There are two types of pension systems: the defined benefits program and the defined contributions program. It is telling that private employers totally abandoned defined benefits pensions in the 70’s and 80’s, while almost all public-sector employers still rely on defined benefits pensions. Private sector employers pay for pensions with their own money, while public-sector employers pay for pensions with someone else’s money.
The mountain of unfunded pension liabilities is entirely due to Kentucky’s addiction to defined benefits pension programs. According to S&P, Kentucky has the worst aggregate pension underfunding among the 50 states. The state cannot begin to recover until it eliminates defined benefits.
A defined benefits pension system is one that promises to pay the retiree, say, 80 percent of their highest real salary and complete medical care until they pass, while a defined contributions system promises to pay the retiree whatever was paid into his retirement and matched by the retiree before retirement.
There are two brutal facts faced by employers under defined benefits. The employer has absolutely no control over the future cost of healthcare or the retiree’s future cost of living. On the other hand, the employer is not responsible for future healthcare cost nor the cost of living under defined contributions retirement systems.
Some readers may be concerned that the typical retirees are in no better position to judge these future costs than are their employers. This is true, but there are cheap and sophisticated, highly diversified investment funds designed to provide for secure retirement. Every reputable private money management firm has access to these products.
Why does something with such adverse consequences have such a lasting grip on our state government? The answer is because defined benefits pension systems give rise to a multitude of opportunities for corruption — like the five pension fund managers in the Kentucky system who had no experience or qualifications in managing investment funds. Management of those funds allows the manager to direct the funds to his cronies, lowering the yield on the fund and weakening the pension system. In some states, members of the legislature can pass special bills that make their friends eligible for the defined benefits pension system. Their access is typically unfunded by the bill.
By far and away the most corrupting feature of the defined benefits pension system is the role it plays in state budgeting. Under the established budgeting system, the state budgeters must estimate the return they will earn on the pension funds and estimate how much the pension liabilities will grow. The difference between the growth in liabilities and what they will earn on current pension funds is the amount they must withdraw from general revenues and add to the fund. For year after year, they under estimate the amount to be deducted, so the unfunded pension liabilities grow and the state spends more than it is entitled to spend.
This steady hemorrhage of pension funds will not be stopped until the state abandons defined benefits retirement systems. This eventually would be achieved if all new hires were given defined contribution retirements.
Furthermore, defined benefits retirement systems are a cancer on the state’s creditworthiness. The mountain of unfunded liabilities will cause a significant downgrade in the state’s bonds and that will cause significant reductions in state services across the board. This is the dreaded “Greek solution.” Note, this cannot happen under a defined contributions retirement system because the state is required by law to make the necessary payments to third parties who manage the retiree’s funds — there is no “fudge factor” in the system.
Bob Martin is Emeritus Boles Professor of Economics at Centre College.