Government Employee Pensions Are Underfunded. Taxpayers Will Make Up the Difference

  • January 20, 2024
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People aren’t messing with their 401(k)s enough, according to the The Wall Street Journal. It used to be “Set it and forget it.” Now, according to the Wall Street Journal’s Jon Sindreu, if you forget it, you might miss it.

Inspired by a BlackRock thought experiment which included perfect knowledge, Sindreu looked backward between 2020 and the present at a person making yearly changes (moving funds to the previous year’s strongest sector) which would have generated a compound annual return of 55 percent, nearly four times more than buying and holding the Standard and Poor’s 500 (or setting and forgetting). For the period of 2016 through 2019, the gain would have been 30 percent, twice the index.

Basing a new strategy on back-of-the-envelope testing back just seven years seems dubious. It also requires discipline and market knowledge that the vast majority of 401(k) investors just don’t have. Most people with 401(k)s just plain have no interest in, let alone knowledge of, financial markets.

At least one company understands that its employees are not cut out to be investors. IBM, starting this year, will “provide a defined benefit plan that will save for an employee’s retirement automatically, with no contribution required from the employee. The result will be a stable and predictable benefit that professionally invests every retirement saving dollar to maximize risk-adjusted rates of return,” summarizes Teresa Ghilarducci in an article for Forbes.

Ghilarducci makes the point that small businesses may go back to defined benefit plans because “the permitted tax-qualified contributions are larger in [defined benefit] than [defined contribution].”

IBM dropped their pension plan fifteen years ago and went to a 401(k) plan. The United Auto Workers did the same, as did many other large and small companies. These moves shifted “the risk of mistakes onto the employees.”

IBM has now declared its 401(k) plan a failure, as has the Mercer/CFA Institute Global Pension Index, which flunks the US model for not “providing enough accumulation, stable investment, and reliable lifetime benefits.”

Ghilarducci says 401(k) participants are stuck with investment options that are high-priced and inefficient. Plus, what happens when that lump sum of accumulated wealth is staring a retiree in the face? Some take distributions slowly and carefully and likely will live below their means and pass what remains to their heirs. Others, however, will buy expensive toys, what Ghilarducci calls the “red truck syndrome—a term coined when newly retired workers with lumps [buy] something they have always wanted—a shiny new truck.”

Defined benefit plans are A-OK if fully funded, but many government employee defined benefit plans are not. In fact, an academic study finds there are incentives for government defined benefit plans to be underfunded. Not to give away the punchline, but government employee pensioners know it’s the law for them to be paid their pension, and the government will force taxpayers to cover any shortfall.

Sarah Anzia and Terry Moe explain the logic behind underfunded government pensions in Perspectives on Politics:

Another basic feature of pension politics is that public workers and their unions have incentives to support the chronic underfunding of their own pensions. Due to state statutes, constitutions, and judicial decisions, pensions promised by state politicians are backed by strong legal protections almost everywhere; and public workers thus know they will eventually get what they are promised even if their pension plans are currently underfunded. Indeed, because full funding on a regular schedule would be tremendously costly for state (and local) budgets—crowding out other services, forcing higher taxes, making the true costs of pensions painfully transparent to citizens—public workers and their unions have incentives to prefer that their pension plans be underfunded. Underfunding enables the fiscal illusion that pension benefits are much less expensive than they really are. If public workers and their unions want increasingly generous benefits in future years, they need to convince the public that these benefits are not costly to provide. At the same time, underfunding keeps employee contributions to their own pension funds at low levels; and by keeping contributions by their employers down, they are freeing up public money for other government services, keeping public workers employed—and providing funds for their own salaries and raises.

Employees in the private sector must spend time researching investment options and hope their investment selections and market timing are right. Meanwhile, government employees can relax and count on taxpayers to make their golden years stress free.