Sunday, December 9, 2012

How To Fix Government Pensions (And Prevent a Financial Meltdown)

Unfunded pension liabilities in Illinois have reached $83 billion, with an appalling funding ratio of 43.4%. Unless this is seriously addressed, our state's credit rating will be downgraded and taxes on businesses and families will soar to fund this growing gap. Over the long run, federal entitlements face even larger per capita unfunded liabilities. The questions are: how did it get this bad and what can be done? To understand this issue, we need to briefly explore the two most common forms of pensions. A Defined Contribution Plan is one in which:

" which the amount of the employer's annual contribution is specified. Individual accounts are set up for participants and benefits are based on the amounts credited to these accounts (through employer contributions and, if applicable, employee contributions) plus any investment earnings on the money in the account. Only employer contributions to the account are guaranteed, not the future benefits. In defined contribution plans, future benefits fluctuate on the basis of investment earnings."

In Defined Contribution Plans, such as 401(k) accounts,  a participant's future earnings are not guaranteed, rather they reflect the contributions (both by the employee and employer) + the appreciation of the investment. If funds decline because of poor management or market downturn, tax payers will not be held liable. If the participant in these plans do not properly plan for their retirement, they do run a greater risk of facing financial difficulties. Understandably, the vast majority of private sector retirement funds operate under this system.

In a Defined Benefits Plan: "an employer promises a specified monthly benefit on retirement that is predetermined by a formula based on the employee's earnings history, tenure of service and age, rather than depending on investment returns." The problem with this type of plan, is that the employer will be liable for any shortfall between the participant's contributions and their defined benefits. Since the vast majority of defined benefit plans are enjoyed by public sector employees, this means that you and I, the tax payer, will bear the burden of the unfunded liability. This is made worse by the fact that politicians, public unions and public workers often collude to raise defined payments to unsustainable levels, because they know that a third party (tax payers) can be forced to foot the bill. Up until now this has been true, but there is a limit; once unfunded liabilities reach a tipping point, tax payers will call upon public workers to fund their own retirements. And there's no rational reason why their pension plans should not transition to defined contribution plans. Not only is this an ethical imperative, but it is the only way to prevent the financial meltdown of Illinois. 

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