Overly optimistic assumed rate of returns are a huge contributing factor to underfunded pension funds. According to the National Association of Retirement Administrators, the average assumed rate of return for public pension funds is 7.3%, which far exceeds the actual rate of return of 5.9%.
By Joy Yang
Currently, a conservative estimate of how underfunded US public pension funds are is at around $1 trillion. Also known as a defined benefit plan, these pensions were created for employees that worked in the public sector, including but not limited to firefighters, teachers, policemen, government workers, etc. By definition, a defined-benefit plan is a plan where employers promise set payouts to employees after they retire. The conception of the defined-benefit plan was supposed to be a win-win for both the government and employees. The government would be able to pay workers a lower salary during their employment, but workers were guaranteed a stable job and a steady source of income after their retirement.
By knowing their future cash flows, employees were able to plan their entire future. In a survey conducted by Accenture, 77 percent of employees in the public sector stated that they stayed with an employer due to pension benefits, while 80 percent believed that pension benefits were a critical factor in accepting a job. And while the rising pension debt crisis might only seem to be affecting current pensioners, there could be greater implications for local municipalities, state taxpayers, and the entire country as well.
In most cases, public pensions are backed by strong legal guarantees. If a municipality’s pension fund is unable to cover for future cash flows, the government is legally obligated to find other revenue sources to cover the loss. Where do these extra funds come from? The answer is, taxpayer dollars and the cutting of public services. Take for example the most extreme case in the state of Illinois. The state’s pensions are underfunded by almost $137 billion, accounting for a little more than one-tenth of all underfunding of public pension fund debt in the US. In trying to make pension payments, the state has already diverted 36 percent of education funds to cover pension payment gaps. Rather than spending taxpayer dollars on necessary services and infrastructure, contributing to pensions has now taken up almost a fourth of the state’s budget.
Overly optimistic assumed rate of returns are a huge contributing factor to underfunded pension funds. According to the National Association of Retirement Administrators, the average assumed rate of return for public pension funds is 7.3%, which far exceeds the actual rate of return of 5.9%. While higher estimated returns allow for a smaller contribution into the pension fund today, it pushes the burden of making pension payments onto future taxpayers. Meanwhile, reports from investment advisory firm Cliffwater LLC have suggested that pension funds are trending towards a high risk, high reward solution in hopes of higher returns. As a result, investing in higher risk assets also increases the likelihood of greater liabilities in the future.
As the population of aging Americans continues to rise, the pension gap will only continue to grow bigger. Until policies are passed that limit growing liabilities in funds, states will forever be playing a cat-and mouse game in an attempt to cover the cost of an ever increasing pension debt with no end in sight. Meanwhile, taxpayers will be shouldering all the burden.