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Books and Culture

Daniel DiSalvo
Unfunded
A valuable and scholarly analysis of the state and local pension dilemma
26 February 2013

State and Local Pensions: What Now? by Alicia H. Munnell (Brookings Institution Press, 240 pp., $29.95)

Prior to the Great Recession, only actuaries, finance types, politicians, and a few policy wonks got into heated arguments about pensions for state and local government workers. No longer. The economic downturn sent funding ratios—the proportion of assets to liabilities—plummeting, and revealed that many governments had not set aside enough money to make good on their promises to employees. The stakes are high: state and local pension plans hold $2.8 trillion in assets, cover 15 million government workers (11 percent of the national workforce), and provide benefits to 8 million retirees. They have major economic effects on every state, city, and town.

Unfunded liabilities for state and local pensions are now getting press attention, but up to now, a serious, book-length scholarly analysis has been unavailable. Alicia Munnell’s State and Local Pensions helps fill that gap. A professor of management and director of the Center for Retirement Research at Boston College, Munnell also has extensive real-world experience, including 20 years at the Federal Reserve Bank of Boston. She also served as an assistant secretary of the Treasury Department and worked as a member of President Clinton’s Council of Economic Advisers.

In a brisk, matter-of-fact style, shorn of polemical language, her book makes six broad claims. First, not all public-pension plans are in trouble. Some states’ plans, such as North Carolina’s and Florida’s, are doing just fine. Others, including New Jersey’s and Illinois’, are in serious trouble. Most state and local pensions, Munnell shows, have improved their investment practices and are more professionally managed today than they were in the 1970s.

Second, Munnell argues that variation in pension-plan funding is “simply a story of fiscal discipline.” She claims that neither the 8 percent discount rate—the assumed rate of return on investments that determines contributions and liabilities—nor public employee unions’ collective bargaining activities has caused the underfunding crisis.

Third, pensions will soon begin to consume a bigger share of state and local budgets. Today they account, on average, for 4.6 percent of state and local revenues. But if they only earn 4 percent return on their investments, pension contributions will spike to 14.5 percent of revenue, becoming the third-largest slice of many state budgets, after schools and health care. Such an increase, if it comes to pass, threatens to crowd out other government functions and priorities.

Fourth, public-sector workers make less in salary and wages than comparable private-sector workers, but their pension and health-care benefits close the compensation gap. Agreeing with much previous research, Munnell also finds that at the low end of the labor market, the public sector pays better, while at the high end, the private sector does. Those in the middle are about equal. Greater job security in the public sector offsets the occasionally dreary working conditions found in government offices. Munnell’s bottom line: compensation differentials between the public and private sectors are modest.

Fifth, because public pensions are more generous and provide greater salary replacement in retirement than those available in the private sector, workers who spend most of their careers in public employment end up with more wealth when they retire than their private-sector counterparts. Such differences are the source of much “pension envy.”

And sixth, as governments consider reform, Munnell suggests that defined-contribution plans should have a role. The portability of such plans can help attract talented people to work for government. Though she does not advocate a wholesale replacement of defined-benefit plans, she does favor the introduction of defined-contribution plans, as Richard C. Dreyfuss and others have advocated, in a limited, narrowly tailored way.

Ultimately, Munnell believes, the solution to the nation’s public-pension problem will only come from state and local governments’ making “tough decisions to distribute pain among current retirees, current employees, future employees, and future taxpayers.” She endorses the efforts of Rhode Island’s Democratic state treasurer, Gina Raimondo, as a model. Munnell cautions political leaders not to cut benefits too severely for future workers and thus undermine the attractiveness of public employment. She also encourages fund managers to reduce holdings of equities and other risky (if often profitable) assets; strong returns too often wind up used for benefit expansions or reduced employer contributions, rather than to offset future market downturns.

Munnell emerges as a prudent moderate on public-pension reform. While she occasionally plays down the pension problem, she admits its seriousness and concedes that the funding shortfalls are not confined to bad actors like Illinois and New Jersey. She agrees with critics like Joshua Rauh and Robert Novy-Marx that the discount rate should be lower, but only for reporting purposes, not for contribution or investment purposes—that is, governments could still make contributions based on higher discount rates of 7 or 8 percent, and such returns should be the long-term goal of fund managers. She believes that a lower discount rate offers the more accurate and transparent accounting method, even if it increases the underfunding ratio in the short term. Ultimately, she sees more cuts coming for future and current workers and for retirees. Yet the jury remains out on whether stakeholders will accept these hard truths and take the incremental steps she recommends.

Some of Munnell’s conclusions are debatable. For instance, few would dispute her contention that an 8 percent discount rate didn’t cause pension underfunding. But most critics of high discount rates argue that they understate liabilities, and that lower rates provide more accurate and transparent assessments. Further, if investment returns are less optimistic and underfunding ratios higher—as they would be with a lower discount rate—legislators will be less likely to offer big pension sweeteners or evade contributions. And even Munnell admits that high discount rates created problems in some cases—had California, for instance, used a lower rate, it probably would not have enacted a large retroactive benefit expansion in the 1990s.

When it comes to public-sector unions’ effect on public pensions, Munnell’s statistical model makes it difficult to determine whether union strength causes underfunding. She concludes that pension underfunding is simply a result of states’ fiscal cultures: some states have good ones, and some don’t. But that just makes us ask what factors produce such cultures.

A recent paper by political scientists Sarah Ansia and Terry Moe found that the power of public-sector unions had large and statistically significant effects on both the generosity of public plans and their degree of underfunding. Their study found that in 2009, a 10 percent increase in union membership in any state raised per-capita pension liabilities by $1,412, or the equivalent of 20 percent of a state’s domestic gross product (multiplying the population by the liability increase). Moving on a scale from North Carolina, the state with the lowest percentage of public employees belonging to unions, to New York, the state with the highest, public-pension liabilities per capita increased by nearly $10,000. Meanwhile, a shift from the least to the most unionized state increased unfunded liabilities by $4,369, or 10 percent of the state’s gross product. These findings, though provisional, suggest that Munnell’s analysis doesn’t settle the issue of public-sector unions’ effects on pension size and funding ratios. More study is needed.

Wherever one comes down on these complicated issues, Alicia Munnell has written a thoughtful and informative book. Hers is a welcome contribution to the debate about how to cope with the extensive promises state and local governments have made to their employees and how to balance those promises against competing priorities.

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