Misdiagnosing the Cause of Pension Problems

Neither revenue sharing nor suburb-dwellers caused underfunding

Michigan and its local governments are facing cuts to shore up massively underfunded pension plans. Who is to blame for the problem? According to two recent essays in statewide media outlets, the blame lies with people who move out of cities and a state government that has cut revenue sharing. Neither explanation is correct and an accurate understanding of pension funding shows exactly why, as well as what to do about pensions.

At Michigan Radio, John Austin argues that city residents who leave for the suburbs are like people who run out on a dinner check. “We ordered up a lot of police, fire, parks, libraries, water mains and buses, but many of us left the table before it came time to pay.”

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In the Detroit Free Press, Stephen Henderson argues that pension woes are the result of a state government that has reduced its support to local governments: “Adding to the woes in places like Port Huron are so-called legacy costs — promises made to previous employees about retirement benefits that cities have not had enough revenue to fully fund, largely because of state-imposed limitations.”

Both of these assertions are incorrect. Pension underfunding is generated neither by a decreasing population nor by a loss of revenue.

The answer to the question of “Why are pension systems in trouble?” lies in this: Pension benefits are supposed to be prefunded. According to the state constitution (Article IX, Sec. 24), pensions are supposed to be funded as they are earned. No government in the state is supposed to underfund pensions. If pensions were properly funded, they would be protected regardless of what happens to the city’s tax base or revenue streams.

A local government is supposed to set aside an adequate amount to pay for the pensions earned by employees as they are earned. This requires a series of assumptions about how much to put in the system based on when employees are going to start collecting their pensions and how long they are going to collect, as well as how much a dollar set aside today — placed in the financial markets — will be worth when they start collecting.

This last assumption is vitally important since we know that markets go up and markets go down. Use more cautious assumptions and you have to set more money in the pension fund; use more optimistic assumptions and you get to put in less money. (And no plan should be managed on the assumption that there will never be a recession.)

Unfortunately, governments in Michigan and across the country have been too optimistic. Investment assumptions tend to be in the 7-8 percent range and governments have struggled to realize such gains.

Governments need to use more conservative funding assumptions or convert to a defined-contribution system where they cannot defer the cost of retirement benefits. In contrast, neither a growing population nor more revenue from the state will prevent pensions from being underfunded.

Read more at www.mackinac.org/pension.


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