenged sponsors and backed by severely underfunded plans are now highly uncertain and unsustainable and subject to arbitrary and chaotic cuts in the bankruptcy and political processes operating today. Moreover, many of these retirees, again owing to poor past choices by their representatives and employers, are not even covered by Social Security, and therefore extremely exposed to risks in retirement.

One solution would be to offer these retirees and older workers a lump-sum payment representing a significant, but not necessarily full, share of the actuarial value of their promised benefits. Government plan sponsors would also be happy to make that deal, as it would remove large and fluctuating net liabilities off their balance sheets, thereby enabling them to move forward, with lower borrowing costs, on sorely needed projects for the social welfare, security and productivity of their citizens. Current discussions to pass the buck by moving these legacy liabilities to the federal government through Social Security or the Pension Benefit Guaranty Corporation are both politically and economically toxic because of the already large and growing shortfalls facing these programs.

In order to protect retired and older government workers, many of whom are inexperienced with investments, the lump-sum payments should be placed automatically in an account whose investments and life annuity purchases are professionally and automatically managed. This account should give the worker a personalized strategy emphasizing a lifetime retirement income flow with the potential for growth and flexibility. More specifically, what would such a responsible and prudent structured account given to retirees look like? While many products and strategies already exist, my careful examination finds that the best approach to achieve a lifetime income flow with growth potential and relatively low levels of management fees and risk is to use a combination of systematic withdrawals from a dynamic portfolio of mixed asset funds, and a schedule of gradual purchases of immediate life annuities. The income flow to the retiree would result from the combination of lifetime guaranteed benefits from a growing number of individual annuity contracts, and withdrawals from the remaining funds invested in a mix of assets that could provide a higher expected return.

In this approach, the laddering of the immediate life annuity purchases over an extended period of time significantly reduces the pricing risk arising from moving interest rates. Moreover, it grants flexibility to the retiree to alter course if unexpected changes in health or other personal circumstance occur and a need for more liquid assets and less guaranteed income arises. Personalization of this broad strategy is essential because no two retirees have identical circumstances and some could be harmed by a broad-brush implementation. Due consideration must be given to age, marital status, health, retirement resources available, income, coverage by Social Security or other pensions, coverage by health and long-term care insurance, gender, risk tolerance of the retired household, and goals being pursued, such as an intended bequest to children or charities. This assessment must be done at the household level in a careful, methodical, and comprehensive way using the best and most current findings of economics and finance.

As the pension liability problems of state and local governments continue to grow, now is the time to act responsibly and realistically for the improved welfare of retirees, young workers, and taxpayers. There are good solutions available. The imprudence, evasion, and buck-passing of the past will no longer work, and we need joint leadership from politicians and workers' representatives to clear the mistakes of the past and move forward.

Mark Warshawsky is a visiting adjunct scholar at the American Enterprise Institute (AEI). He is the author of Retirement Income: Risks and Strategies, (MIT Press, 2012). 

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