How Bad Is America’s Pension Funding Problem?

Unfunded liabilities in pension funds are just as onerous as other kinds of debt. Such liabilities now total more than $2.5 trillion and are growing at a rapid pace.

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No sooner had the Chicago teachers’ strike been settled than a new crisis emerged last week in the Windy City. The Chicago Teachers’ Pension Fund was reported to be on the brink of collapse. That fund is not alone. Although the troubles that plague the Social Security system get the most attention, similar dangers now threaten many other kinds of retirement funds. Some plans are being inadequately funded, some have earned unexpectedly low returns, and some suffer from a Baby Boom bulge in the number of retirees. Moreover, the problems facing these funds will in many cases be harder to fix than those for Social Security. And the scale of the total potential shortfall is immense.

There are basically two types of retirement funds. Defined-contribution plans, such as 401(k)s and IRAs, are tax-advantaged accounts owned and largely funded by employees themselves (sometimes with additional contributions by employers). The only real risk for these funds is that the investments in the account may perform poorly. Over the past 12 years, unfortunately, most stocks have gained little or have actually declined in value. As a result, many people approaching retirement today have far less money than they expected.

While such a shortfall is distressing, it doesn’t compare with the dangers posed by the other type of plan. So-called defined-benefit plans promise to pay benefits to retirees based on the length of time they worked and their former salaries. If these plans run short of money, they not only leave retirees unsure that their benefits are safe, they also create a potential cost for whoever has to bail them out (often taxpayers). Such plans can slide along for years hiding their growing internal deficits with accounting tricks. But at some point, the funding gap becomes too big to disguise – which is what is happening now. How bad is the total problem? Let’s add it all up.

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Start with Social Security, which is paying out more than it takes in (not counting the trust fund which will eventually be exhausted). That operating deficit will total more than $800 billion over the next 10 years, according to government projections.

Federal government employees, meanwhile, are covered by a more generous plan, the Federal Employees Retirement System (FERS) annuity, which tops up their Social Security. FERS is also suffering from rising costs, which are becoming burdensome. Indeed, the U.S. Postal Service has warned that it could default if it is not given relief from its funding obligation.

FERS itself was a reform to control the deficits being accrued by the old civil service retirement system. And although hefty government contributions have kept FERS in balance for current employees, the unfunded liability for employees still covered by the old system totals more than $630 billion. While there is no real risk that the Federal Government will be unable to pay promised benefits, the cost has led to calls for restructuring the system more aggressively and requiring employees to contribute substantially more.

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Next, let’s look at the state and local level. Since the recession, most states have been trimming pension costs for public-sector employees. The Wall Street Journal reports that 31 states have reduced benefits for new hires, 26 have required higher contributions from workers and nine have reduced cost-of-living adjustments for retirees. Nonetheless, a huge unfunded liability remains. Boston College calculates that such cuts have reduced a $900 billion shortfall by only $100 billion. Unlike Federal pension plans, which cover a broad cross-section of employees, state and local plans vary enormously from one place to another — so that the worst are much worse than the average. The portion of the obligations that are funded varies from more than 80% to less than 40%.

Finally, corporate pension plans are in the red as well. More than two-thirds of the companies that make up the S&P 500 have defined-benefit plans, and as of last quarter only 18 of them were fully funded. Seven had shortfalls of more than $10 billion apiece, according to the New York Times. All told, the unfunded liabilities add up to around $355 billion, or about 22% of the funds’ promised benefits. Moreover, recent legislation has allowed companies to use higher (and more optimistic) return assumptions. In the very short run such changes take financial pressure off troubled companies and also boost corporate income tax revenue for the government by reducing deductions. But in the long run the deficit is increased and eventually has to be paid.

All together, those unfunded pension liabilities add more than $2.5 trillion to America’s $16 trillion Federal debt and $2.8 trillion state and local debt. Just as it is vital to reduce government deficits, it will eventually be necessary to bring down this pension funding deficit. One way would be to slash retirement benefits by 20%. Another would be to force employees to pay an additional 5% of their salaries toward such benefits. Or taxpayers could cough up the money, bailing out pension funds as they get into trouble. Switching everyone over to defined-contribution plans, such as 401(k)s, would eventually solve the problem as far as young workers are concerned, but would still leave a huge unfunded liability for those approaching retirement.

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None of the solutions sounds very pretty, but one thing is sure: The sooner the problem is tackled, the less painful it will be.