The Challenges Facing Public Pensions in the United States, and How Best to Solve Them

The city of Prichard, Ala. is widely acknowledged to be the first American government unit to default on its public pension obligations. When the fund ran dry in 2009, Prichard simply stopped paying the city’s pension beneficiaries. As a result, many of the retired workers who had once received pension checks filed for bankruptcy; some came out of retirement, and others died in destitution before the issue could be resolved. Prichard’s example provides a stark warning to public pension funds across the United States.

A new research paper, “Underfunded Public Pensions in the United States: The Size of the Problem, the Obstacles to Reform and the Path Forward,” co-authored by Harvard Kennedy School (HKS) Senior Fellow Thomas Healey, Kevin Nicholson, MPA 2012/Tuck School of Business Dartmouth College 2012; and Carl Hess, Towers Watson Investment, argue that the public pension problem in this country is widespread and largely misunderstood. In the paper, the authors declare, “Across the United States, state and local government-sponsored pension plans are in trouble."

The paper’s substantial evidence suggests that public pension funds are “dangerously underfunded to the extent that their assets are unable to meet future liabilities without either outsize investment returns or huge cash infusions." While sizing the magnitude of this problem, the authors zero in on the complex nature of pensions as a form of deferred compensation, and ultimately offer a series of potential policy options that can be implemented to address the issue of public pension underfunding.

The potential solutions explored in the paper fall into one of two categories: potential benefit design changes, and potential financing changes. The components of each category of solutions include:

Potential Benefit Design Changes

• Eliminate legislative end runs around the collective bargaining process (i.e., sweeteners). Benefits would be either negotiated or legislated, but not both.


• Eliminate final-salary plans in favor of final average compensation (FAC), career average or hybrid (e.g., cash balance) designs.


• Reduce/eliminate postretirement cost-of-living adjustments, or make them subject to affordability (possibly conditioned on funded status).


• Tighten up eligibility for heavily subsidized benefits, such as disability and early retirement.


• Tighten up eligibility for overtime hours to reduce opportunities for pension padding.


• Raise the age of eligibility for full retirement benefits. When early retirement is offered, it should be actuarially fair.


• Reduce benefit accruals (i.e., use lower percentages of compensation to calculate benefit accruals).


• Combine pensions with Social Security participation.


• Raise employee contributions.

Potential Financing Changes

• Reduce the intergenerational risk transfer.


• In keeping with the previous item, annual required contributions (ARC) calculations could be based on: A risk-free rate used to discount liabilities postemployment; a discount rate reflecting the asset allocation invested to match the liabilities during employment.


• Require amortization of deficits over reasonable periods. On the basis of an individual participant, amortization should not last much longer than an employee’s remaining work life.


• Make contributing the ARC a legal requirement. This would require federal legislation for the state plans and federal or state legislation for plans sponsored by local governments.
• Control and monitor the size of a pension plan’s funding ratio.

The authors conclude that, "The increasing formal recognition of the financial threat posed by unfunded pension liabilities serves to underscore the time-sensitive nature of pension reform measures." Healey and his co-authors hope that the warnings, examples of progress, and potential solutions provided in their paper, will catalyze and inform effective public pension reforms across the nation.

Thomas Healey is a Senior Fellow at the Kennedy School's Mossavar-Rahmani Center for Business and Government. He was formerly adjunct lecturer at the Kennedy School, where he taught the course in Financial Institutions and Markets. Healey joined Goldman, Sachs & Co. in 1985 to create the Real Estate Capital Markets Group, and founded the Pension Services Group in 1990. He became a partner in 1988, a managing director in 1996, and remains a senior director of Goldman Sachs. Prior to joining Goldman Sachs, Healey served as Assistant Secretary of the U.S. Treasury for Domestic Finance under President Ronald Reagan.