The Coming Crisis In Funding Retirement Benefits

Apr 25th, 2020 | By | Category: Featured Issues, Politics & Current Events

Baby boomers (those born between 1946 and 1964) are retiring in record numbers and are living longer.  Because high-income workers have experienced faster wage growth than the rest of the population, a greater share of US wages is now exempt from the payroll tax, which stops at $132,900.  Result? A smaller tax base to fund Social Security benefits.  Thus, Social Security costs are projected to exceed income next year for the first time since 1982, forcing the program to dip into its nearly $3 trillion trust fund, built up when payroll taxes exceeded benefits.  Unless Congress acts that trust fund will be depleted in 2034, with benefits then automatically cut by more than 20%.  As Richard Rubin and Kate Davidson of the Wall Street Journal argue, “Social Security presents a political challenge, but it is also a math problem.  Today’s taxes must generate enough money to pay benefits that today’s recipients accrued over their working lives.  That math is changing,” as noted above.

In 1983, President Ronald Reagan worked with congressional Democrats to deal with the 1982 crisis by raising the retirement age and accelerating scheduled tax increases.  But President Trump has ruled out cuts to future benefits or any talk about compromise with the Democratic leadership on reforming Social Security to salvage benefits for future retirees.  Furthermore, Democrats want to expand the popular program, emphasizing low-income retirees, widows and people who left the workforce to care for family members.

Despite the coming crisis and despite the failure of both Republicans and Democrats to be honest about Social Security with the public, Social Security cannot be changed without strong public consent, which does not now exist.  Indeed, a 2018 Pew Research Center poll showed that 78% of Democrats and 68% of Republicans oppose cuts in future benefits.  Younger voters showed more support for reducing future benefits, and 42% of people ages 18 to 29 assume they won’t get any benefits.”  As Tom Reed, House Republican from New York stated, “The longer we wait, we have fewer and fewer solutions that can be implemented in a practical way.  “[I] would love to do this without tax increases, but it is clear if you do the math that is becoming more and more difficult.”

A second aspect of funding retirement benefits relates to pension funds, especially those associated with public employees.  Many of the public employee pension plans are defined-benefit pensions, where an income based on final salary is paid for the rest of life.  Arguably a very expensive proposition, this is heightened by the fact that we are living longer.  “Pension shortfalls are common across America, with the average scheme being just 72.4% funded.  That adds up to a collective shortfall of more than $1.6 trillion.”  Here are a few examples of the current pension shortfalls:

  • The Illinois Teachers Pension Fund is 40.7% funded.
  • Chicago Municipal is just 25% funded and the “risk of insolvency” is real.
  • The Chicago police fund is “severely underfunded” with a shortfall of $10 billion.
  • In Kentucky, in 2001 its retirement system was 120% funded and employers were putting in just 1.9% of payroll. After the dotcom slump, the funding position deteriorated.  By 2005 the scheme was less than 75% funded and the required contribution had gone up to 5.3%.  By 2015, the contribution leapt to 33% of payroll and by 2018, they were asking for 41%.  Kentucky’s scheme covering “non-hazardous” workers is just 12.8% funded.

As The Economist reports, severely underfunded retirement pension funds risk “entering two vicious circles.  The first involves costs.  Kentucky’s public pension scheme covers a wide range of state employers and some have to pay 85% of payroll to cover their pension obligations.  Employing someone on $50,000 a year requires an extra $42,500 of contributions [to the pension fund].  They naturally seek to lay off workers to reduce the cost.  But that leaves fewer people paying in without changing the number currently receiving retirement benefits.  That increases the short-term squeeze.  The second concerns the accounting treatment of public-sector funds.  Many assume nominal returns on their portfolios of 7% or more after fees.  This optimism has a big impact . . . But if a scheme becomes severely underfunded, a plunge in the stock market could leave it unable to cover current payouts.”

Pension schemes are vulnerable to a market downturn and many were left reeling after the global financial crisis of 2008-9.  As Heather Gillers of the Wall Street Journal reports, “Pension funds for years have been piling into stocks to try to reduce shortfalls after a decade’s long slide in bond yields slashed the returns they could expect from their fixed-income portfolios.  Today, stocks make up nearly 60% of pension fund assets, a 13-year high.”  The sustained drop in stock values will strain the budgets of states and cities, since many are already stretching to shore up retirement funds.  “Public pension funds held about $4.5 trillion as of 30 September, according to the Federal Reserve.  That is $4.3 trillion less than the value of promised future benefits.”  The market volatility of the last several weeks has drastically affected the underfunded pension schemes but it has also affected the nation’s better funded pension plans.  The current volatility also creates challenges for corporate pension funds, which operate under stricter rules than public funds about how to assess their liabilities.

The pension crisis has been rumbling on for years, but some states and cities are in a downward spiral.  This will result in poorer public services and/or tax increases to meet fund requirements.  This might encourage workers and firms to move somewhere else, thereby further shrinking the tax base, making pension promises even more difficult to fulfill.  Whether it is the US Social Security system or the public employee pension funds, the crisis is upon us.  Will our political leaders continue to hide the truth of this crisis or will they face it, explain it to the American people and lead?  I am quite frankly not optimistic.

See Richard Rubin and Kate Davidson in the Wall Street Journal (5-6 October 2019); Heather Gillers in the Wall Street Journal (6 March 2020); and The Economist (16 November 2019), pp. 63-64, 14-15.

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