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Pensions need to be reformed

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By Robert Novy-marx & Joshua Rauh
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.

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