Why are pensions underfunded?

There are two ways that pensions can be underfunded: (1) employers do not put in as much money as actuaries recommend, and (2) assumptions about pension funding do not match experience. For MPSERS, it’s been a combination of both factors.

According to a 2014 performance audit of MPSERS by the state auditor general, the largest determinant of underfunding was a failure to meet the state’s assumed investment returns.

Stay Engaged

Receive our weekly emails!

But putting less money in the system than recommended also plays a role. Over the past decade, the state deposited into the pension fund $2.2 billion less than its annual required contributions.

Pensions have protections in the state constitution. Why are they being threatened?

Article IX, Sec. 24 of the state constitution makes pensions contractual rights; it also mandates that governments pay for them.

If governments do not set aside enough cash to pay for these benefits, then there is an unfunded liability that must be paid down. If the government does not have cash sufficient to pay the benefits earned and it cannot catch up on underfunding, the contractual obligation between the government and its pensioners cannot be met. The obligation may face amendment if the government files for bankruptcy.

This is what happened to Detroit. It is unclear what would happen for a state-administered system that does not have an avenue to bankruptcy courts.

Will converting to a defined-contribution retirement system cost taxpayers more?

Defined-contribution systems can be just as generous as defined-benefit pension plans. The proposed plan in SB 102 mirrors the contribution rates for the existing hybrid plan.

Some have raised the point that the rules of the Governmental Accounting Standards Board require governments to pay more initially to catch up on unfunded liabilities. This, however, is not a funding requirement and other governments, such as Oklahoma, have transitioned away from defined-benefit plans without having to devote more cash to paying off unfunded liabilities.

Moreover, unfunded liabilities have to be paid off at some point with or without closing the system.

Will employees lose professional management of their retirement accounts if they have to make their own investment choices?

Most employers provide professional advisers who offer retirement advice to help employees prepare for retirement. And there are myriad product options that can be included in defined contribution-style systems, from low-fee index funds to target-date retirement funds. These options can be more closely matched to an individual’s own risk preferences than is possible in the current pension-fund process.

Government-managed pension funds themselves can be subject to politically driven investments and obligations that can weaken their performance.

Moreover, the investments made by pension managers are largely in the markets also accessible through defined-contribution retirement systems. In other words, employees with defined-contribution retirement accounts can invest in the same securities as pension investment managers if they want to. In some cases, defined contribution funds are invested and managed by the existing public pension boards.

But more importantly, these defined-contribution plans, by design, simply cannot be underfunded. Professional pension management does not protect pensioners if managers do not have adequate money to invest, which unfortunately has been the case of the current system.

How do governments catch up on unfunded liabilities?

Once actuaries acknowledge that there is a gap between what governments have saved to pay for retirement and the expected (and discounted) future payouts, the government in question needs to develop a method for paying down those unfunded liabilities. In addition to setting aside money to pay for the benefits being earned by employees each year, the government needs to start making additional payments to amortize this debt.

The debt does not need to be made up in a single year and the state is paying these liabilities off over the next 24 years.

A good amortization policy ensures that debt will be paid down and that the costs of underfunding be paid down by the time employees retire.

Will converting to a defined-contribution retirement system harm current employees?

Converting new employees to a defined-contribution system will secure the pension benefits already earned by people who are on the job now. By not adding to its long-term obligations with each new hire, the state will have a greater ability to catch up on the gap it faces for existing employees. The pensions earned by teachers and other school employees, meanwhile, would be untouched.

Does MPSERS need new members to remain solvent?

Pension systems are required by the state constitution to be prefunded. They are not Ponzi schemes that require new employees to pay the benefits of older members.

Employee contributions defray part of the costs of the benefits that they earn. But they do not pay to catch up on unfunded liabilities, nor can they be required to do so. Such an action has been considered as a “taking” by the courts. Unfunded liabilities have to be paid down regardless of how many people are in the system.

Will defined-contribution plans subject workers to the whims of the market?

Pension funds invest in the same marketplace that is available to defined-contribution plans. But in addition to bearing the risks of market fluctuations, they are subject to threats of underfunding. A properly designed defined-contribution system does not face the risk of underfunding.

Right now, employer costs for employee benefits in the state’s largest pension system equal 30 percent of payroll. It would not take a financial genius to provide a secure retirement if this amount were set aside for employees to invest. Yet these high costs have put pressure on schools to contract out more and more for services; they also have meant fewer pay raises for teachers.

Should we wait to see the results from the hybrid plan created in 2010?

The state remains subject to underfunding risks for employees in the 2010 hybrid system, where employees are offered a defined-benefit plan and a small, additional defined-contribution plan. Thus, new employees are still offered benefits that can be underfunded in the future. In addition, the state has paid $1.6 billion less than its full annual required contributions for pension benefits and has missed required contributions every year since these reforms were put in place, increasing the underfunding in the system for members in both hybrid and legacy plans.

West Virginia’s conversion was a failure and the state had to reopen its pension plan. Wouldn’t the same thing happen for Michigan?

West Virginia had a drastically underfunded pension plan when it closed its teacher retirement system and continued to underfund it afterward. Hence, West Virginia’s problems occurred despite the reform, not because of it. It was only after the state devoted substantial money from its tobacco settlement that it began to be better funded. Yet even with these cash infusions, the plan remains underfunded.

Isn’t MPSERS underfunded because Engler “robbed” the system?

Gov. Engler stopped prefunding retiree health care benefits, a practice continued by Gov. Granholm. No theft ever occurred.

New school employees are now offered supplements to a defined-contribution plan,  intended to pay for retiree health care.

As for Engler’s impact, the state developed $22.2 billion of its $25.8 billion in unfunded pension benefits since he left office in 2002.

Did closing the state employee system in 1997 contribute to its underfunding today?

The state employee defined-benefit pension system became underfunded after closing because it failed to meet investment targets and because the state failed to pay its annual required contributions. In fact, closing the defined-benefit system and converting new hires to a defined-contribution system saved the state employee pension system from being further underfunded.

Will employees contribute enough to a defined-contribution plan to earn a decent retirement?

Maximizing employer compensation over a typical career under the terms of SB 102 can result in a reasonable retirement. This defined-contribution plan gives workers the freedom to save as much as they would like instead of the current mandatory contributions.

And workers quickly earn retirement benefits. Under SB 102, they vest half their employer’s contributions after two years of working, and the full 100 percent in four years. By contrast, it takes 10 years to earn any pension benefits at all in MPSERS and half of employees will leave the system before they vest. Even then, 42 percent of retirees in MPSERS earn less than $15,000 in annual pension benefits.


Related Articles:

How Some Michigan Cities Dodge the Unfunded Pension Liability Trap

State Government Up to Its Eyeballs in Pension Debt

State’s Largest Teachers Union Offloads Some Pension Obligations Onto Taxpayers

Why Michigan Pension Reform Matters

Pension Reform Failure Cost Michigan Taxpayers $6 Billion or More

Pension Funding: Why Your Town is Going Broke

Share