By Chuck Reed
One of the biggest problems with defined benefit pension systems for public employees is that most of the decision makers have an incentive to over promise and underfund. This incentive structure affects politicians and union leaders all over the country who can’t resist giving or getting a benefit today that will have to be paid for by someone else far in the future. These types of governance issues are often missed in the debate about what can and should be done about the skyrocketing retirement costs for public employees.
A report published last week by the Manhattan Institute highlights a significant challenge that many states and municipalities face, but is rarely ever addressed, which has helped lead to today’s public pension crisis: the role of pension boards. Although there are overwhelming efforts throughout the country to reform pension systems and reign in the nearly $4 trillion in U.S. pension debt, the issue of how many public pension boards are assembled and how they govern sadly remains neglected. And until this important piece of the puzzle falls into place, true pension reform in many parts of the country cannot be obtained.
As the report points out, the governance and makeup of public and private pension systems vary drastically—and in most scenarios, private systems always come out on top. For example, the diversity in public pension board composition leaves much to be desired, where in some cases there is only a single public official that administers the plan, or in other cases where a board is dominated by members whose self-interests often outweigh those of plan beneficiaries.
Another example of how public and private boards differ is the amount of power that each typically wield. According to one survey cited by the report, 88 percent of government pension boards exercise direct authority over the investment decisions of their funds, and 89 percent control their funds’ actuarial assumptions, both of which are key components in calculating the funding levels and risks that a plan faces. This substantive decision-making power left in the hands of people who lack expertise to make such important decisions spells disaster.
On the other hand, the federal Pension Protection Act ensures that private pension holders are protected by limiting pay outs when a plan is less than 80 percent funded, by using market-based discount rates based on high-quality corporate yields and by mandating that plan sponsors have to make up shortfalls within seven years. Perhaps if such mechanisms were in place in areas like my home state of California, which has the largest public employee retirement plan in the country, taxpayers would not be faced with billions of dollars in unfunded liabilities.
According to the report, “Some of the largest public pension funds, including those for California employees and teachers and those for New York City and state employees, have placed substantial emphasis on social, political and environmental concerns in managing their portfolio investments,” so much so that they’ve set themselves up for failure. And until many states and municipalities change the way their pension systems are governed, we can expect more of the same.