5 Solutions to Pension Problem

“Failing to address the public pension crisis promptly would be economically catastrophic, triggering bankruptcies of cities, school systems and potentially even entire state governments,” Josh McGee, Vice President for Public Accountability Initiatives at the Laura and John Arnold Foundation, wrote in a paper released Thursday.

The Laura and John Arnold Foundation is a Houston-based organization that aims to “maximize opportunities and minimize injustice in our society,” focusing on public accountability, education and criminal justice.

In publishing the paper, “Creating a New Public Pension System,” the Foundation’s goal is to educate policy makers and the public about the pension problem and develop fair reforms, McGee wrote.

The primary problem with the current pension system is the “accumulation of unfunded liabilities,” according to McGee, a result of a confluence of issues including lower-than-expected investment returns, insufficient contributions and underestimating the cost of future benefits.

To create a sustainable and fair reform, policymakers need to address unpredictable costs, incentives for states to underfund the plan and labor market distortions, according to McGee. “All three of these structural flaws stem from the way that retirement benefits are promised in a traditional DB system,” he wrote. “Solving these three problems would eliminate future pension underfunding and would increase the security and utility of benefits for public employees.”

McGee proposes that changing the way pension benefits are calculated can ease the burden on states to fulfill their promises.

“The way to create a sound, sustainable and fair retirement savings program is to stop promising a benefit and instead promise an accrual or savings rate,” McGee writes. “This would mean that instead of committing to a fixed percentage of final average salary after a specified number of years of service, the employer would instead commit to contributing a fixed percentage of salary for every year worked.”

McGee identifies common alternatives that highlight how flexible pension plans can be in implementing new solutions.

Solution #1: Defined Contribution: Employees choose their investments and bear the market risks associated with them. Michigan has used a DC plan for state employees since 1990s, McGee notes.

Solution #2: Cash Balance: In a cash balance plan, employees don’t manage their investments. The plan is managed by the retirement system and promises an average investment return. Employers may offer retiring workers an annuity based on the size of their accounts or the ability to take all or a portion of the account as a lump sum. This structure is used in Nebraska and some private sector firms, according to McGee.

Solution #3: Side-by-Side Hybrid: Here the sponsor maintains both a DB and DC plan and allows employees to choose between the plans. Strict accounting controls prevent the problems inherent in DB plans. Utah and Florida use a side-by-side hybrid.

Solution #4: Stacked Hybrid: Unlike a side-by-side hybrid, employees are offered a small DB plan to provide a minimum amount of retirement security, with an additional DC plan. The federal employee retirement system uses this structure, as does Rhode Island, according to McGee.

Solution #5: Cap on Employer Contributions With Explicit Cost Sharing: This is an agnostic approach, the goal of which is to eliminate cost uncertainty and maintain a political incentive to control costs. A proposed ballot initiative in California caps employer cost at a specific percentage of earnings and specifies that the cost of all benefits will be divided equally between employee and employer, McGee writes.