Pension Underfunding Has a Cause — But it is Not Smaller Workforces

Pensions do not operate like Social Security

The costs of defined benefit pension systems are meant to be paid as pension credits are earned by employees. For government workers, paying these costs as they are earned is a state constitutional requirement. But this has not happened, a failure that has generated billions in unfunded taxpayer liabilities. Moreover, a lack of understanding of how pension funding actually works leads to incorrect reform prescriptions from lawmakers and others.

Consider this letter to the editor in The Detroit News:

"Once new employees were frozen out of MSERS [the state employee retirement system] the average age of enrollees increased rapidly. Systems like MSERS run on the same logic as Social Security: the promise of a secure retirement is kept, and costs stay low to all involved, because there are new, young employees participating in it every pay period."

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In fact, the smaller membership in this system prevented the state from generating billions in unfunded liabilities. This is because government pension funds do not, in fact, operate like Social Security. When a worker earns a pension, his or her employer is supposed to set aside the money necessary to pay for that pension. The money gets set aside while an employee is in the workforce and invested in order to pay for the pension that worker earns.

In contrast, Social Security payments go to current retirees. This is a pay-as-you-go system instead of a prefunded system.

The state and its local governments have not adequately set aside money to pay for the pensions earned by employees. There are $26.5 billion in unfunded liabilities in the state-managed school system alone. This is largely due to overly optimistic assumptions about how much needs to be set aside today to pay for benefits to be paid tomorrow.

The letter further argues that Michigan must have more people in the system to pay for benefits earned by others. This is also a mistaken view of how pension funding works. Employees do not pay to catch up on other members’ underfunded benefits — this would likely be an illegal taking.

Instead, employers set aside money to catch up on unfunded liabilities. The payments are determined by the level of underfunding, not the number of employees working.

Mistaken assumptions about how pension funding works lead to the wrong conclusions, like arguing that adding more people to an underfunded system will make it better funded. Government managers should instead acknowledge that they have failed to set aside the money needed to pay for the pensions earned by employees and instead offer workers retirement benefits that will not be underfunded — like 401(k)-type plans.

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