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Washington state employees, like most state and local government workers across the nation, are offered a defined benefit pension in retirement. A defined benefit plan differs from defined contribution 401(k)-style pension plans that most private sector employees participate in. In a defined benefit pension, an employee is offered a fixed monthly benefit at retirement. Any investment risk involved with funding those benefits is taken by the employer. In a defined contribution plan, by contrast, the employer offers the employee a fixed contribution to a retirement account, but the employee chooses how to invest that contribution and accepts the risk and return involved with those investments.
“The keys to reforming Washington pensions start with better accounting and better information.” — Andrew Biggs
Defined benefit pension plans require that governments accurately anticipate future benefit costs and make regular contributions that will be sufficient to meet those costs. Around the country, citizens have become concerned regarding the solvency, cost, generosity and risk of public sector pension plans. Washington’s pension plans are well funded by public sector standards. Nationwide, public pensions report unfunded liabilities of around $770 billion.
But, as economists increasingly point out, public pension accounting standards are lax relative to those that private pensions are required to use and are inconsistent with how economists and financial markets would value pension liabilities. Using more realistic accounting rules, public sector pensions nationwide face unfunded liabilities topping $3 trillion.
These critiques apply to Washington’s pensions as well. While the state’s plans appear reasonably well funded relative to other public sector pensions, their funding status has slipped significantly in recent years due to missed contributions, benefit increases and poor market returns. Moreover, were Washington’s plans measured using the accounting standards private sector plans are required by the federal government to use, the plans would be only 52 percent funded on average and face unfunded liabilities o f $50 billion. As a result , Washington’s reported funding– worrying though it may already be–is in many ways a mirage. Significant reforms and prolonged political discipline will be required to put these plans back on track.
But lack of political discipline has been one of the drivers of pension shortfalls. Over the years, lawmakers have increased benefits in good times and lowered pension payments in bad times. But these benefit increases continue even after the good times have soured, and skipped payments are slow to resume even after tax revenues recover. In many ways, political factors are just as large a threat to pension financing and overall fiscal discipline as is the underfunding hidden by current accounting rules.
Pension reforms should take both financial and political risk into account and consider options that are both more transparent and less susceptible to elected officials’ desires to promise benefits now but pay for them later. Defined contribution pension plans are used by most Americans saving for retirement and, properly designed, there is little reason that public sector employees cannot follow the same model.
A final introductory note: Many of the figures cited here and much of the analysis draws upon actuarial valuat ions and the 2010 Risk Assessment conducted by the Office of the State Actuary. Washington is unusual in having its pension analysis conducted by an actuary employed by the State rather than an outside firm retained under contract. While each approach has its pros and cons, in this case Washington’s policymakers and citizens have been rewarded with some of the best actuarial analysis available in the country. While it is to be expected that an analyst coming at pension financing from an economic perspective would disagree with an actuary coming from a more t radi t ional approach, the Risk Assessment produced b y Washington’s actuaries is a model of what the profession should be providing to its customers (lawmakers and the public). While this paper is critical of actuarial valuation of pension liabilities, to the degree it is critical of the work of Washington’s actuaries, it is only because their work highlights almost all the relevant issues cited by economists but fails to take the final step to a full market valuation of pension liabilities.
Andrew G. Biggs is a resident scholar at AEI.
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