Public vote for change

The Republic victory at the November elections has huge implications for public pension funds. The results are, in fact, supportive of reform to retirement systems that are threatening to bankrupt several state and local administrations. A few newly elected governors advocate moving towards a hybrid pension model where at least a portion of future benefits is funded by defined contribution plans such as 401(k)s in order to share market risks with employees. But California, the state most in need of this system - according to the Milken Institute - will not be contemplating any radical change because the governor-elect, Jerry Brown, and both state chambers are Democratic, and heavily influenced by the powerful public employee unions.

The 50 states collectively face a $72bn (€52bn) shortfall in their budgets in 2011, according to the National Conference of State Legislatures and they have enough to cover only 76% of their pension obligations. Total unfunded public pension liabilities increased to $457.8bn in 2008 from $368.5bn in 2007, according to a June 2010 report by Standard & Poor's.

California and Illinois are in the worst situation. On 2 November 2010 they held local ballots calling for pension reform. Voters in eight Californian cities and counties approved measures slashing public pension benefits, and residents of more than 40 suburban Chicago communities approved a ballot question demanding that the Illinois Legislature lower benefits for future state workers. Besides, four newly elected Republican governors in Alabama, Nevada, Tennessee and Wisconsin want to introduce 401(k)-style plans for public sector employees. A fifth Republican governor, Tom Corbett of Pennsylvania, and the independent, Lincoln Chafee, governor-elect of Rhode Island, both prefer a hybrid that combines features of 401(k)s and fixed benefits.

So far, only Alaska and the District of Columbia have mandatory defined contribution plans for all workers, according to a June report by Ron Snell, director of the state-services division for the National Conference of State Legislatures. Seven other states have some form of hybrid plans for public workers.

The fact is that making adjustments to a traditional defined benefit plans by concurrently raising the retirement age and increasing employee contributions will not fix the problems of big pension systems. Perry Wong and I-Ling Shen, researchers with the Milken Institute, write in their paper ‘Addressing California's Pension Shortfalls - The Role of Demographics in Designing Solutions': "If no corrective actions are taken, the combined liability of the three major state pension funds - the California Public Employees' Retirement System (CalPERS), the California State Teachers' Retirement System (CalSTRS), and the University of California Retirement System (UCRS) - will be more than 5.5 times as large as total state tax revenue around 2012-13. The three major funds' combined unfunded liability per working-age adult in California, will soon more than triple, from more than $3,000 in 2009 to more than $10,000 by 2014."

Even the recent deals agreed by out-going Calafornia Governor Arnold Schwarzenegger with seven unions to roll back temporarily pension benefits, including raising the retirement age and the employees' contributions, will only "chip away at the problem", according to Wong and Shen, because they cover only the next contract period. Their conclusion: "In order to achieve a more lasting and effective pension overhaul, it will eventually be necessary to shift to a risk-sharing retirement plan. Generally, this type of plan, similar to a defined benefit plan, guarantees a basic pension benefit or a minimum rate of return to pension contributions that are risk-free to the employees. But it does ask the employees to bear the investment risks for part of their future benefit in the same fashion as a defined-contribution plan, such as a 401(k)."

The advantages would be to reduce the asymmetry between investment risk and guaranteed benefits, which would decrease the likelihood of a "crushing" pension liability, explain Wong and Shen, while still providing a fixed, if lower, guaranteed pension, which is an important recruiting tool.

The two researchers concede that making such changes will take time and courage from both legislators and union leaders, and will need broad public support.



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