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In case of pension emergency

Legislatures nationwide will no doubt be debating what to do about public pensions with large unfunded liabilities. Below are two options getting considerable attention.

May 1, 2006


Ron Wirtz Editor, fedgazette
In case of pension emergency

Moving to defined-contribution plans is all the rage in the private market and has been suggested as a cure for poorly funded government pension plans.

Michigan made the leap in 1997. Chris DeRose of the Michigan Office of Retirement Services, which oversees four state pension plans, said the shift was made because "that's what was being done" in the private sector, and the Republican governor in office at the time supported defined-contribution plans. Letting younger workers take their accrued retirement benefits with them when they changed jobs was also considered important.

Though it applied only to newly hired public employees and any existing workers who wanted to opt in, the move to a defined-contribution plan was "very controversial," DeRose said, passing both houses of the Legislature by just one vote. To date, there has been no analysis of the comparative generosity of the different pension plans. Though employee unions and others in the state would like to return to a universal defined-benefit system, DeRose called that "politically unlikely."

The financial effect of adopting defined-contribution plans is muted because it involves only new government workers. Diverting new members away from a structurally flawed defined-benefit plan can stop a certain amount of bleeding. But it does not correct preexisting financial problems because employers must keep all promises made under the defined-benefit plan.

Setting up defined-contribution plans is also part of a larger strategy to establish different (and typically lower) benefit levels across the board for new workers. Euphemistically called "tiered benefits," such efforts are derided by public employee unions as "selling the unborn" because they put all the sacrifice on tomorrow's public employee.

Such a move is fairly rare, but not unprecedented, within defined-benefit plans. In 1989, the Minnesota Legislature created a reduced tier of benefits for new public employees—though in many cases, those benefits got ratcheted back up over time.

Pension obligation bonds:

Faced with large unfunded liabilities, some states and larger cities are looking to plug actuarial gaps with wads of money from bond sales.

When governments do this, they are playing an investment game called arbitrage, betting that the rate of return from bond proceeds invested in the pension fund will exceed the interest rates they must pay to borrow that money. Investment returns are the wild card here: POBs typically carry an interest rate of 5 to 6 percent, so if average investment returns exceed this amount over the life of the bond, the government comes out ahead. However, if returns are lower, they've compounded the problem, widening the funding gap.

Parry Young of Standard & Poor's noted in a 2004 research brief that POBs "have returned with a vengeance." During the 1990s, about $15 billion in POBs were issued. That figure is likely to be dwarfed this decade. In 2003, the state of Illinois sold $10 billion in POBs to prop up a staggering pension fund. Oregon issued a $2 billion sale the same year; Wisconsin, $1.3 billion in 2002. Smaller units of government also use POBs. In 2002, for example, the city of Minneapolis sold $25 million in bonds, with the proceeds going to the Minneapolis Employees Retirement Fund.

Results to date have been mixed, according to Young, with success or failure "based largely on the vicissitudes of market timing." Ironically, most research suggests that POBs can work well for those governments that have the capacity to bear additional financial risk. But the common rationale for using POBs runs counter to that—financially strapped governments resort to them because they have few other politically tenable options.

At least some governments recognize that POBs are a gamble. Montana considered using POBs to address $1.5 billion in unfunded liability in two of its public pensions. However, according to a September 2005 report, the state investment board "does not recommend this option. This is considered risky given that the volatility of the investment returns is what got the retirement plans in the current situation."

Ron Wirtz
Editor, fedgazette

Ron Wirtz is a Minneapolis Fed regional outreach director. Ron tracks current business conditions, with a focus on employment and wages, construction, real estate, consumer spending, and tourism. In this role, he networks with businesses in the Bank’s six-state region and gives frequent speeches on economic conditions. Follow him on Twitter @RonWirtz.