Opinion: There is a way to fix the US $ 4.6 trillion mess in public pension plans – Canada shows us how

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Retirees of the Teamsters union are protesting the major cuts to their pension benefits in 2016. Getty Images

In “The Sun Also Rises” by Ernest Hemingway, Mike is asked how he went bankrupt. His response: “Two ways. Little by little, then suddenly. He might as well describe the prognosis for many of the nation’s 5,300 public pension funds, which hold $ 4.4 trillion in assets versus what the Federal Reserve estimates to be $ 9 trillion in liabilities.

Most US public pension plans were in surplus in 2000. Today, according to their own accounting – which differs from the Fed’s – they hold less than 75 cents on every dollar they owe their 33 million members. Funding deficits are now affecting municipal bond ratings and COVID-19 has introduced new strains on public finances.

Pension reform is needed, but no one seems to know what to do. And few people want to move the boat.

We argue in a recently published study that there is a way out, even for public pension plans as deeply submarine as those in Illinois, Kentucky and New Jersey. The answer? Just look to northern Canada to see what can be done.

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Canada today has a well-funded and sustainable public pension system. It’s not always the case. Until the end of the 1980s, its public pensions were in poor condition. During the inflationary 1970s, benefits were improved through retroactive indexation without increased funding. Contributions were mixed with other public funds and loaned to provincial governments, not invested in markets. In some cases, Canadian provinces did not even have a good grasp of the true actuarial value of their pension liabilities.

Provincial finance ministers have come to realize that failure to undertake comprehensive pension reform would jeopardize the retirement security of public sector workers. Current retirees could still collect their pensions, but young workers could not. But pension protection would lead to higher taxes, pitting workers against taxpayers.

Elected officials have implemented comprehensive reforms. Today – some 30 years later – that story should be required reading for elected officials of state and local governments across the United States.

Reform does not simply mean finding new ways to invest money in search of higher returns. It is impossible to solve the problems of a pension fund solely through the investment portfolio. On the one hand, almost all pension plans have negative cash flow, paying more benefits than contributions. Generating a cash return or holding cash balances is essential to fund the benefits each year, but it lowers the overall return on investments.

In addition, many pensions unrealistically aim for annual returns of 7% or more. Most market strategists don’t believe that diversified pools of tens or hundreds of billions of dollars in assets can achieve this level of return decades into the future, especially given today’s low interest rates. The target return is doubly important because it is also the rate by which the flow of future pension benefits is discounted. An excessive discount rate makes a pension fund appear more financially sound than it actually is.

Instead, secure pensions require much more than spicy investment models. The basics: recognizing the real deficits. Correct the mistakes of the past with catch-up funding. Align the interests of stakeholders through appropriate legal structures and governance. Ensure future sustainability through careful plan design. Improve investment offices. And mitigate long-term risk by matching fund assets to liabilities.

Five steps

Canada has done all of this. Here’s how.

First, actuaries were engaged to properly assess the funding gaps that have been closed. In some provinces, taxpayers have fully absorbed the cost of these discrepancies. In others, workers have agreed to share the costs equally.

Second, the plans were reformulated under the joint sponsorship of the interests of employers and employees. This has given employees a strong voice in determining the level of their benefits. He moderated that voice with recognition of a shared burden to ensure the sustainability of the long-term plan: a seat at the table in exchange for in-game skin.

Third, the new legal structure has led to more conservative funding models. Canadian pensions are designed conservatively. Membership and employer contributions cover about 80% of benefits in Canada, compared to 55% in the U.S. Although employer contributions are similar in both countries, Canadian employees pay more into their pension plans compared to to future benefits than their peers in the United States.

“It is impossible to solve the problems of a pension fund only through the investment portfolio. ”

Fourth, Canadian governments have created independent and sophisticated investment offices to manage pension assets. In the case of smaller plans, the portfolios have been consolidated for more efficient management.

Fifth, pensions were oriented towards investment with the objective of asset-liability matching. Today, they are averaging returns of 5.6%, compared to 7.2% in the United States. Despite this, Canadian pension plans outperform those in the United States.

Canadians prefer longer-lived assets such as directly owned real estate, toll roads and port facilities to generate the cash flow needed to pay for the promised benefits. They allocate a quarter of their portfolios to such “real assets”, compared to 10% in the United States.

US public service pension plans tend to favor equity risk strategies because they have to “shoot for the stars” to meet their ambitious investment goals. Public and private equity and hedge funds make up 60% of US retirement portfolios, but only 41% of Canadian portfolios.

When done right, this strategy pays off. Otherwise – or when the markets do not oblige – the drop becomes substantial.

Pension reform in the United States will not happen without strong opposition. While the general consensus is that public pensions have strong protections in law, the math for unions – concerned with the well-being of current and future retirees – would be to accept higher contributions today to protect benefits. in the future. Otherwise, it is increasingly likely that future workers would be transferred to 401 (k) type defined contribution systems or “shared risk” systems like Wisconsin’s.

Finally, the unions would like to prevent preventative legislation that protects municipal bondholders and taxpayers in the event of potential pension plan bankruptcy, as happened in Central Falls, RI.

Illinois has the least funded public pensions in America. Neighboring Wisconsin designed its system around shared risk. Rather than pitting taxpayers and workers against each other, this system adjusts benefits or contribution levels based on the value of assets versus liabilities (benefits cannot fall below a minimum level ). One is on the verge of failure, while the other seems strong and enduring.

Does Washington have a role to play in state and local pension reform? The Comptroller General of the United States argued that “Congress should closely monitor actions taken by states and local governments to improve funding for their plan to determine whether congressional action may be necessary.” This was in a 1979 report. Inaction and lukewarm responses over the following years to make the necessary public pension reforms mean that today, sustaining and sustaining full funding levels could cost anywhere between. 4% and 5% of the annual tax revenues of states and communities.

Continuing to drag our feet will create additional burdens on future taxpayers and cause unpleasant surprises for retired public sector workers.

As the new administration begins to work with states on their many public finance challenges, it should put public pension reform at the top of the agenda – and heed the imagination our neighbor to the North started 30 years ago.

Ingo Walter is Emeritus Professor of Finance at the NYU Stern School of Business. Clive Lipshitz is a Managing Partner at Tradewind Interstate Advisors and a Visiting Fellow at New York University.