Five Things to Consider Before Cutting Pension Benefits

The message from voters about public pension plans is clear: They're ready to cut the retirement benefits of police, firefighters, teachers and other state and municipal workers.

The latest indicators include the failed recall of Gov. Scott Walker in Wisconsin - which started with his efforts to cut pensions - and referendums in San Jose and San Diego, where voters overwhelmingly backed pension reform measures.

A recent study by the U.S. Government Accountability Office found that 35 states have reduced pension benefits since the 2008 financial crisis, mostly for future employees. Eighteen states have reduced or eliminated cost-of-living adjustments (COLA) - and some states have even applied these changes retroactively to current retirees.

This week, the Pew Center on the States reported that states are continuing to lose ground in their efforts to cover long-term retiree obligations. In fiscal year 2010, the gap between states' assets and their obligations for retirement benefits was $1.38 trillion, up nearly 9% from fiscal 2009. Of that figure, $757 billion was for pensions, and $627 billion was for retiree health care.

Pensions are, no doubt, consuming a larger share of some state and local budgets. The bill has come due for years when plan sponsors did not make their full plan contributions; in the years leading up to the 2008 financial crisis, many papered that over by relying on strong stock market returns. Many plans also took major hits in the 2008 crash, and returns have since been hurt by low interest rates.

But - before we continue swinging the axe - here are five things to keep in mind about public sector pensions:

1. Pensions aren't simply a gift from taxpayers.

They're an integral part of total compensation, along with salary, health benefits and vacation. Unlike private sector defined benefit pension plans, most state and municipal workers contribute hefty amounts from their salaries. For those who aren't participating in Social Security, the median contribution is 8.5% of pay; for those who do contribute to Social Security, the median contribution is 5% and rising, according to the National Association of State Retirement Administrators.

Investment earnings account for 60% of all public pension revenue, NASRA reports; employer contributions cover 28% and employee contributions account for 12%.

2. Many workers don't get Social Security.

30% of state and municipal workers work for states that have not opted into Social Security. That means pensions are their only source of guaranteed lifetime income in retirement. Social Security comes with automatic cost-of-living adjustments to protect retirees from inflation - a feature that is on the chopping block under many public sector reform plans.

3. Pension underfunding isn't as bad as you think.

It's true that funding in some states has dropped to frightening levels. Illinois, for example, which failed to make the necessary plan contributions for years, has a funded ratio of 43.4%. But nationally, the story is more positive. Aggregate asset/liability ratios have been rising. The funding level for all state plans combined was 77% last year, up from 69% in 2010, according to Wilshire Consulting.

Most public sector pension plans have a target funding ratio of 100%. However, ratings agencies consider a ratio of 80% to be adequate. By comparison, private sector pension plans are considered at risk of default if their funded ratios fall below 80%.

However, it's worth noting that public sector funding ratios rely on long-term rate of return assumptions around 8%. Actuaries support that projection, since it is upheld by actual long-term investment history. But economists argue that a more conservative assumption should be used, reflecting only what a fund could earn on Treasuries or corporate bonds - closer to 4%. If public plans adopted lower projections, their funded ratios would be sharply lower than reported.

4. Pensions are more efficient than 401(k)s.

Despite the under-funding of some plans, defined benefit pensions provide retirement benefits more efficiently than defined contribution plans. The efficiencies stem from pooling of longevity risk, maintenance of portfolio diversification and professional investment by pension fund managers.

"With a 401(k), we ask people to be their own investment advisers, which takes about 200 basis points off the return," says Diane Oakley, executive director of the National Institute on Retirement Security, a not-for-profit research and education organization. "Then we ask them to be their own actuaries and decide how long they will need to draw their own money out - and most people can't do that."

That means when workers are shifted from pensions to defined contribution, the value of benefits fall - or taxpayers are on the hook to keep benefits level. For example, a study last year by the comptroller's office in New York City found that it would cost the city's taxpayers 57% to 61% more to provide workers in the city's five defined benefit plans with equivalent benefits via a defined contribution plan.

5. The retirement crisis is real.

The Federal Reserve's recently issued Survey of Consumer Finances contains these stunning figures: the median American family's net worth fell nearly 40% in the three years ending in 2010, and the asset accumulation of most was set back almost two decades. Real income fell 7.7 %.

Americans' confidence in their ability to retire is at a historical low point. Just 14% report they expect to have enough money to live comfortably in retirement, according to the Employee Benefit Research Institute. 60% of households tell EBRI that the total value of their savings and investments -excluding their homes - is less than $25,000.

Against that backdrop, pensions are the only safety net available to public sector workers, especially in states where they are not enrolled in Social Security. That means there's a real risk that pension reforms could push public sector retirees into poverty.

Consider the actuarial assessment of pension reform in one such state - Louisiana, where Gov. Bobby Jindal this month signed a bill that would put new hires into a 401(k)-style cash-balance pension plan starting in 2013. A report by actuaries for the Louisiana legislature concluded that ". . . because there is no Social Security coverage, such a member may very well become a ward of the state because he or she has no other available resources." (Editing by Beth Pinsker Gladstone; Editing by Dan Grebler)

(The writer is a Reuters columnist. The opinions expressed are his own.)