Pensions need to be reformed
By Robert Novy-marx & Joshua Rauh
Published: Monday, Oct. 22, 2012, 8:50 p.m.
How much will the underfunded pension benefits of government employees cost taxpayers? The answer is usually given in trillions of dollars, and the implications of such figures are difficult for most people to comprehend. These calculations also generally reflect only legacy liabilities — what would be owed if pensions were frozen today. Yet with each passing day, the problem grows as states fail to set aside sufficient funds to cover the benefits public employees are earning.
Recently, we studied how much additional money would have to be devoted annually to state and local pension systems to achieve full funding in 30 years, a standard period over which governments target fully funded pensions. We found that, on average, a tax increase of $1,385 per U.S. household per year would be required, starting immediately and growing with the size of the public sector. An alternative would be public-sector budget cuts of a similar magnitude, or a combination of tax increases and cuts adding up to this amount.
Most states have traditional defined-benefit pension systems, which guarantee a certain payment upon retirement. In the past 10 years a handful of states have added defined-contribution elements, in which workers share in the market risk of their pension investments, as most private-sector workers do through IRAs or 401(k) plans. Most of these modifications, however, affect only new hires.
Our findings were calculated assuming that states invest somewhat cautiously and achieve annual returns of 2 percent above the rate of inflation. But even if states continue to bet that the stock market will bail them out and if the market were to perform as well over the next 30 years as it did over the past half-century, the required per-U.S. household tax increase would still amount to $756 per year.
And, of course, the returns could be much worse.
Without increased contributions, states are digging deeper holes each year. And as happens with all debt, if the debtors wait to pay it down, they will pay even more down the line.
How about increasing public-employee contributions? To obtain the necessary amount, contributions would have to rise by 24 percent. Cutting public employees' take-home pay by this magnitude is infeasible and would place a huge burden on younger public employees.
In short, some redirection of taxpayer resources to cover pension obligations seems inevitable. In addition, states must enact reforms that will stop the explosion of pension debt.
Systems could consider introducing mixed defined-benefit and defined-contribution plans for all employees, not just new hires. Cost-of-living adjustments should be re-examined, and new designs should also be considered.
The bottom line is that, as long as government accounting standards allow systems to justify low contribution levels by using optimistic guesses about returns that can be earned on portfolios of risky assets, traditional public-employee defined-benefit plans will generate more and more debt. And without reform, the eventual cost of funding these plans will, someday, make the $1,385 per-household increase required today seem cheap.
Robert Novy-Marx is an assistant professor of finance at the University of Rochester's Simon Graduate School of Business. Joshua Rauh is a professor of finance at the Stanford Graduate School of Business and a senior fellow at the Hoover Institution.
Show commenting policy
TribLive commenting policy
You are solely responsible for your comments and by using TribLive.com you agree to our Terms of Service.
We moderate comments. Our goal is to provide substantive commentary for a general readership. By screening submissions, we provide a space where readers can share intelligent and informed commentary that enhances the quality of our news and information.
While most comments will be posted if they are on-topic and not abusive, moderating decisions are subjective. We will make them as carefully and consistently as we can. Because of the volume of reader comments, we cannot review individual moderation decisions with readers.
We value thoughtful comments representing a range of views that make their point quickly and politely. We make an effort to protect discussions from repeated comments either by the same reader or different readers.
We follow the same standards for taste as the daily newspaper. A few things we won't tolerate: personal attacks, obscenity, vulgarity, profanity (including expletives and letters followed by dashes), commercial promotion, impersonations, incoherence, proselytizing and SHOUTING. Don't include URLs to Web sites.
We do not edit comments. They are either approved or deleted. We reserve the right to edit a comment that is quoted or excerpted in an article. In this case, we may fix spelling and punctuation.
We welcome strong opinions and criticism of our work, but we don't want comments to become bogged down with discussions of our policies and we will moderate accordingly.
We appreciate it when readers and people quoted in articles or blog posts point out errors of fact or emphasis and will investigate all assertions. But these suggestions should be sent via e-mail. To avoid distracting other readers, we won't publish comments that suggest a correction. Instead, corrections will be made in a blog post or in an article.
- Agreement nears on Springdale police chief’s duties
- A-K Valley students offer F.R. Strong support
- Governor signs child abuse protection bills
- Starkey: Fleury’s future at stake
- Victory on Friday could propel Bunola’s Salka into title fight
- Five years later, Crosby wants another Cup win
- Legal experts question prosecuting South Fayette boy for recording bullies
- Leechburg adds 2 part-time police officers
- Watch out for the freeze
- Dinner in Minutes: Souvlaki (Lamb Kabobs) with Lentils and Rice Pilaf
- Bronze flower vases stolen from cemetery