Back in the day before private employers dismantled their pensions and replaced them with 401(k)s, if someone told you that they had a pension, you would not know whether they worked for the public or private sector. Today, however, if someone says, ‘I have a pension,’ that usually means they work in the public sector.
Public employees make up 14% of the total workforce. Fifty-two percent of them have college degrees, which is higher than in the private sector, where only 35% do. Fifty-seven percent of public employees are female, compared to 42% in the private sector, and 30% of public employees, roughly six million workers, are not covered by Social Security.[i]
Some of the states that have poorly funded their public pensions (e.g., Illinois, which has a funding ratio of just 39%) are also some of the thirteen states where Social Security doesn’t cover public employees. Colorado is one of these states, and its 59% funding ratio is not much better than Connecticut’s at 47%.[ii]
A Pew Research Report puts the funding gap for all public employee pensions at $1.24 trillion. Every state is different, though. For instance, Washington, South Dakota, New York, Nebraska, Idaho, Wisconsin, and Tennessee are in great shape with funding ratios at 90% or better. Others, such as Illinois, Kentucky, New Jersey, and Connecticut, are in big trouble, with funding ratios of only 40% to 50%.[iii]
Public employee pensions are funded in three ways: (1) The states contribute; (2) Employees put in a percentage of their salary; and (3) The pool of money grows. In states where Social Security covers employees, the median employee contribution rate is 5%. In states without Social Security, the median employee contribution rate is 8%.[iv]
Some states, including Rhode Island, which at one point had the nation’s highest underfunding on a per-capita basis, shifted their public employees to a hybrid program that combines a less generous traditional pension with a 401(k).[v]
With 401k(s), employers contribute money for their employees’ retirements while they are working. Employees can also set aside a portion of their pay. (The government provides the tax incentives to do so.) However, it is up to the worker to set aside enough for a comfortable retirement.
The painless way for states to make up for funding gaps is to hope that the $3 trillion already in these plans grows fast. That way, neither the state nor the public employee is required to contribute additional funds. However, growing a portfolio when interest rates are this low requires plans to reduce holdings of safer investments, such as bonds, and increase holdings of riskier assets such as stocks, hedge funds, real estate, and private equity.
According to Alicia Munnell, Peter F. Drucker Professor of Management Sciences at Boston College’s Carroll School of Management and director of BC’s Center for Retirement Research, two-thirds of public pension plan assets are invested in stocks, hedge funds, real estate, and other alternative investments.[vi]
Joshua D. Rauh, Professor of Finance at Stanford Graduate School of Business and a senior fellow at the Hoover Institution, adds, ‘US Public pension funds have $315 billion of commitments to private equity, venture capital, and private real estate funds. This is compared to $89 billion for all university endowment funds combined, and $98 billion for all sovereign wealth funds.’[vii]
This April, at the height of the stock market carnage, famed reporter Bethany McLean penned a piece for Vanity Fair that discussed the large investments public employee pensions made in private equity, making private equity like the big banks—too big to fail and in need of a bailout from the federal government.[viii]
The good news for public employees is that it is extremely hard for states to get out of their pension commitments no matter how poorly they are funded or how much they have invested in private equity. The bad news is, unlike the federal government, states don’t own a printing press.
Maybe the Rhode Island solution of a combination of a traditional pension along with a 401(k) ends up being the way forward that allows states to continue to provide smaller but well-funded pension benefits to their public employees. [ix]
[i] Alicia H. Munnell, State and Local Pensions What Now? (Kindle Version)
[ii] The State Pensions Funding Gap: 2018, https://www.pewtrusts.org/en/research-and-analysis/issue-briefs/2020/06/the-state-pension-funding-gap-2018#:~:text=At%20%241.24%20trillion%2C%20the%2050,due%20to%20strong%20investment%20performance.
[iii] The State Pensions Funding Gap: 2018, https://www.pewtrusts.org/en/research-and-analysis/issue-briefs/2020/06/the-state-pension-funding-gap-2018#:~:text=At%20%241.24%20trillion%2C%20the%2050,due%20to%20strong%20investment%20performance.
[iv] Alicia H. Munnell, State and Local Pensions What Now? (Kindle Version)
[v] Alicia H. Munnell, State and Local Pensions What Now? (Kindle Version)
[vi] Alicia H. Munnell, State and Local Pensions What Now? (Kindle Version)
[vii] J.D. Rauh (personal communication, July 14, 2015)
[viii] McLean Bethany, Too Big to Fail, Covid-19 Edition: How Private Equity Is Winning the Coronavirus Crisis, Vanity Fair, April 9, 2020, https://www.vanityfair.com/news/2020/04/how-private-equity-is-winning-the-coronavirus-crisis
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These are the opinions of financial advisor Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only, and should not be construed or acted upon as individualized investment advice.