Dear S&B; With all the talk surrounding underfunded government pensions,
how does one go about “fixing” them? Bruce – Santa Barbara
If you want to fix an underfunded pension, the first thing you need to do is understand how they are constructed. A pension plan is simply a promise to pay a future benefit. Think of it as a future deferred debt payment.
Pension plans usually have benefit formulas based upon years of service, participant earnings and a minimum retirement age. A formula may say something like this, “at “Y” age of retirement, you are eligible to receive X% of your salary adjusted by a service year formula and you will be paid that benefit for life.”
When a company or government makes these types of promises, they are supposed to put enough money aside for the future expected payments. An actuary (number cruncher) calculates a minimum of five (5) critical components (age, salary, years of service, life expectancy and expected investment results) to figure out how much should be saved in the plan to cover these future liabilities.
When people talk about a pension plan being $X dollars underfunded, that means they do not have enough money today, to cover the future liabilities as if they were due now. And there are a lot of government plans that are underfunded.
According to the Sacramento Business Journal, they took a look at California’s largest city and county pensions and found the aggregate to be short $136 billion dollars. The “best” of the worst being the City of Fresno Employee’s Retirement System , having enough money set aside for 78% of their obligations (22% short on what they have promised). But don’t think Fresno is in great shape as they have multiple pensions with the Fire and Police fund ranked at #23 and their County Employee system at #8 with only 49.4% funded.
The worst pension plan in the study coming in #1 on the most underfunded list was Kern County at only having 41 cents on every dollar of obligations promised. If you are wondering about Santa Barbara County, the Employee Retirement System was #6 with 47.4% of the obligations funded (Ventura was #9 with 50.7%).
Why aren’t these pensions failing? Just because they are underfunded does not mean they don’t have money. Think of this like any pyramid or Ponzi scheme. You only have to have enough money today to pay those you make current payments to. The problem becomes a real issue when there is no more money. Otherwise, why not just kick the can down the road (think of Social Security and Medicare as well).
In the real world, this has dire consequences. For the government, it generates a committee, a study and a report which inevitably needs more review or another committee for further analysis. We can save you the effort and waste of time with how you fix any pension problem. Newsflash, it is not all that complicated, there are limited levers to pull.
Option 1: Convince your actuary to assume your participants are going to die sooner than expected and then they actually have to die on that schedule.
Option 2: Earn higher rates of return. That is a function of the capital markets and obviously uncontrollable and uncertain.
Option 3: Put in more money. That would be nice, there is so much “extra” of it floating around. But seriously, the inevitable is to try to increase taxation (or “fees”) to help with budget shortfalls. But cutting back “costs” is another solution as well. A combination approach is probably most realistic.
Option 4: Renegotiate contract and benefit packages. Have fun with the unions on this. It is far easier to talk about new hires and a different class of employee, but the problem today is routed in the aging tenured workforce.
Option 5: Negotiate to shut down the plans and convert them to different structures such as a 401k (funded largely by the employee with no guarantees). However, when you do this, you accelerate the obligation that needs to be paid out so if you owe $1 but only have 60 cents, you have to come up with the missing 40 cents to make all the parts “whole.”
Option 6: Declare bankruptcy and let the court system go through the process to break contracts, renegotiated terms and obligations. No one wants this. No one. And this has happened very infrequently in the history of this country. According to attorney James Spiotto of Chapman and Cutler, LLP, “municipal bankruptcy filings are very rare in comparison to their corporate counterparts. Of more than 55,000 municipal entities, fewer than 600 have filed for bankruptcy protection since 1937.”
However, municipalities like Vallejo outside of San Francisco have taken this path, largely due to the large promises associated with the contract salaries and retirement benefits on their books.
But choosing bankruptcy may not fix all the issues; it surely did not for Vallejo. The legal costs were enormous and in any litigation the outcome can be uncertain. However, it did help Vallejo to cancel the collective bargaining agreements and negotiate new contracts including health care and leave time cuts.
But they decided not to test the court regarding the pension plans and that liability still hangs out there. The end result was a severe cut to infrastructure and city services. Their reputation left tarnished and making it more difficult to attract business and capital in general. As Jonathan Weber, editor in chief of The Bay Citizen puts it, “Thinking about bankruptcy as a solution to your city’s financial troubles? There has to be a better way.”
Author’s Note: Brad Stark, MS, CFP®, AAMS, CMFC and Seth Streeter, MS, CFP® are Co-Founders of Mission Wealth Management, LLC (MWM), a Registered Investment Advisor. The information contained in this article is general in nature and should not be construed as comprehensive financial, tax, or legal advice. The views expressed herein are not endorsed by National Planning Corporation (NPC). As with any financial or legal matter, consult your qualified securities, tax, or legal representative before taking action. Advisory services offered through MWM. Securities offered through NPC, Member FINRA/SIPC. NPC and MWM are separate and unrelated entities. Certain statements contained within may be forward-looking statements, including but not limited to, statements that are predictions of or indicate future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties; all statements are subject to change without notice. Also, historical performance cannot predict future results. If you have any questions you want addressed, please submit them to email@example.com.