The Public Pension Crisis

Table of ContentsI. Introduction 4II. The Political Economy of Public Pensions 9A. How Large Is the Potential Fiscal Problem? 10B. Are Public Pension Promises Excessive or Abusive? 16C. Why? 26III. State Law Constraints on Underfunding Pension Liabilities and Pension Reform 31A. State Balanced Budget Requirements and Pension Plan Funding 31B. State Law Limitations on Pension Reform 36TV. Federal Constitutional Law Constraints on State Pension Reform 45A. The Contract Clause and Pension Reform 45B. The Takings Clause and Pension Reform 63V. Bankruptcy, Reduction of Pension Obligations, and Default 67VI. Concluding Observations 84I. IntroductionThe first decade of the new millennium was a difficult one for state and local government finances, and the second decade has started out even worse. In addition to the difficulty governments at all levels are experiencing in trying to maintain services without raising taxes, some analysts claim that many state and local governments are sitting on a fiscal time bomb - underfunded public employee pension and health care liabilities1 that threaten to destroy the fiscal well-being of many state and local governments. Some accounts predict that absent significant benefits reductions (which may not be legally feasible), state and local governments will soon be devoting an untenably large portion of their budgets to making pension payments and satisfying other obligations to retired workers.Unfunded liabilities are possible because government pensions are still largely defined benefit plans, and the law generally does not require full advance funding of the projected costs of accrued benefits. In a defined benefit plan, an employee is promised a specific dollar amount of retirement benefits, usually based on the employee's final salary. These promises are often accompanied by promises of lifetime government-financed health care, without regard to the cost to the public employer. Although states operate under balanced budget requirements, it turns out that underfunding pension obligations does not violate these state law requirements.2 Thus, current taxpayers are able to push off pension and other promises to retirees to future generations of taxpayers.Private industry has moved away from defined benefit plans toward contribution plans, under which employers contribute a fixed amount to an employee's retirement plan and the employee receives retirement benefits based on the performance of the investments purchased with the contributions. The advantage of a contribution plan to employers is obvious - certainty. Once an employer makes the contributions required under the plan, there is no chance that actuarial miscalculations or market downturns will require additional contributions in the future. The employee, not the employer, bears the risk of a market downturn or inflation that might reduce the value of the pension.Defined contribution plans also have some advantages for employees. First, employees may gain control over their funds and have the power to direct investments to their preferred level of risk. Second, employees' retirement funds are not subject to the solvency of the employer. There is no opportunity for employers to manipulate contribution levels. Further, once the employer's money is deposited into the account, the employer cannot raid the fund or take any other action that would prejudice the employees' ownership of the fund.3While most public employers and employees in the United States set aside money each year to fund future projected pension obligations, many public pension plans are seriously underfunded either intentionally or due to unrealistic assumptions concerning investment performance and the amount that will be owed over time.4 This means that unless contributions are increased substantially, future pension payments to retired government workers will be made, at least in part, from current revenues. …