Should State Pension Plans Play Wall Street With Employees’ Money?

In a recent examination of state pension plans, my colleagues and I discovered that states are increasingly tempted to solve their underfunded pension plan problems by acting a bit like Wall Street: hoping to make money out of the deposits they hold in a fiduciary capacity for their employees.

When a state plan has inadequate funding to pay promised benefits, someone eventually has to cover the difference.  It could be taxpayers, those in the plan, or those who will be in the plan.

Because current and future taxpayers are already on the hook for a lot of past bills that have been left to them, states have tried to reduce their potential burden.  Because existing state employees, especially those near retirement, have made plans for the benefits they have been promised, they have been asked to give up only a little.  In many cases, their additional cost is confined to higher employee contributions for the remaining years of their careers only.  Since the other two groups have been spared much of this burden, new employees have been asked to pay significantly more in both higher lifetime contributions and lower lifetime benefits than existing employees.

In our examination of one example, a reformed New Jersey plan, it turns out that many or most newly hired employees are unlikely to get lifetime benefits from the plan that are any higher than what they could earn with a modest interest rate—say, 2 or 3 percent—on their own contributions.  Only those who work for the state for a very long time, such as 25-year-olds who stay between 30 and 40 years, get more.

The plan, however, assumes actuarially that the state will still earn a return of 8¼ percent on those employee contributions.  In effect, the state hopes to make money out of their employee contributions just like a bank or Wall Street does: by leveraging up deposits, borrowing at one rate, and earning money at a higher rate.

A number of economists, actuaries, and accountants (see, for instance, Joshua Rauh and Robert Novy-Marx, Andrew Biggs, and, most recently, the Government Accounting Standards Board) have questioned the assumption of such a high rate of return.

We raise a further issue.  Whatever the appropriate rate, how much should a state depend upon future employees to be net contributors to a pension plan, rather than net beneficiaries from it?

2 Comments on “Should State Pension Plans Play Wall Street With Employees’ Money?”

  1. Carl says:

    Rosy Scenario solves all problems.
    And it doesn’t hurt that governments use cash accounting instead of accrual accounting. Makes it easy to run up debts while claiming to balance the budget.

    If the Fed stopped flattening the yield curve, and banks weren’t allowed to play maturity transformation games, pensions and IRAs could get decent yields by simply buying long term CDs and similar instruments. Mortgages would be more expensive, however.

  2. Kat says:

    It’s too risky considering most pension plans are mandatory-contribution plans. I have a strong dislike for the idea of my retirement capital being risked without my input. If it’s going to be that way I’d rather just put it in my own 401k. I think you just have some government investors being dazzled by financial salesmen.

Leave a Reply

Your email address will not be published. Required fields are marked *