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State and Local Pensions (Maybe Rhode Island Figured it Out?)

by | Apr 22, 2017 | Government

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 percent of public employees, roughly six million workers, are not covered by social security.[i]

Illinois is the poster child for a screwed-up public pension, with a funding ratio of only 39%. That means, for every $100 the state owes an employee, it has set aside only $39. Recently, the Mayor of Chicago, Rahm Emanuel, blamed a $636 million payment to the Chicago pension system for 1,050 school-system workers losing their jobs.[ii]

Some of the states that have done a poor job of funding their public pensions—e.g., Louisiana, which has a funding ratio of just 56%—are also states where Social Security doesn’t cover public employees. Massachusetts is also one of these states—and its funding ratio, at 61%, is not a whole lot better than Louisiana’s.[iii]

A Pew Research Report puts the funding gap for all public employee pensions at $1 trillion. Every state is different, though. Florida, North Carolina, and Tennessee, for instance, are in good shape. Others, such as Illinois, Kentucky, and Connecticut, are in big trouble, with funding ratios of only 40% to 50%.[iv]

Public employee pensions are funded in three stages: (1) the states contribute; (2) employees put in a percentage of their salary; and (3) the pool of money grows. On average, states contribute about 5% of their budget to their pension system. In states where employees are covered by social security, the median employee contribution rate is 5%. In states without social security the median employee contribution rate is 8%.[v]

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).[vi]

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, at the end of the day, 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 their holdings of safer investments, such as bonds, and increase their holding of riskier assets, such as stocks, hedge, 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.[vii] 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 $89B for all university endowment funds combined, and $98B for all sovereign wealth funds.”[viii]

When I was starting my career 25 years ago, I remember sitting on a plane next to an executive in the financial services industry. He thought public employees should invest their contributions going into their voluntary retirement programs, such as 403(b)s and 457 plans, aggressively. His rationale for this was: because their state pensions were conservative, public employees had an opportunity to take more risk with these voluntary contributions.

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. The bad news is that government guarantees wrapped around a lot of high-risk investments usually ends badly. And 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 benefit to their public employees.

These are the opinions of 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.

[i] Alicia H. Munnell, State and Local Pensions What Now? (Kindle Version)

[ii] Juan Perez Jr., Bill Ruthhart and Heather Gillers, CPS set for $200 million in cuts; mayor floats property tax plan, http://www.chicagotribune.com/news/local/politics/ct-chicago-schools-pension-payment-met-0702-20150701-story.html

[iii] The State Pensions Funding Gap: Challenges Persist, http://www.pewtrusts.org/~/media/Assets/2015/07/PewStates_StatePensionDebtBrief_Final.pdf?la=en

[iv] The State Pensions Funding Gap: Challenges Persist, http://www.pewtrusts.org/~/media/Assets/2015/07/PewStates_StatePensionDebtBrief_Final.pdf?la=en

[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] Alicia H. Munnell, State and Local Pensions What Now? (Kindle Version)

[viii] J.D. Rauh (personal communication, July 14, 2015)

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