By: Tim Hayes Financial Advisor - posted in: Financial & Retirement Planning - Last updated Nov 19, 2018

The Public Employee Pension Puzzle

by | Financial & Retirement Planning

Back in the day before private employers dismantled their traditional pensions and replaced them with 401(k)s, if someone told you that they had a pension, you wouldn’t know whether they worked for the public or private sector. Today, however, if someone says, “I have a pension,” that usually means they work in the public sector.

Public sector employees make up 14% of the total workforce. Fifty-two percent of them have college degrees—which is higher than in the private sector, where only 35% do. Fifty-seven percent are female, compared to 42% in the private sector, and 30% of public employees, roughly six million workers, are not covered by social security.[i]

Some of the states that have done a poor job of funding their public pensions—e.g., Louisiana, which has a funding ratio of just 56%—are also states where Social Security doesn’t cover public employees. Massachusetts is another state where public employees are not covered by social security—and its funding ratio, at 61%, is not a lot better than Louisiana’s.[ii]

A recent Pew Research Report puts the funding gap for all public employee pensions at $1 trillion.[iii] Every state is different, though. Florida, North Carolina, Georgia, Delaware, and Tennessee, for instance, are in good shape. Others, such as Illinois, Kentucky, New Jersey, and Connecticut, are in big trouble, with funding ratios in the 40% range or in the case of New Jersey, resorting to borrowing to fund their pension.[iv]

“Funding” means how much money states have put away to pay commitments. Illinois is the poster child for a screwed-up public pension, with a funding ratio of only 39%. That means, for every $100 the state owes an employee, it has set aside only $39. Recently, the Mayor of Chicago, Rahm Emanuel, blamed a $636 million payment to the Chicago pension system for 1,050 school-system workers losing their jobs.[v]

State and Local Pensions

Public employee pensions are funded in three stages: (1) the states contribute; (2) employees put in a percentage of their salary; and (3) the pool of money grows. On average, states contribute about 5% of their budget to their pension system. In states where employees are covered by social security, the median employee contribution rate is 5%. In states without social security, the median employee contribution rate is 8%.[vi]

The painless way for states to make up for funding gaps is to hope that the $3 trillion already in these plans grows fast. That way, neither the state nor the public employee is required to contribute more funds. However, growing a portfolio when interest rates are this low requires plans to reduce their holdings of safer investments, such as bonds, and increase their holding of riskier assets, such as stocks, hedge funds, real estate, and private equity.

How the 2017 Federal Tax Cuts and Jobs Act Can Help Solve the Public Pension Problem

According to Alicia Munnell, Peter F. Drucker Professor of Management Sciences at Boston College‘s Carroll School of Management and director of BC’s Center for Retirement Research, two-thirds of public pension plan assets are invested in stocks, hedge funds, real estate, and other alternative investments.[vii] Joshua D. Rauh, Professor of Finance at Stanford Graduate School of Business and a senior fellow at the Hoover Institution, adds, “US Public pension funds have $315 billion of commitments to private equity, venture capital, and private real estate funds. This is compared to $89B for all university endowment funds combined, and $98B for all sovereign wealth funds.”[viii]

The good news for public employees is that it is extremely hard for states to get out of their pension commitments no matter how poorly they are funded. The bad news is that government commitments wrapped around a lot of high-risk investments usually ends badly. (Think banks)

Some states, including Rhode Island—which at one point had the nation’s highest underfunding on a per-capita basis—shifted their public employees to a hybrid program that combines a less generous traditional pension with a 401(k).[ix]

With 401k(s) and 403(b)s, employers contribute money for their employees’ retirements while they are working. Employees can also set aside a portion of their pay. (The government provides the tax incentives to do so.) However, at the end of the day, it is up to the worker to set aside enough for a comfortable retirement.

[i] Alicia H. Munnell, State and Local Pensions What Now? (Kindle Version)

[ii] The State Pensions Funding Gap: Challenges Persist, http://www.pewtrusts.org/~/media/Assets/2015/07/PewStates_StatePensionDebtBrief_Final.pdf?la=en

[iii] The State Pensions Funding Gap: Challenges Persist, http://www.pewtrusts.org/~/media/Assets/2015/07/PewStates_StatePensionDebtBrief_Final.pdf?la=en

[iv] The State Pensions Funding Gap: Challenges Persist, http://www.pewtrusts.org/~/media/Assets/2015/07/PewStates_StatePensionDebtBrief_Final.pdf?la=en

[v] Juan Perez Jr., Bill Ruthhart and Heather Gillers, CPS set for $200 million in cuts; mayor floats property tax plan, http://www.chicagotribune.com/news/local/politics/ct-chicago-schools-pension-payment-met-0702-20150701-story.html

[vi] Alicia H. Munnell, State and Local Pensions What Now? (Kindle Version)

[vii] Alicia H. Munnell, State and Local Pensions What Now? (Kindle Version)

[viii] J.D. Rauh (personal communication, July 14, 2015)

[ix] Alicia H. Munnell, State and Local Pensions What Now? (Kindle Version)

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