May 31, 2012
By Jason Richwine, Ph.D.
In the contentious national debate over public pension costs, Wisconsin is "ground zero." Yet few taxpayers know how much they are paying for the state's public pension system.
Here's an important piece of information: Using proper financial accounting methods, the pension plan for most state workers actually costs more than two-and-a-half times what the government's actuaries claim. Seen in this light, the recent pension reforms signed by Gov. Scott Walker are far from radical. And much more remains to be done.
To understand the real cost of defined benefit pensions, it's helpful to review the basics of how they work. State and local defined benefit plans for government employees are supposed to be fully funded, meaning plan administrators must set aside money each year to pay the benefits active workers have earned in that year.
These annual pension contributions go into an investment fund. The combination of the annual contribution and the interest it earns is then supposed to pay for future benefits that current public workers have earned.
In practice, though, it rarely does.
To determine the annual contribution, actuaries working for pension funds develop estimates of the "normal cost" of pensions, which is the amount of money that must be set aside today to pay for the future benefits that have been accrued that year.
The Wisconsin Retirement System is the pension plan that covers most of the state's government employees. Its estimated normal cost was 11.6% employee wages in 2011. But government actuaries dramatically underestimate pension costs in an important way: They base their normal cost calculation on the expected rate of return on plan investments - 7.2% for the WRS - which does not account for the riskiness of those investments.
There is nothing wrong with having a target or "expected" rate of return on investments, but the risk associated with those investments needs to be taken into account. The WRS might achieve 7.2% average returns, but it must pay its promised pension benefits regardless. Thus, the published normal cost reflects only part of the cost of the pension plan. Additional cost comes from the guarantee that benefits will be paid, even if the plan's investments do not generate the predicted returns.
When the published normal cost of public pensions is adjusted to reflect the guaranteed nature of pension benefits, the normal cost of WRS increases from 11.6% of wages to 29.5% - more than two-and-a-half times greater.
Before the Walker reforms, most state employees in the WRS contributed only about 0.2% of their wages toward the pension plan. Now that the reform bill has passed, most workers must contribute 5.8% of their wages, lowering the actual taxpayer cost to 23.7% (29.5 - 5.8) of wages. Put another way: to get the same guaranteed return associated with the WRS, a private-sector worker would need to invest 23.7% of his wages in a 401(k) each year.
The new 5.8% employee contribution has been widely reported as representing "half" of pension costs, but 5.8% is half of the improper normal cost estimate that is unadjusted for risk. In reality, most government employees in Wisconsin now pay about one-fifth of the cost of their retirements, not half.
From that perspective, the Walker pension reforms have been decidedly moderate. What is really needed are structural reforms that help to ensure that contributions to the pension system truly reflect costs.
Fortunately, the most recent budget act requires Madison to study a variety of structural changes. Reform options include moving toward a 401(k)-style plan, creating a "cash balance plan" (a traditional pension/401(k) hybrid), and allowing workers to partially opt out of the existing DB system. Whatever the study ultimately recommends, one of its major goals should be to provide the transparency needed so citizens can fully understand the costs of the pension system they are funding.
First appeared on JSOnline.com.
Jason Richwine, Ph.D.
Senior Policy Analyst, Empirical Studies
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