Opinion: Closing the $1.3 Trillion Gap In State Pension Funds

(March 9) -- Earlier this week, The New York Times documented how state pension plans are putting more money in riskier investments while private companies are moving their pensions to safer climes. As the Times reports, states are "seeking higher returns for their pension funds, to make up for lost ground in the last couple of years and to pay all the benefits promised to present and future retirees."

As disconcerting as this might be, it's only the tip of the iceberg when it comes to the troubles plaguing state pension funds.

Thanks to decades of bureaucratically controlled investments and shoddy accounting practices, states across the country are struggling to reconcile a $1.3 trillion gap in their pension programs. And while state legislatures pay lip service to this problem, they have few realistic plans to address the mountain of debt threatening to bury taxpayers and betray public employees when they reach retirement.

The problem at the root of this funding gap lies in the very structure of state pension programs.

Today, these programs are run as "defined benefit" plans. States promise retirement benefits for government workers based on complex formulas, and are supposed to manage their pension assets well enough to support these promised payments.

But what's happened is that states can and do promise to public employees benefits that are unrealistically high given the state's financial forecasts -- in part because of loopholes in government accounting standards.

At the same time, because state governments have full control of the employees' pension funds, nothing requires them to put the employees' and taxpayers' interests first. Instead, legislatures and pension boards, like all political bodies, sway with the political winds, even if it means lower returns, putting taxpayers on the hook to cover any shortfall.

So, for example, CalPERS, one of California's public pension plans, embarked on a long-term "green energy" investment plan with its public pensions in 2006. The move no doubt pleased environmentalists, but the investments returned a scant 3 percent, wildly underperforming the stock market during that time.

Then there was New Jersey Gov. Christie Todd Whitman, who from 1998 to 2003 held "pension holidays," suspending employee payments into the pension system so workers could spend the money elsewhere. Other states have since followed Whitman's example. Today, New Jersey's public pensions lack billions of dollars in funding, and both public employees and taxpayers will suffer.

Unfortunately, poor state stewardship of pensions is the norm, and rarely the exception, a fact underscored in a recent study of state pension programs by the Pew Center on the States.

Given the enormity of the problem, piecemeal reforms of the kind advocated by the Pew study won't be enough to fix it. The only way to tackle the nightmare of pension debt is to tackle the flawed incentives and risks inherent in all defined-benefit pensions.

Private employers discovered the solution 40 years ago. Since the 1970s they've been shifting their pension programs to 401(k) plans, which offer greater employee control and ownership of their retirement funds. These "defined-contribution plans" let workers contribute to their own retirement accounts with payments matched by their employers.

With these plans, the employer is no longer responsible for guaranteeing or managing payments -- bankruptcy no longer means the employees lose their retirement. And, while imperfect, defined-contribution plans have shown over these past 40 years to solve almost all the problems that continually plague the public pension system.

But while a few states -- such as Florida, Kansas and Utah -- are considering defined-contribution plans, the idea hasn't taken hold, largely because of fierce opposition from politically powerful public employee unions.

It's time state governments decide whose side they are on. Continuing the current system won't do the states' teachers, firefighters and policemen -- or their taxpayers -- any favors.

Aaron Merrill is a research assistant for the State and Local Policy Project at the Mercatus Center at George Mason University.

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