If School Pensions are ‘Vital,’ They Should Have Been Properly Funded

Defined benefit pensions could work just fine for both employers and employees. But government pensions have a major problem: They are ultimately run by politicians who are good at and used to making promises, but also good at and used to passing the bill to somebody else. The consequences of failing to pay the true cost of these promised pensions occur decades into the future, so it’s very easy for politicians to just push the burden onto future taxpayers.

Michigan’s largest government pension system, the one for school employees, is a slow-motion fiscal disaster. Lawmakers have promised current and past employees some $72.3 billion in benefits but only saved enough to pay 60 cents on the dollar of those promises. The pension fund, then, is $29.1 billion short of the amount the state’s own actuaries estimate is needed.

The costs of the shortfall are immense. The annual interest payments on this debt alone cost more than what the state spends annually on prisons.

In fact, that $29.1 billion unfunded liability makes school employees and retirees the state’s largest creditors. This is not fair. School employees never consented to let the state borrow money from them.

Under a defined-benefit pension system, when an employee earns benefits, the employer is supposed to set aside enough money in the same year to pay the costs of that benefit. In the case of public employment, this practice keeps the costs of today’s service from being a burden on future taxpayers and assures employees their benefits will be there when they retire.

The future is uncertain, so to determine how much to save and invest to meet the system’s promises, pension managers must make assumptions: how much will employees earn, how long they will live, and what kind of returns can be expected from pension fund investments going forward are three key assumptions.

There are many ways to get it wrong, and the perhaps the easiest one is to make overly optimistic assumptions, particularly about investment returns. Unfortunately, the state’s been too optimistic for a long time. The result is that Michigan’s school pension system has been underfunded in 42 of the past 43 years.

When pension administrators recognize there’s a funding gap, they develop a plan to fill it. But the plan that Michigan’s pension managers chose for the school system was so inadequate that, until recently, it wasn’t even paying the full interest costs on the system’s debt.

The solution is simple: State leaders must stop the practice of promising benefits now and trying to pay for them later. This means no longer promising lifetime pension benefits to every new employee hired by a Michigan school. New employees should instead be offered automatic contributions, with optional matching funds, to 401(k)-style savings plans that generate no long-term taxpayer liabilities. People still in the system can continue to earn pensions, and the state will continue to pay out what has been promised, but over the long haul, lawmakers will be prevented from pushing retirement costs onto future taxpayers.

Some interest groups are concerned about this proposal. They include school administrators, unions and the managers of the current school pension system. Some of them have falsely claimed that the current system poses little risk to taxpayers and that no longer enrolling new hires would incur “transition costs.”

But this is not correct. Such costs are entirely optional, and even if they are paid, it saves taxpayers in the long run. Interest on pension debt is one of the most expensive types of state debt that taxpayers are responsible for.

The other claim is that a newer, so-called “hybrid” retirement plan has fixed all the problems. It remains susceptible to underfunding like the older plans and has only existed since 2010. During its brief life, the plan has benefited from stellar returns from the stock and bond markets; even so, it has just 0.1 percent more in assets than liabilities. So to say that the plan will never go into debt is Panglossian and irresponsible.

Finally, the system’s defenders argue that defined-benefit pensions are inherently better for employees than a 401(k)-style, defined-contribution plans. If they really believe this, though, they have a moral obligation to match their deeds to their words to ensure that pensions are funded as they are earned.

This means that pension managers should have used realistic assumptions — not pie-in-the-sky ones — about future payroll growth and investment returns. They should have actually made the required annual contributions. And long ago, they would have stopped kicking the costs into the future. School interest groups would have to have been watchdogs to ensure that this happened.

The system’s current $29.1 billion unfunded liability is a testament to how far short these groups fell in this endeavor.