Recently, issues within Minnesota and neighboring state North Dakota have brought visibility to the fact that many state and local pensions are vastly underfunded. For instance, North Dakota introduced legislation that would eliminate pensions for public employees, instead leaving them with individual retirement accounts, or 401Ks.
What's the difference?
A pension is generally a defined benefit, meaning that an employee is guaranteed a specific benefit upon retirement, such as the average of their last 5 years of salary or a specific monthly amount. Defined contribution plans, often labeled 401Ks or 403bs, do not guarantee a specific benefit for employees upon retirement. Instead, the plans define a specific contribution that an employer will make on behalf of an employee, such as 3% of gross pay per month.
What's the gravity of the problem?
Nationwide, the Pew Charitable Trust estimated in 2007 that states lacked $361 billion to meet their pension obligations, an additional $370 billion is needed to cover the vastly underfunded health benefits that have been promised to state employees.
In Minnesota the Teachers Retirement Association (TRA) is in pretty bad shape, with only 59 percent of its obligations covered. Without changes, they will run out of money by 2032, meaning individuals within that plan would cease to be paid their benefits.
What can be done?
In order to become adequately funded, pension funds can undertake a series of actions: cut pension benefits, increase contributions among employees and employers, reduce the cost of living adjustment (COLA) which seeks to balance inflation, or increase the retirement age. Another factor in underfunding is the expected earnings percentage; some states and localities may have unrealistically high targets that they will never meet. However, lowering investment targets would require even larger contributions or benefit cuts to meet commitments, which are politically unfeasible.
In general, it is essential to devise institutions and arrangements that do not depend upon self-interested public officials for responsible stewardship. There are institutional innovations that can help public officials make these unpopular decisions. Ideas include: increasing the autonomy and independence of auditors, providing greater insulation from pension boards and legislators, or creating a multistate body with the authority to monitor public pensions and establish guidelines regarding fund balances and expected rates of return.