States all over the country are grappling with ever-increasing unfunded pension liabilities. My home state of Connecticut trails such pension liability behemoths like Illinois and New Jersey, but still ranks high on the danger list. In June 2010 the Connecticut public pension fund had $9.3 billion in assets but its actuaries calculated that the state still needed an additional $21.1 billion to meet all its pension obligations. It was only 44 percent funded.
By June 2016, six years later, state pension assets grew to $11.9 billion, a 28 percent increase, largely because of the increase in the stock market. Nevertheless, despite Gov., Dannel Malloy’s tax increases and commitment to funding pensions, the pension liability had grown to $32.3 billion, a whopping 53 percent increase. After six years under Malloy, the pension system was only 37 percent funded. What caused the increase?
The governor, who will not seek re-election this year after serving two terms, has placed the blame for rising pension liabilities on his predecessors in office, as well as on the legislature which has been controlled by fellow Democrats throughout his tenure. His complaint is a common one heard all over the country. If only previous politicians had had the guts to face up to reality and popular pressure, pension liabilities would be manageable. Instead, politicians just pushed the day of reckoning down the road.
There is some truth in Malloy’s assessment, but actually there is no way that any of these state public pension plans can ever be adequately or fully funded.
To understand we can use a very simple illustration. Suppose you were to go to a financial advisor and state that your goal was to have $40,000 a year in income when you retired. It would be simple for the advisor to say that assuming a 4 percent rate of return, you would need to have $1 million dollars in your retirement account. $1 million times 4 percernt provides $40,000 per year. However, if you only assume a 2 percent rate of return, you would need $2 Million dollars in your retirement account. $2 million times 2 percent equals $40,000.
In other words, the expected rate of return that the actuaries use has a great deal to do with their assessment of future pension liability. Despite the increase in Connecticut pension assets during Gov. Malloy’s tenure, the pension liability has grown even faster largely because of the low interest rate environment during those years. If the expected rate of return is reduced, actuaries must indicate that pension liability is growing. Politicians have no control over interest rates.
Lack of control is one of the reasons why most business corporations have dropped their defined benefit pension plans over the past few decades. A business could be thriving but its pension actuary could kill its balance sheet by claiming that it had to put billions more into the pension plan because of a decline in expected rate of return due to circumstances entirely beyond control. In a defined contribution or 401k type plan, a corporation’s contribution is a manageable percentage of payroll.
Businesses changed their pension plans years ago because they lived in a very competitive environment. States and municipalities were not in the same situation. Not only did public entities not worry about profits and losses, politicians had little incentive to strike hard bargains with public service unions. In business, management and labor sit across the negotiating table from one another. In government, the politicians negotiating with the unions are usually on the same side of the table.
Not only do governors and legislators rely heavily on union votes and campaign contributions, but also they, their families, and friends usually gain from any benefit they grant to union members. For example, during his tenure Gov. Malloy has appointed a number of Democrat legislators to high paying positions in his administration or on the judicial bench. While these politicians served in the legislature, actuaries would determine their pension liability as a percentage of their $35,000 part-time salary.
But they need to serve only three years in their new positions to throw all pension calculations out the window. Instead of getting 60 percent or 70 percent of $35,000, the actuaries will have to figure that they will receive the same percentage of some six figure salary. The governor has recently nominated his long-time Stamford Democrat friend Andrew McDonald to serve as Chief Justice of the State Supreme Court. McDonald’s minimal contributions to the pension fund during his eight years in the legislature will come nowhere near providing a six-figure pension.
What incentive did Malloy have to change the pension system for non-union employees in his administration or in the state court system? In the last eight years he could have put all of them into a 401k plan with the stroke of a pen. Alternatively, he could have easily changed the definition in the benefit formula for these non-union employees. Instead of basing their pension on the average of their highest three years of service, the governor could have used the average of all the years of their public service. While he talked about unfunded pension liabilities, his actions belied his words.
Francis P. DeStefano, Ph.D., of Fairfield, is a writer, lecturer, historian and retired financial planner.