PUBLIC EMPLOYEE RETIREMENT: A STATE OF MIND OR AN OBLIGATION OF THE STATE? SPRING 2014 A Tale of Broken Promises, Funding Shortfalls and Long-term Insolvency

TABLE OF CONTENTS

Contents

Executive Summary ________________________________________________________________ 1

Birth and Evolution of Retirement _____________________________________________________ 2

Structure and Funding _______________________________________________________________ 7

Detroit __________________________________________________________________________ 18

Solutions to Retirement ____________________________________________________________ 20

Conclusion ______________________________________________________________________ 22

Contact Information _______________________________________________________________ 24

Sources _________________________________________________________________________ 25

EXECUTIVE SUMMARY

Page 1

Executive Summary

Retirement, at its core, is perceived by many to be a promise. It is the promise that, after dedicating a

lifetime to working in a position, a person will be able to receive a check in the mail every month

allowing them to live the peaceful, secure lifestyle they have set their sights on. Although this dream

did not always exist in America, it has run so deep into history that citizens not only see retirement as a

luxury, but as something everyone is entitled to. Although the dream remains the same, the means of

actually obtaining it in the current environment is growing more and more out of reach.

Historically, social insurance programs were not demanded by the American people, but instead were

given to them by means of the Social Security Act of 1935. This Act was not intended to replace

savings for retirement, but instead to be a supplement to prior savings towards retirement. Through

amendments to the Act following its passage in 1935, the initial intention of Social Security was lost,

and since then has even helped exacerbate the pressure on municipal pension funds through provisions

that will be investigated in this case.

Within the arena of retirement, the management of public pension funds has become an even more

pressing issue. As of 2012, 38 states were reported as being less than 80% funded, with liabilities

collectively growing into the trillions of dollars. It has even been speculated that these reports

understate the present values of the pension funds’ liabilities compared to their true liability. With the

states and cities acting as employers of thousands of workers, an underfunded pension fund could mean

that employees will either see a significant reduction in their expectations of a pension, or in more

dramatic cases, may not see a pension or retirement benefits at all.

As news seems to come out on a daily basis reporting about cities undergoing Chapter 9 bankruptcy,

and the severe condition of public institutions due to underfunding, it begs the question, how did the

states come to this desperate condition? In United States history, the use of price controls brought about

the popularity of pensions as a mean of incentivizing employment. Though the wage freezes have long

melted away, the tradition of offering a pension promise still goes on strong. Despite the fact that

public pensions were also intended to be a supplement to retirement savings, that belief has also been

obscured over time in favor of a mentality in which pensions are considered a full replacement.

One critical characteristic of public pensions is the fact that they are defined-benefit plans ultimately

paid for by the taxpayers. When municipal governments need more money to allocate in their budgets,

the logical means of obtaining these funds is through raising taxes. Since this method of obtaining

funds falls upon the citizens of a State, it is usually met with resistance often unfavorable to a

politician’s reelection campaign. Alternative methods for reducing the pension liability include

reducing benefits or the cost-of-living adjustment, which are then met with resistance by unions and the

employees dependent on these plans.

Public pensions also run into the often-debated issue of asset allocation. Some public pension funds

might be tempted to reallocate a higher percentage of their funds into equities for the sole purpose of

being able to report a higher discount rate and subsequently a lower overall pension liability.

Unfortunately, this allocation may not necessarily be instituted with the intention of increasing returns.

If politicians would instead consider coupling defined-benefit plans with a defined-contribution plan,

or a retirement savings account, then they could decrease pension obligations funded by taxpayer

money, and instead empower citizens to be conscious and invest in their own savings and investments.

BIRTH AND EVOLUTION OF RETIREMENT

Page 2

Birth and Evolution of Retirement

HISTORY OF SOCIAL SECURITY

The concept of state-sponsored retirement originated in the early 1880s in Germany under Chancellor

Otto von Bismarck. At this point, Marxism was sweeping across Europe and its enthusiastic supporters

were beginning to demand more socialist policies. In an attempt to quell unrest and appease Marx’s

supporters, von Bismarck suggested the first social insurance program in 1889.i It was the promise of a

fixed annuity, awarded to people past the age of 65. According to the National Bureau of Economic

Research, the life expectancy of men and women in Germany during the late 1800s was approximately

39 years. Since adults that lived until the age of 60 were only expected to live a 12 additional years,

Otto von Bismarck’s promise to mollify the socialists was not too large a gamble at the time.

The Social Security Act of 1935 was a product of the rise of Progressive Republicanism in the United

States. The party believed that the main function of government was to serve the people by restricting

the power of corporations and expanding government control. Wisconsin senator Robert La Follette

and John R. Commons, an economist from the University of Wisconsin, worked together to form “The

Wisconsin Idea” laying the groundwork for the Social Security Act of 1935.ii Edwin Witte and Arthur

Altmeyer, students of Commons, both ended up taking major political positions under the Roosevelt

administration. The president appointed Altmeyer as Assistant Secretary of Labor, a position Altmeyer

used to draft the order that created the Committee of Economic Security. Altmeyer appointed Witte as

chairman, who then drafted the Social Security Act of 1935.

Like the social insurance plan provided by von Bismarck decades earlier in Germany, the Social

Security Act set the retirement age to 65. This age was not chosen to mimic that of the German

chancellor, but was instead based on actuarial data from 1934, recovered and presented by Witte in

Senate hearings for the Act. According to “A Timeline of the Evolution of Retirement in the United

States” by the Georgetown University Law Center, life expectancy in 1935 was 60 years. Due to

medical and technological advances, life expectancy has dramatically increased in the United States.

Despite this, it took almost fifty years to push the age of receiving full benefits a meager two years

back, to the new age of 67, reflecting how sensitive the issue of retirement is in American society. It

also shows that politicians were more inclined to ignore current actuarial data than bring the issue of

retirement to a debate, fearing that such a stance might make reelection more difficult.

One of the critical components of Social Security law was enacted as a rider on another bill. In the face

of excessive government spending in 1972, Congress prepared legislation to increase the debt limit.

Ironically, as Congress addressed federal budgetary issues, Senator Frank Church introduced a rider to

the bill that would “provide an immediate 20% increase in benefit amounts, and another to provide for

automatic annual Cost-of-Living-Allowances (COLAs) for Social Security benefits.”iii The primary

purpose of the COLA is to safeguard benefits from reduction by inflation, accomplished by adjusting

the benefit based on the percentage change in the Consumer Price Index for Urban Wage Earners and

Clerical Workers (CPI-W), a number calculated by the Bureau of Labor Statistics.

In 1983, the Social Security Act was amended again to alter the age of receiving full social insurance

benefits to 67.iv Despite the fact that Social Security taxes were raised from 2% to 6.15% in the 1977

Social Security amendments, 1982 projections predicted that the fund would run out of money within a

year, so an additional provision established that the earliest one could collect reduced benefits was at

BIRTH AND EVOLUTION OF RETIREMENT

Page 3

the age of 62. It took something as severe as the threat of insolvency in under a year for the

government to finally put the old actuarial data aside, and address Social Security funding.

HISTORY OF PENSIONS AND RETIREMENT SAVINGS ACCOUNTS

Fundamentally, a pension is an annuity promised to a person after a certain number of years of service.

The dream of being paid a pension was not always prevalent in American life. Although pension plans

existed in the United States since the Revolutionary War, it was not until World War II that they

actually gained popularity. In 1943, Roosevelt implemented Executive Order 9328 to amend the

Stabilization Act of 1942.v Essentially, the order sought out to freeze wages and salaries to control

inflation. In the same year, The War Labor Board ruled that the wage freeze did not apply to fringe

benefits, encouraging employers to offer pension, health and welfare benefits as an alternative

incentive to attract work. As the need for funding of government programs increased income taxes, the

tax deferral component of pensions attracted more workers. Indirectly, it was the government’s use of

price controls that led to the popularity of retirement benefits.

DEFINED-BENEFIT PLANS

The wage freezes eventually subsided, but the belief that every worker was entitled to a pension had

solidified. Pension plans traditionally come in one of two forms: defined-benefit and defined-

contribution. In a defined-benefit (DB) pension, the employer promises a fixed monthly benefit after

retirement, based on a formula that factors in employee earnings, tenure of service, and age. Although

some private entities offer this sort of plan, DB plans are now more commonly offered in the public

sector. A survey conducted by the Bureau of Labor Statistics indicates that 80% of state and local

government workers are enrolled under defined-benefit plans, leaving less than 20% enrolled in

defined-contribution plans.vi In a defined-benefit scheme, investment risk and the responsibility of

portfolio management is taken out of the hands of the employee, while the liability to repay the

promise is placed on the employer.

Since defined-benefit plans are typically seen in the public sector, they cover public workers such as

firefighters, police officers, and school teachers. The employer that provides their pension plans is the

state or local government in which they reside. Defined-benefit plans must follow some stringent legal

requirements. The maximum benefit permitted is $195,000, the full benefits of the plan are not fully

vested until after the age of 62, and benefits of the plan do not pass on to heirs.vii The functionality and

funding of these plans by state and local governments has been in center spotlight in recent debate and

public discourse, which will be further touched on in the discussion of funding.

By 1970, 45% of all Americans working in the private sector were covered by some sort of pension

plan. In 1972, NBC news released “Pensions: The Broken Promise,” a report that provided some

pressure for future pension legislation. According to the report, the legalese that most pension plans

were written made it difficult for workers to fully understand the requirements of receiving the full

benefits. In fact, it was common practice for employers to fire employees who had worked with a

company for twenty or more years when their pension plans were months away from vesting. In other

cases, the entity itself failed, leaving employees who were expecting to receive a pension with nothing.

In 1974, The Employee Retirement Income Security Act (ERISA) was enacted into federal law. The

Act tried to combat issues with pensions in the private sector by establishing requirements of full and

clear disclosure of plans’ financial information, standards of conduct, and vesting after a specified

BIRTH AND EVOLUTION OF RETIREMENT

Page 4

minimum number of years.viii ERISA also introduced the anti-cutback rule, allowing companies to

freeze pension plans if necessary and stop employees from building up additional benefits. Even

though employers were given the power to freeze pension plans, they were not allowed to go back on

promises to pay for the benefits employees had already earned. This type of provision empowered

companies in financial struggle to make up for lost funds, while at the same time protected employees

from having their benefits terminated.

ERISA also established the Pension Benefit Guaranty Corporation (PBGC). PBGC is an independent

organization of the United States government that provides coverage to employees in the event that

their pension plan gets terminated due to a company’s inability to pay. Since PBGC does not receive its

funding from taxation, it survives mainly off of the assets from failed plans, recoveries from the

unfunded liabilities from the plan sponsors’ bankruptcy estates, and its own investments using leftover

assets.ix

DEFINED-CONTRIBUTION PLANS

With ERISA’s more stringent requirements, companies in the private sector had a greater incentive to

make good on their promises of retirement benefits. The combination of ERISA requirements and the

Revenue Act of 1978 inspired the popularity of defined-contribution plans. In 1978, the Internal

Revenue Code (IRC) was amended to include a provision called 401(k), under which employees were

not taxed on the part of their income they chose to receive as deferred compensation.x In the 1980s,

employers who offered pensions to their employees began to feel the effects of ERISA, and realized

that the cost of offering pension plans and following through on that promise was actually very costly.

As a result, companies began offering 401(k) plans as a supplement to pensions. Eventually private

sector employers stepped away from offering defined-benefit plans and placed the responsibility of

managing retirement funds on the employees.

A defined-contribution (DC) plan is a retirement plan in which the employee contributes a portion of

their salary into an investment account of their own. Ultimately, the employee is in control of how their

deferred compensation is invested. In this type of scheme, the employer typically hires an

administrator, such as Charles Schwab, to oversee the account and shift the funds at the discretion of

the employee. In short, when the plans vests, the employee is entitled to employer contributions with

the additional possibility of gaining on investment earnings in the account. Unlike a defined benefit

plan, the responsibility of managing this account rests mainly with the employee. Since the employee is

directly deferring a portion of their paycheck to this account, the employee can pass on the benefits to

heirs. Types of defined-contribution plans other than the popular 401(k) plan are 401(3b), Individual

Retirement Accounts (IRAs), and Roth IRAs. The primary feature that distinguishes these plans from

one another is how they are individually taxed.

UNIONS

The public pension issue is a product of many societal forces, one of which includes organized labor.

Public sector unions have pushed for greater pension benefits for years, and while unions were

instituted to protect the employees they represent, unintended consequences have played a role in

putting municipalities in precarious financial situations. To understand the impact unions currently

play, it is worth discussing how organized labor got to its current state.

BIRTH AND EVOLUTION OF RETIREMENT

Page 5

Prior to the 1800’s, labor disputes were isolated incidents and without much impact. In the beginning

of the 19th century, migration to urban centers (coupled with an influx of immigrants from across the

Atlantic) created an environment where skilled workers found themselves competing with each other

for jobs. At this time, craft unions began to form, where workers in the same occupation attempted to

band together to improve their conditions. In 1827, the Mechanic’s Union of Trade Associations

formed in Philadelphia, and later the International Typographical Union formed in 1852, uniting local

unions across the country and even including Canadian unions as well. Early attempts at organized

labor had a philosophical bent motivating them as well. Beyond direct benefits to workers like pay

increases and defined workdays, these organizations were motivated by a belief in social equality and a

disdain for large wealth gaps.

The labor movement continued to evolve as the Knights of Labor, formed in 1869, gained influence.

The Knights espoused working class values, and attempted to coordinate hundreds of strikes at one

time across multiple industries. The organization experienced massive growth in the early 1880s, but

bit off perhaps more than it could chew, and the American Federation of Labor became the major

presence of organized labor in the late 1800s. Under the leadership of Samuel Gompers, the AFL

emphasized autonomy for each trade union, and steady growth ensued.

In 1914, the Clayton Act established that unions were exempt from antitrust laws, giving them more

credibility. When World War II broke out, patriotism mandated that the AFL strongly support the war

effort, but in the economic growth that followed (and Gompers’ death in 1924), unions lost power.

“Yellow-dog” contracts were used in this time period, which were employment contracts essentially

mandating that workers wouldn’t become a member of a union. Refusal to sign effectively meant

termination. In 1929, the Great Depression decimated the economy. Unions took a hit as members

couldn’t pay their dues, but protests swept the nation as workers demanded relief. In 1932, Herbert

Hoover signed the Norris-La Guardia Act, making the aforementioned yellow-dog contracts illegal, and

making it more difficult for courts to issue injunctions against strikes. During this time, unions’

political power grew. In the elections of 1934, the left-leaning labor movement put their weight behind

Democrats, who took the House 322-103.

The AFL organized unions by craft, but a desire for industry-organized unions led to the Congress of

Industrial Organizations (CIO). In 1941, anti-union sentiment took hold after Westbrook Pegler

reported on racketeering in Hollywood labor unions. Taft-Hartley followed in 1947, restricting union

powers and authorizing right-to-work laws. The AFL and CIO merged in the early 1950s, but unions in

the private sector have been in decline ever since.

Countering the private sector decline, organized labor in the public sector has become a powerful force

in the country. Teachers’ unions emerged in the 1920s, and have since become the dominant sector of

unions in the public arena. In 1958, Kennedy issued an executive order upgrading the status of federal

workers. Public workers have a number of advantages in bargaining power over private ones. When

private-sector workers strike, the company can move a factory to a different state, or simply close it

down. Municipalities do not have this option. One city obviously can’t relocate to a different state, and

there is no market for government work; public sector functions must continue to operate. For these

reasons, controversy concerning public sector unions has existed for decades. Franklin D. Roosevelt

even admitted “the process of collective bargaining, as usually understood, cannot be transplanted into

the public service.” When public sector workers strike for higher wages, they are essentially holding

the city hostage and forcing higher taxes on citizens. On principle alone, strikes in the public sector

obstruct necessary functions of the government.

BIRTH AND EVOLUTION OF RETIREMENT

Page 6

The philosophical problems presented by unions in the public sector have not prevented their

accumulation of power. When Chicago teachers went on strike in 2012, students were unable to go to

school, demonstrating that even public education lacks adequate defense against organized labor in the

public sector. Unions continue to push back against pension reform, making it much more difficult for

cities to institute responsible, conservative pension plans that would ensure fiscal solvency.

Some states have managed to push back against the unions. Scott Walker, the governor of Wisconsin,

was able to take away collective bargaining rights from public employees in 2011. While this is fiscally

more responsible, it is an exception rather than the norm. Even if unions were stripped of much of their

power across the country, employees in the public sector deserve some sort of protection. Either way,

unions in the public sector will continue to be a powerful force in years to come, and pension reform

will not come easy.

RETIREMENT TODAY

It is no surprise that Americans, as a whole, are getting older. With the post-World War II “baby-

boomer” population approaching its sixties, most of the 76 million will be entering retirement within

the next seventeen years. According to the CIA World Factbook, an estimated 46 million Americans are

currently over the age of 65. This number is projected to grow to 89 million by 2050 by calculations of

the Population Reference Bureau. As the population continues to age, what is the probability that the

aged American will remain employed? OECD data reveals that the normal retirement age for

Americans is 67 years old. However, data also reveals that 20% of Americans between the ages of 65

to 69 remain employed, and it is not until age 70 and above that this number falls to 5%. This implies

that Americans expect to stop working and reap the fruits of their labors by age 70.

As the United States grays and the expectations of

retirement draw near, there is a question of how average

Americans will be receiving their benefits and which benefit

plan they will be most dependent on. According to the

United States Census, there are an estimated 316 million

people in this country. The Bureau of Labor Statistics

estimates that 200 million are currently able to participate in

the labor force. On a federal level, 165 million Americans

are covered under Social Security. Of these 165 million

Americans, 51% have no private pension coverage and 34%

have no savings set aside specifically for retirement. The

Bureau of Labor Statistics holds that the estimated size of

the US workforce in March 2014 is 146 million people.

This, coupled with the SSA data, suggests that about 71

million people have pension coverage with Social Security

while the remaining 74 million with Social Security either have a pension or have nothing set aside for

the future.

For those fortunate enough to be receiving Social Security and a pension, there is the question of how

long they will be able to enjoy the benefits. The actuarial life table provided on the Social Security

Administration estimates that the average additional life expectancy of males after age 67 is about 16

years and for females is about 19 years. This means that the government would have to cover one

individual for an average of about 17.5 years.

STRUCTURE AND FUNDING

Page 7

In February 4, 2014, Vanguard reported that the average nominal account balance for 401(k) plan

participants was $101,650. According to US News, the average annual withdrawal rate of responsible

401(k) holders is 5.2% after age 70. Assuming a person is on a standard 401(k) plan and opts to receive

periodic distributions over their life-span, this average American will be withdrawing a meager

$5,285.80 annually until they pass away. Since $440.48 is not an adequate amount of money to live off

of in a month, the average American must turn to Social Security. According to the Social Security

Administration, in December 2013, the average monthly benefit for retired workers was $1,294 a

month. Thus, the average American working in the private sector can expect to receive $1,734.48

monthly until they die. The fate of those relying on public pensions is currently a gamble contingent on

the actions that will be taken by state governments in the next few years.

Structure and Funding

STRUCTURE AND FUNDING OF SOCIAL SECURITY

Since its implementation, the basic elements of the program’s funding were further carved out. In 1939,

the Social Security Trust Fund was established in which all payroll taxes would be pooled in either the

Old Age Survivors Insurance (OASI fund) or the Disability Insurance (DI) funds. According to federal

law, trust fund income is only invested in special issue securities held by the United States Treasury.

The logic behind this is to increase liquidity and hedge risk.xi Unlike marketable securities, special

issues can be redeemed at any time at face value and are not subject to the risks of the open market.

In the 1960 amendment to the Social Security Act, the formula for calculating the interest on special

issues of the fund was changed to what is used today.xii Even though special issues cannot be traded in

secondary markets and remain exclusively within the trust funds, the interest rate determined on these

bonds are “determined from the average market yield rate on government obligations that are not due

or callable for at least 4 years.”xiii The act also determined that the two types of special issues are short-

term, which are traded on a daily basis, and long-term, which mature between one and fifteen years.

David C. John, a senior research fellow for the Heritage Foundation, argues that the Social Security

Fund model is what makes Social Security mostly an illusion. He states in an article that the Fund is

mostly an accounting device that carries the misnomer of a fund. When the government collects payroll

taxes from employers, the cash goes into the hands of the Treasury, not the Fund. With this cash, the

STRUCTURE AND FUNDING

Page 8

Social Security Administration either directly sends it off to beneficiaries, or uses it “to finance

anything from aircraft carriers to education research.”xiv

Any money that remains after the spending is converted into special issues rather than invested in

stocks and bonds on the secondary market. According to the Office of Management and Budget in

1999, “these funds are not set up to be pension funds, like the funds of private pension plans. They do

not consist of real economic assets that can be drawn down in the future to fund benefits. Instead, they

are claims on the Treasury, that, when redeemed, will have to be financed by raising taxes, borrowing

from the public, or reducing benefits or other expenditures.” This highlights the fact that the

government cannot keep kicking the can down the road in terms of handling the funding issue.

Another important issue to note is how the amount that beneficiaries receive is determined. The

way that benefits are typically determined is that workers in a lower pay bracket end up receiving a

higher return than highly-paid workers. This is not to say that lower-paid workers necessarily receive

more money but that they receive a higher percentage of their pre-retirement earnings than the worker

who makes more money. In fact, on average, a lower-paid worker receives a benefit of 55% of their

pre-retirement earnings while a higher-paid worker receives 25%.xv The fact that lower-paid workers

receive a higher percentage of their pre-retirement earnings when calculating the Social Security

benefit comes to play in the discussion of the Windfall Elimination Provision further along in this case.

STRUCTURE AND FUNDING OF PUBLIC PENSIONS

In March of 2013, Illinois was accused of fraud by the SEC. Mary Williams Walsh of the New

York Times wrote in “Illinois Is Accused of Fraud by SEC” about how state and local governments

fund their pension systems. Illinois was under SEC investigation because from 2005 to 2009, the state

misled investors about the condition of its pension system. In that time frame, Illinois faced increased

pressure as the state government came to the realization

that it would actually have to pay for everything it had

promised. This meant retirees and bond buyers would

have to compete for the same limited money supply. Out

of desperation, the state government painted a rosy

picture of the rating and return of their municipal bonds to

investors. This kind of fogginess about the condition of

funds to investors drew the SEC into the investigation.

In the article, George S. Canellos, acting director

of the SEC’s Division of Enforcement, was quoted saying

that “time after time, Illinois failed to inform its bond

investors about the risk to its financial condition posed by

the structural underfunding of its pension system.” One

reason why Illinois’s government is particularly

devastating is that it is one of a number of states where

most public workers do not participate in the Social

Security system. If Illinois fails to find a way to get

enough money in their pension fund, either thousands of

public workers will not see a dime of retirement money,

or the federal government will intervene and set the precedent that there is no real risk of default.

STRUCTURE AND FUNDING

Page 9

It would be thought that the creditors of Illinois bonds would get some kind of red flag about the level

of exposure that took when purchasing the securities. Somehow, credit rating agencies did not take

Illinois’s true financial condition into account since Illinois had a credit rating of A2 by Moody’s and

A+ by Standard & Poor’s rating scale a year before the SEC accused the state of fraud. According to

Standard & Poor’s definitions of credit ratings, an “A” rating has a “strong capacity to meet financial

commitments, but somewhat susceptible to adverse economic conditions and changes in

circumstances.”xvi Unfortunately, Illinois is not the only state that has both been misrepresented and has

distorted the condition of both their pension funds and financial condition. Although it is true that

Illinois and other state and local credit ratings were far from the truth, it begs the question of whether

the rating agencies were at fault or the state accountants that created subpar reports or perhaps even the

very standards that they had to adhere to.

In an analysis done by the Pew Center, there was a gap between the states’ assets and their obligations

for public sector retirement benefits of $1.38 trillion in the fiscal year of 2010.xvii The Center estimates

that in the short term, states will have enough cash to cover retiree benefits, but in the long term, even

with strong market conditions, face the risk of drying up. Experts claim that a healthy pension system

should be at least 80% funded. In fact, this is a standard that corporate pension plans must adhere to by

the guidelines of ERISA. Bloomberg reported that in 2012, 38 states were underfunded by this

definition.xviii

Out of all 50 states, only Wisconsin was nearly 100% funded. The most underfunded pension plans

were Illinois at 40.37%, followed by Kentucky at 46.77% and Connecticut at 49.08%. This

underfunding of pension plans will not only be devastating to the retirees not receiving the plans but

also the public institutions run by the states. The question now remains as to how so many states will

be unable to fully fund their pension programs.

The funding of public pension systems is

a very chaotic and costly game of asset

allocation and actuarial forecasting. In

2011, the United States Census Bureau

reported that public pension systems

pulled in revenues of $616.1 billion.

These revenues included both realized and

unrealized net gains and losses on

investments. In the breakdown of the

revenues, the report showed that out of

this $616.1 billion, $479.6 billion came

from reported earnings on investments,

while the other $136.5 billion came from

contributions from local and state

governments, and employees. In the

report, there was no indication of how

much of the $479.6 billion in revenues came from realized and unrealized gains and losses on this

investment income. Also it is worth noting that these reported revenues consist of unrealized gains on

investments at a discount rate of 8%.

In 2011, Joshua Rauh and Robert Novy-Marx investigated various methodologies for finding the

present value of state pension liabilities, as well as finding the discount rate in a publication titled

STRUCTURE AND FUNDING

Page 10

“Public Pension Promises: How Big Are They Worth?” According to the study, state pension funds on

average use an 8% discount rate for converting expected future pension values into present value and

have an approximate duration of 15 years. Before delving into the specifics of finding a more

appropriate rate, it is important to understand various methods of finding the present value of accrued

actuarial liabilities.

The most simplistic way of calculating the state pension liabilities is by accumulated benefit obligation

(ABO), which is the amount of money pension plans would owe retirees even if the plans were

completely frozen today. The cash flows attached to an ABO are based on pension plan formulas,

current salaries, and current years of service. In fact, the way to calculate the ABO is to simply take the

flat predetermined percentage of their final salary amount and multiply it by years of service plus the

COLA determined by the state and pension plan. This formula works in simple cases in which the

calculation occurs as soon as the employee stops working. The fundamental error of this model is that

it misses the dimensions of increasing wages or independent wage risk or even inflation. Due to these

shortcomings, states typically report their liabilities using broader measures.

A broader measure of state pension liability is the projected benefit obligation (PBO). Unlike ABO, it

takes into account projected future salary increases. However, this method falls short because it does

not account for future years of service. The second broad measure is the projected value benefit (PVB),

which discounts a full projection of what employees are expected to receive if their salary grows and

includes an of an actuarial estimation of future years of service. In fact, PBO is calculated as a fraction

of the expected PVB obligation at time of separation.

Despite the fact that PVB is the most dynamic of

these methods for calculating the state pension

liability, most states use a method called entry age

normal (EAN). According to the study, 68% of 116

state plans report liabilities using EAN, while an

additional 17% use methods of a similar nature and

the remaining 15% use projected unit credit (PUC).

EAN distinguishes the PVB in proportion to

discounted wages earned to date relative to

discounted expected lifetime wages. The EAN can

also be calculated as an estimated percentage of

employee wages that would have to be set aside to

meet retirement benefits. This assumes that savings

can be invested at the risk-free rate used to value

liabilities. To some degree, it looks like a defined-contribution plan without the investment risk.

As predicted, all of these methods generate a different number for total state pension liabilities. In June

2009, states reported a total liability of $3.14 trillion. Under the assumption of an 8% discount rate and

15 year duration, Rauh found that the liability would be $2.76 trillion under ABO, $3.07 trillion under

PBO, $3.15 trillion under EAN, and $3.75 trillion under PVB. Although PVB reports the highest

liability at this discount rate, it is probably a more accurate way of calculating state liability. The PVB

is a superior calculation of state pension liability because it recognizes both the expected full service

and final salary of even the youngest workers, while EAN and PBO recognize a fraction of PVB and

ABO only recognizes current service and salary.

STRUCTURE AND FUNDING

Page 11

As previously stated, the commonly accepted discount rate is the enigmatic rate of 8%. In fact, in 2009,

the mean discount rate of 116 state pension plans was 7.97% and the median was a clean 8%. The

reason why this number has been so prevalently used is because the discount rate assumptions are

based on the Government Accounting Standards Board (GASB) and the Actuarial Standards of Practice

(ASOP), which encourage the use of the 8% rate. If a financial stream of payments is to be discounted

at a rate that accurately reflects risks, then this methodology is counterintuitive. Instead, liabilities

should be discounted at rates that reflect the market risk that mirrors the nature of these liabilities. As

Rauh states in the study, “the way the liabilities are funded is irrelevant to their value.” Interestingly

enough, corporate pension plans must report their liabilities using a discount rate based on a yield

based around Treasury yields, which mirror the market risk of a pension liability.

One potential replacement for the dominating 8% rate would be through the use of a rate comparable to

the state’s general obligation debt rate. General obligation (GO) debt consists of municipal bonds

secured by the state’s repayment of debt through tax revenues. These obligations might reflect a similar

nature of payment as state pension liabilities, but what really matters is the fact that both carry a similar

level of market risk. It is similar because taxpayers assume that defaults for GO debt and pension

liabilities are alike (although it is likely that risk of default is less likely for pension liability than GO

debt). Specifically, beneficiaries will receive recovery payments proportional to that of municipal

creditors experiencing a default. Under the assumption that pension benefits also have the same priority

as GO debt, the discount rate can be determined as the state’s zero-coupon bond rate, corrected for the

personal investor’s marginal tax rate. This rate was dubbed by Rauh as the “taxable muni rate.”

Another replacement for the 8% rate would be a rate based on the treasury zero coupon yield curve,

which is naturally default-free. The reason why it might be prudent to view the liabilities from a

default-free perspective is because it is congruous with the mentality of the beneficiaries’ and

taxpayers’ perspective. Since the taxpayers are “the ultimate underwriters of this default-free promise”

it makes sense to understand the liability from this point of view. There are obviously a lot of

shortcomings with using this as a measure. Firstly, although the default-free curve is theoretically risk-

free, it does reflect premiums not present in a pension liability such as an inflation risk premium and a

liquidity price premium. Since there is a lack of consensus on the size of these premiums in regards to

pension liability, it is too hard to adjust for these discrepancies.

By putting the unadjusted government-reported total pension liability under the 8% discount rate, the

present value of the liability comes out to be $3.14 trillion. By using the taxable municipal discount

STRUCTURE AND FUNDING

Page 12

rate on the ABO, the liability is $3.20 trillion with $1.87 trillion from annuitants, $0.10 trillion from

separated workers not receiving benefits, and $1.23 trillion from active workers. Using the treasury

discount measure on the ABO, the liability is a whopping $4.43 trillion with $2.28 trillion from

annuitants, $0.20 trillion from separated workers not receiving benefits, and $1.94 trillion from active

workers. What these discount rates are attempting to illustrate is not that the taxable municipal rates

and treasury rates produce higher or lower measures of the state pension liabilities, but that when rates

are marked to market conditions, the result is different from that of the illusive 8% catch-all rate. And

this difference is relevant because, unlike the 8% rate, these two discount rates find a present value that

is more akin to the nature of the liability itself. This introduces the question of what the present value

of these state pension liabilities truly is, and what kind of impact that will have on how investors will

react to how underfunded these plans truly are.

To explore how underfunded these state plans are, it is

important to first evaluate the revenue stream that the

state has to work with. In the 2012 Annual Survey of

Government Finances, Illinois reported tax revenues of

$36.26 billion. According to Joshua Rauh in the Kellogg

Business Blog, Illinois has an obligation of $14.5 billion

in pension payments in 2019. Since the state pension

funds function on a “pay-as-you-go” system, this means

that 40% of tax revenue would go directly to paying for

these obligations. Rauh estimates under the generally

accepted 8% return assumption, Illinois’s pension fund

will likely run out in 2018. Unfortunately, Illinois is not

the grimmest prediction. Both Oklahoma and Louisiana

are predicted to run out as early as 2017.

STRUCTURE AND FUNDING

Page 13

To investigate the issue of underfunding, it is critical to follow exactly how these funds are being

allocated. In the year 2011, the Census Bureau reported that 34.6% of the total assets in public pension

funds in the US was invested in corporate stocks, 17.3% was invested in foreign and international

securities, 14% in corporate bonds, 8% in government securities, and the remaining 26.1% in many

miscellaneous investments.xix This data suggests that state and local pension funds mainly rely on stock

market performance to gain returns on their pension funds.

There are 3,418 state- and locally-administered pension systems in the United States. Membership in

2011 was reported to be 19.4 million. Of these 3,418 pension systems, each one follows its own unique

actuarial cost method for determining when retirees receive pension benefits and how much they are

able to receive. Each state also sets its own guidelines in terms of how the assets in the fund will be

allocated, and whether or not they want to use external sources to do the investment for them.xx Also,

though all states and local governments must adhere to the principles of GASB and ASOP, not all

accounting methods are alike. In fact, different states use different methods to calculate accrued

liabilities all together. The quality and accuracy of the financial reporting of these pension funds is an

issue that Illinois and other state and local governments will have to answer to as the truth about the

security and investment of these funds unravels.

Just like the article by Walsh suggested, one notable source of acquiring assets for these investments is

through the sale of municipal bonds. Although the issue discussed in the article addressed the

questionable credit-worthiness of these investments, another underlying issue is the accuracy to which

these securities are discounted and then reported. In another article, Joshua Rauh explored the

municipal discount rates by projecting how long state governments can continue to run their employee

pension programs before the funds eventually dry up. Rauh modeled 3 different state contribution

scenarios and assumed investment returns of 6%, 8% and 10% for each of the 3 scenarios with an

assumed average inflation rate of 3%. In the three scenarios, Rauh used state contributions as the

independent variable.

In the first scenario, he predicted that if states were to only contribute to their funds through the use of

municipal bonds, the funds would run out in 2024 with a 6% return, 2028 with an 8% return, and the

2040s with a 10% return. Considering the level of honesty in disclosure of the credit-worthiness of

these investments, an 8% or 10% return would be very unlikely. In the second scenario, Rauh had the

states contribute an additional $50 billion per year. With a 6% return the funds would run out in 2028,

with an 8% return the funds would run out in 2037, and with a 10% return the plans would be

overfunded. In the final situation, Rauh had the states contribute an additional $75 billion per year.

With a 6% return the funds would run out in 2030, with an 8% return the funds would run out in 2045,

and with a 10% return the plans would be overfunded.

STRUCTURE AND FUNDING

Page 14

FUNDING OF CORPORATE PENSIONS

Before covering recent legislation and issues within single and multi-employer pension funding, it is

important to cover some of the major differences between state and corporate pension plans. As

discussed previously, private pensions must answer to the requirements and guidelines of ERISA and a

“healthy” pension plan should be at least 80% funded. Under ERISA and the acts that have amended it

over the past few years, private defined-benefit pension plans are required to meet high funding ratios.

If these plans do not meet these high standards, then the company is required to provide notice of this

status to participants, beneficiaries, the bargaining parties, the PBGC, and the Department of Labor.

After this, the company must reduce benefits if they are adjustable in nature and freeze the plans while

still owing the liability. According to the United States Department of Labor, the company is then

required to adopt a plan to restore the financial health of the plan.xxi If this plan fails and the company

ultimately cannot pay for these plans, then plans covered under the protection of PBGC will go under

its jurisdiction.

Unlike the guidelines of corporate pension plans, public pension plans do not have the same strict

guidelines to prevent underfunding and, by extension, insolvency. Since public pensions are ultimately

thought to be default-free, the only issues that have been really investigated are ways to lower the

pension liabilities. Unlike the corporate pension plans, which must take specific procedures when there

is a risk of failing to meeting the promise, the concern is whether or not the federal government will

have to pick up the tab (the likely case) and theoretical methods of how to reduce the liabilities.

Since the employer in question is a group of politicians, there is an inherent conflict of interest in the

decisions that they make. In 2011, the Congressional Budget Office suggested in “Economic and

Budget Issue Brief” different methods that states could take to combat underfunding. They suggested

raising employee contributions, shifting partly to defined-contribution plans, or increasing the vesting

age. They also recommended that states alter the COLA, raise taxes, reduce government spending, and

invest in “riskier” assets.xxii

Although all of these suggestions could truly reduce the state pension liabilities and help alleviate the

pressure on state governments, any of these suggestions would be unfavorable stances for a politician

to take in hopes of reelection. If politicians were to make such bold suggestions while in office, they

would have to face the wrath of unions and retirees who don’t want to see any kind of reduction in

benefits despite the critical state of the governments. Therefore, instead of making the difficult decision

to make unpopular reforms to public pensions, the states are forced to produce lower pension liability

STRUCTURE AND FUNDING

Page 15

numbers by manipulating the discount rates for finding the present value. As previously discussed, if

the present value of public pension plans was calculated at a lower discount rate, the true size of the

pension liability would be revealed. Since public pensions do not follow the same strict requirements as

corporate pensions, the states have the ability to artificially raise the discount rate by reallocating funds

more heavily into equities for that sole purpose.

To open the discussion about single-employer pension plans, we review the provisions and implications

of the Pension Protection Act of 2006 (PPA). According to a report done by BlackRock, the act

required pension plans “to target 100% funding on a market-related basis which used a discount rate to

measure the liability value that was linked to the corporate bond yield curve.”xxiii Another strict

requirement was that contributions were required to recover any kind of deficit. One major impact that

this had was that the expected return on pension plan assets did not impact how funding levels or

contribution requirements were calculated. In addition, PPA contained provisions to accelerate

contribution requirements for plans at risk of default and limited the benefit increases and accruals for

plans deemed underfunded.

As previously stated, a healthy pension

plan is considered to be at the minimum

80% funded. Unlike public pension plans,

private pension plans are bound to report to

FASB. Despite the ambitious requirements

of PPA, corporate pension plans have been

struggling to meet the 80% mark.

According to BlackRock’s “Corporate

Pension Update”, in June 2012 the funded

ratio of a typical US defined-benefit

pension plan was 76%.

On July 6, 2012, President Obama signed

into law the Moving Ahead for Progress in

the 21st Century Act (MAP-21). This act allowed companies to make lower pension contributions and

caused the premiums paid to PBGC to rise. The act enables firm to make lower contribution payments

by allowing firms to use higher discount rates, thus lowering liability values via “Interest Rate

Stabilization.” This permits the use of an average corporate bond yield over the past 25 years, with a

corridor around the average. In financial accounting, the corridor rule requires disclosure of a pension

actuarial gain or loss, and in the case that this gain or loss exceeds 10% of the fair value of plan assets,

it can be amortized gradually overtime. Under MAP-21, the corridor will begin at the usual 10% at

2012, but each year will relax by 5%, so by the time it is at the 25-year average, the corridor will be at

30%. Since historical corporate bond yields were higher than current yields, the higher discount rate

subsequently lowers the value of liabilities and thereby forces lower contributions. The implications of

MAP-21 is that although it simply lowers contributions today, it does not impact the size or timing of

the pensions, therefore meaning higher contributions in the future.

In the world of private pension plans, companies sometimes fund the retirement plans of their

employees through the use of multiemployer pension plans. These plans are designed so that workers

are covered under more than one employer in the same industry that come together and collectively

bargain a level of contribution by each party into one account, with the inclusion of a labor union.

Logistics of multiemployer pension plans were established under the Taft-Hartley Act of 1947. At the

STRUCTURE AND FUNDING

Page 16

time, the New Deal had strengthened the power of unions through the Wagner Act to a point where

employers were subsequently disempowered by unions. Unions in the country were so influential at the

time that the act came into law by overcoming a veto imposed by President Harry Truman who had to

respond to the outcries of labor leaders.

According to the Bureau of Labor Statistics, before Taft-Hartley was passed, very few multiemployer

plans existed.xxiv The creation of the Act itself is thought to have catalyzed the popularity of these

plans. This type of pension plan has gained popularity because employees covered under this plan are

able to gain credits towards their pension under multiple employers. Defined-benefit plans usually base

benefits heavily on length of service. In vocations, such as construction, that involve frequent job

switching, it is more difficult to receive credits for a pension. Under a single-employer defined-benefit

plan, a worker would have to be with an employer for at least five years to become vested. Under the

multiemployer plan, the service that a worker completes under multiple employers is considered as

being under the same plan. Another benefit of this scheme is that if one of the companies under the

plan fails, the others are required by agreement to pick it up. All multiemployer pension plans are also

fully insured by PBGC.

In the article, “Thought Secure, Pooled Pensions Teeter and Fall”, Mary Williams Walsh of The New

York Times shows the hazards that multiemployer pension plans are facing in terms of funding.

According to the article, multiemployer pension plans currently cover 10 million Americans, and

dozens of the plans to cover the beneficiaries are failing. The most notable failure is that of the

Teamsters’ Central States pension plan, with more than 400,000 members. With the growing failure of

the pension plans, the Congressional Budget Office projects that PBGC will run out of money in seven

years, leaving retirees with nothing. Currently PBGC has premiums of about $110 million annually to

work with, implying that it would only take “the failure of one big plan to wipe out the whole

program.”xxv

Currently, PBGC has structured its investment scheme so that 30% of its assets are invested in

marketable equities, and 70% are invested in fixed income securities. It does not plan on changing this

structure any time soon.xxvi This current setup of the capital structure is not congruous with current

market trends. According to MarketWatch, in 2013 the S&P 500 had its strongest performance since

1997, as well as other indices, including the Dow Industrials and Nasdaq Composite. There is an

ongoing debate over the relative “safety” of investing retirement funds into equities rather than fixed

income securities. To boost their returns and potentially hedge their risk, PBGC could consider

following CAPM and only invest in the portfolio that yields the highest Sharpe ratio. If risk needs any

adjustment after that, it could be achieved by adding or selling risk-free securities.

PERSONAL FUNDING OF DEFINED-CONTRIBUTION PLANS

As previously discussed, another option for funding one’s retirement is through the use of a defined-

contribution plan. Unlike a defined-benefit pension, something like a 401(k) or IRA is considered to be

a personal savings plan at its core. An employee forgoes a portion of their paycheck, typically 6.2%,

the employer matches that contribution, and the money is put aside and invested into assets at the

discretion of the employee through the use of an administrator.xxvii The main difference between the

multitudes of defined-contribution plans is how they are taxed.

Two notable types of DC plans are the 401(k) plan and the Individual Retirement Account (IRA).

Under the 401(k) scheme, a person needs to be working under an employer that offers such a plan,

while anyone under the age of 70.5 can participate in an IRA. In a 401(k) plan, savers can contribute up

STRUCTURE AND FUNDING

Page 17

to $17,500. If the saver is over the age of 50 years old, they are able to contribute $5,500 more, for a

total of $23,000. The rule of thumb is that the employer’s contribution limit is dependent on the

employee’s contribution, meaning that all contributions made by the employee and the employer

cannot exceed $51,000 or 100% of the employee’s total income. 401(k) plans allow employees to make

these contributions on either a pre-tax or post-tax basis. Since the earnings on the investments within

the account are tax-deferred until the account is tapped into, there is an incentive for employees to

allow the accounts to compound interest, delaying taxation to receive higher earnings.

In a 401(k) plan, assets can be distributed or withdrawn when they choose to retire, attain the age of

59.5, or terminate the plan. At age 70.5, the employee under the 401(k) plan must begin required

minimum distributions (RMDs). If an employee plans on distributing before the age of 59.5 then they

are subject to a 10% early distribution penalty. According to Investopedia, to increase investment

options, it is typical for workers under a 401(k) plan to roll it over to a traditional or Roth IRA.

Unlike the 401(k) plan that is uniform in its delivery, the IRA usually comes in the form of traditional,

SEP, SIMPLE, and Roth. Under the traditional IRA, savers are able to contribute up to $5,500 with an

additional $1,000 if the saver is over the age of 50 years old. After age 70.5, the saver can only make

Roth IRA contributions and the ability to receive tax deductions on the contributions can be limited

depending on the amount of money that the worker earns, and whether or not they already receive

benefits through an employee benefit plan. In a Simplified Employment Pension (SEP) scheme,

contributions to the IRA are immediately 100% vested and the owner directs the investments. In this

plan, the employer can contribute up to 25% of the employee’s wages to the account. In a SIMPLE

scheme, the IRA functions like a 401(k) plan in the sense that it is employer-sponsored.

The main difference between a traditional IRA and a Roth IRA is the taxation of contributions and

distributions. In a traditional account, contributions are tax-deductible, meaning that the employer will

not have to pay income taxes on the money that they place into the account. However, when the

employee decides to retire and withdraw from the traditional account, they will have to pay the income

tax. If the saver is in a lower income tax bracket at retirement, then the saver can benefit from being

taxed at a lower bracket at withdrawal. In a Roth account, contributions are not tax-deductible, but

instead withdrawals are tax-free after age 59.5. Another feature to the Roth IRA is that savers can

participate without limitation in both the Roth IRA and an employer pension plan. Also, unlike the

traditional IRA, Roth IRA plans do not require distributions based on age.

Regardless of whether an employee enters into a defined-contribution plan with an employer or sets up

their own retirement savings account under an IRA, it is obvious that there are fewer complications in

terms of funding these accounts when compared to the burdens created by defined-benefit pensions and

even Social Security. While the federal, state, and local governments are trying to figure out how to

allocate their funds in such a way to cover all of the promises that they made to workers, the defined-

contribution plans leave the majority of the decision-making and responsibility of funding into the

hands of the employee. The differences between these different modes of funding will be up for

discussion as the federal government, municipal governments, and even corporations that offer

defined-benefit plans, try to reform the way that their promises have been structured for their

employees.

DETROIT

Page 18

Detroit

CHAPTER 9 BANKRUPTCY

In July of 2013, after years of tabling the issue, a serious

discussion of retirement was finally brought to the table as Detroit,

a city populated by an estimated 701,000 people, filed for Chapter

9 bankruptcy. According to an article by Monica Davey and Mary

Williams Walsh titled “Billions in Debt, Detroit Tumbles into

Insolvency”, this was the largest municipal bankruptcy filing in

American history in terms of debt. Although there is no consensus

on how much the city actually owes, the emergency manager of

Detroit’s finances, Kevyn Orr, estimates that the debt falls between

$18 and $20 billion. Although the city experienced particularly

heinous forces, including the desolation of the automotive industry,

rampant poverty, and the overt pressures of the financial crisis,

their situation shone a light on issues surrounding state liabilities

that had been in the dark for many years.

Currently, Detroit is trying to prove its insolvency to receive the

relief of bankruptcy. The benefits that Detroit is hoping to gain

from this filing is relief from the $18 to $20 billion debt through

the reorganization of debt to their creditors by extending debt

maturities, reducing the amount of principal or interest, or refinancing the debt by obtaining a new

loan. In restructuring the debt, there is a very high chance that pension plans will have to be cut, since

Orr has included them in the $11 billion of unsecured debt. Detroit roughly has 100,000 creditors that it

will have to answer to, including banks, bondholders, other municipal funds, and over 20,000

retirees.xxviii Of these 20,000 retirees, the average annual pension payment per retiree is around

$19,000. On average, police officers and firefighters receive $30,500 and top executives and chiefs

receive as much as $100,000 a year.xxix It would be particularly devastating if these plans are cut

because most of these employees are not covered by Social Security.

DETROIT & SOCIAL SECURITY

It has been a curiosity to many as to why Detroit and other city and state employees are not a part of

the Social Security system. Initially, Social Security was created with the intention of being a

supplemental income program, so for a long time, state and local government employees were not

covered under Social Security, since it was believed that they were secure under a public pension. It

was not until 1991 that states could enter into Section 218 agreements. Under this agreement, retirees

are either entirely covered by Social Security in absolute coverage groups, or partially covered by

Social Security in retirement system coverage groups.xxx One downside to entering the Section 218

agreement is the obvious 12.4% withholding of wages to cover the FICA tax.

Another more inconspicuous reason why a state might not go into Social Security is the Windfall

Elimination Provision (WEP). Under a public pension plan, the employer would not withhold Social

Security taxes, so the pension received from the employer will reduce the amount of Social Security

DETROIT

Page 19

benefits the employee can receive. As discussed previously, under Social Security, lower wage earners

are able to recover a higher percentage of their pre-retirement earnings than higher wage earners. Due

to this model, public workers were able to reap the higher benefits of Social Security while

simultaneously receiving pensions. WEP was created in 1983 to combat this issue. It basically takes a

worker’s average annual wage and divides it into three slices. Of average monthly earnings, the first

$816 is multiplied by 90 percent, the next $4,101 by 32 percent, and the remainder by 15 percent.xxxi In

short, this means that people under public pensions receive significantly lower benefits of Social

Security than private sector employees.

DETROIT FIRE & POLICE PENSIONERS

Due to the obvious disadvantages of joining Social Security due to WEP, Detroit’s pensioners are at the

full mercy of the bankruptcy proceedings since all they can expect in the form of benefits are the public

pensions now subject to reduction. According to the Detroit Free Press, pension funds are

approximately $3.5 billion underfunded. Since Detroit is proceeding forward in the Chapter 9

bankruptcy, the restructuring of debt will reduce this number, opening up the question of how pension

plans will be restructured. One item that has been of large debate is the fact that 83 cents of every

Detroit police and firefighter payroll dollar is spent on government pensions, leaving behind a meager

17 cents to the city.xxxii The city already struggles to survive with liabilities that consume almost 42

cents of every general fund dollar, and yet in 2010, an actuarial firm found that Detroit’s general

retirement system funded at 89%, and the police and fire pensions funded at 102%. It was also

predicted that by 2017, the Police and Fire Retirement system would have to absorb 83% of the city's

payroll to maintain funding at 72% if funding continued the way that it has.

With these reports and projections in mind, it would seem most prudent that Detroit’s debt

restructuring would reduce pension plans for uniformed workers. Unfortunately, the Detroit police and

fire unions put enough pressure on the state government to come to a deal with Detroit’s mediator,

Gerald Rosen, to not cut police and fire pension plans. In a USA Today report, it was revealed that not

only would police and firefighters keep all of their promised pensions but they would also keep half of

their COLA, which is currently at 2.25%.xxxiii In this deal, the Retired Detroit Police and Fire Fighters

Association agreed to go through with this in exchange for the city contributing $350 to detach the city

art institute from public funding due to complaints of it taking away money from pension funding.

In summary, the deal would require general retirees to accept 4.5% cuts to their monthly pension

checks and the complete elimination of COLA increases, while police and fire retirees get no cuts to

monthly checks but absorb a reduction in COLA increases by half of what they are receiving today.

Even though Detroit is applauding itself over finally breaking deals after almost a year of debate and

bargaining, the workers who are not in uniform will have to suffer since they do not have unions

aggressively fighting for their interests.

Two days after the announcement of Detroit’s agreement with the uniformed pensioners, President

Obama began discussions with the state about giving $100 million in aid to the city to lower the impact

on Detroit pensioners. This $100 million in aid would be wrapped in the guise that it is going towards

remedying Detroit’s blight, abandoned buildings. In fact, the aid would be coming directly from the US

Department of Treasury’s “Hardest Hit Fund” which was put in place in 2007 to help states during the

housing downturn.xxxiv The reason why President Obama will not admit that this money is actually

being given to help the pensioners is because he already publicly stated that there will be no federal

SOLUTIONS TO RETIREMENT

Page 20

support for the bailout of Detroit. Unsurprisingly, the administration has received significant pressure

from unions to act on the issue.

Another recent development in the case of bankrupt Detroit has been the $350 million pledge over 20

years by Governor Rick Snyder of Michigan to help aid Detroit in what has been dubbed “the grand

bargain.” This large contribution to save Detroit’s pension funds is a bargaining chip for a final

settlement by retirees and unions. The parties must agree to relinquish their right to pursue lawsuits

over pension cuts against the state of Michigan, and accept the pension fund adjustments proposed by

the city. Another $330 million has been pledged by nonprofits to help alleviate the debt, as well as

prevent the shutdown of Detroit’s art institute. With all of these contributions set to temporarily

alleviate the pensioners, other creditors, particularly bondholders, are concerned. Amy Laskey, the

managing director of Fitch Ratings, expressed concerns about prioritizing pensioners over other

creditors by stating that “actions and rhetoric that suggest bondholder rights are not an important

consideration will continue to damage market perception of the state and its local governments.”xxxv

These concerns will continue to arise as Detroit’s mediation proceedings continue.

Solutions to Retirement

In the wake of funding issues surrounding Social Security, public pensions, and private pensions,

government representatives have made different efforts to solve the crisis. As previously examined, the

Congressional Budget Office rationally suggested that states make hard decisions like raise employee

contributions, shift partly to defined-contribution plans, alter the COLA, raise taxes, reduce

government spending, and invest in equities. Not all solutions that have been proposed by

representatives have been as rational, or even realistic, in some cases.

The current chairman of the Senate Health, Education, Labor, and Pensions (HELP) Committee,

Democratic Senator Tom Harkin of Iowa, has made multiple proposals to address the retirement crisis.

In his 2012 report titled “The Retirement Crisis and a Plan to Solve It”, Harkin suggested reforms for

both pensions and Social Security. The section that covers the reformation of pensions, suggests an

approach that he calls “USA Retirement Funds”, which would be privately-run hybrid pension plans.

He recommends that there would be universal access via automatic enrollment to these funds and they

would follow the same model as other payroll-withholding systems.

He envisions that these pooled funds would have professional asset management take accountability

away from employers by taking management responsibility or financial risks. The funds would have to

undergo a licensing process and would be under strict regulations. His logic of having all of the state

pensions pooled under one fund is that it would dilute costs and overall risk. Most importantly, a

person’s total monthly benefit would be determined based on a combination of the total contributions

made by, or on behalf of, the employee and the investment performance over time. Although Harkin

stresses the importance of automatic enrollment and behind-the-scenes investing since “people are

frequently overwhelmed by the complexity of the financial decisions”, he simultaneously hopes that

USA Retirement Funds would be a supplement to defined-contribution funds rather than supplant them

entirely, since “individual retirement savings are a critical component of retirement security.”xxxvi

In a portion of the plan, he discusses potential reformations for Social Security. The way that he plans

to reform the system is by means of “The Rebuild America Act.” Through this proposed legislation,

Harkin believes in fixing Social Security by changing the method of calculating Social Security

benefits in such a way that expands benefits by 15% over a 10-year period. He calculated that this

SOLUTIONS TO RETIREMENT

Page 21

change would increase benefits to beneficiaries by $60 a month. Another recommendation is to alter

the calculation of the COLA by using a basket of goods specific to the elderly rather than the CPI-W.

The final provision to remediate the Social Security system would be to try to bring more revenue into

the system by phasing out the payroll tax on people who earn less than $110,100. In its place, the Act

would tax people about the stated wage cap. In short, Harkin hopes to make his bold new strides of

funding Social Security by shifting the payroll tax burden to higher wage earners.

In the January 2014 “State of the Union” address, President Obama discussed his suggestion to fix the

retirement crisis under a plan called MyRA. The plan will allow homes making $191,000 or less

annually to save up to $15,000 in the plan over a period of 30 years before having to roll their savings

over to a Roth IRA. More importantly, the main difference between MyRA and other retirement

investment accounts is that unlike the IRAs that require a level of basic investment knowledge,

President Obama is targeting this plan at lower-wage earners who are less familiar with the topic.

Similar to the scheme proposed by Harkin, President Obama makes this plan automatic in the sense

that the plan is opened by the employer, and the contributions to the plan are also automatic. However,

unlike Harkin’s plan, which involves the investment in a plethora of assets determined by the managers

of the fund, the MyRA is essentially a savings bond, as the rate of return will be pegged to the Thrift

Savings Plan (TSP) Government Securities Investment Fund, a defined-contribution plan for US civil

service and retirees. According to the Federal Employees Retirement System (FERS), there are

currently 4.6 million participants and $358 billion in assets under management. In 2012, the fund had

an annual return of 1.47% and an average return of 3.61% from 2003 to 2012.xxxvii The plan can be

opened with a $25 minimum contribution and then minimum contributions of $5. A MyRA would be

highly portable and like a Roth IRA, the money saved is withdrawn without a tax penalty.

The inherent issue with the plans proposed by Harkin and President Obama is the automatic and blithe

nature of such schemes. Instead of empowering workers with the knowledge of how to invest their own

savings, everything is automatic and decided upon for them. Although currently four out of five TSP

funds are invested in index funds managed by BlackRock, Treasury Secretary Jacob Lew stated that

100% of the contributions to MyRA accounts will be invested in a Treasury security and thus “backed

by the full faith and credit of the United States.” The logic behind this is that the retirement savings and

balance will never experience a loss. The problem with an investment that never experiences any loss,

is that it is no longer an investment but instead another fabricated promise. If the TSP Fund begins to

take a similar form to the Social Security Fund, then the cycle of imagined rates of return incongruous

to that of the markets will continue.

The fund that will be used to house the contributions of the people under MyRA is called the G Fund.

This could prove problematic, considering that during the times that the federal government has

approached the debt ceiling, the government has borrowed money from the G Fund to meet its debt

obligations.xxxviii Although the money is always returned into the fund after the ceiling is raised, it is a

concern that the general public will be contributing to a fund that the government can borrow into

during times that it needs to avoid hitting the debt ceiling.

CONCLUSION

Page 22

Conclusion

Overall, the retirement crisis is not one that will be solved with one piece of legislation, or a federally

initiated program, or a bundle of aid money, or the restructuring of state debts. It will be solved by the

empowerment of the individual. Undoing the problems created by retirement would require undoing

years and years of history and convincing millions of Americans that their dreams of a life after work is

out of reach. The only viable option is to finally educate people on what it means to retire and how to

properly manage their own earnings.

By enacting more policies that take the decision-making out of the hands of Americans, government

further promotes the dependency that the current system is grappling with. Encouraging opening up an

Individual Retirement Account is a huge leap forward in terms of having people take personal

responsibility for their futures. By making it automatic on behalf of the employer and the employee, the

government is yet again taking the power away from the individual and leaving them blind about the

basics of personal finance and the time value of money. Not to mention the type of IRA account being

proposed by the United States government may have the ulterior motive of providing money to pull

from the G Fund to avoid hitting the debt ceiling. Like H.L. Mencken said, “When somebody says it’s

not about the money, it’s about the money.”

As for the state pension funds, it is critical for both officials and the public to not get swept up under an

illusion of the present value of liabilities reported to the government. Instead of focusing on

manipulating the discount rate by adding more equities to their asset allocations, there should be a

focus on changing the policies themselves to support a healthy public pension. The problem with

changing policies at this point is that promises have already been made. Telling a firefighter or a police

officer or a worker at the Department of Motor Vehicles that they will not see the same amount of

money that they were expecting is going back on that promise. As much as the labor unions have been

a barricade against reformations, to an extent they are right that municipalities cannot go back on the

obligations they have agreed to when employing individuals.

However, now that the problems with promising money that cannot be repaid have been unveiled, it is

up to policymakers to change these obligations for the future. If they are unable to change the amount

that they promise to workers in the future due to union pressures, then at the very least they need to

consider alternatives like raising taxes, reducing the COLA, or reducing spending. Politicians should

explain that at the end of the day, taxpayers are the ones paying for these annuities, and if they demand

to maintain a higher retirement benefit, then they need to pay for it.

Perhaps an even more innovative solution to the crisis would be for municipalities to explain to people

that pensions, and even Social Security, were not created with the intention of being the sole source of

money for people after retirement. Social insurance programs were created with the intention of

supplementing the amount of money that people already saved for retirement. The way to get people to

start saving could be to connect state employees to a menu of firms that offer IRAs with clear

explanations of how each type of account works. Since the municipal governments act as employers,

perhaps they should appoint a Savings Account Committee, whose sole intention is to train upper-level

employees about how to comingle their pensions with a savings account to provide for their future.

CONCLUSION

Page 23

Some critics might say that this is too much effort for people, but frankly if people want to live

comfortably after retirement the current situation does not provide much of a choice. Perhaps, instead

of waiting for people to enter the public labor force to begin their education on retirement, there should

be a national initiative to include basic financial education in the public education system. If people

had a rudimentary knowledge of personal finance, the idea of investment and understanding the nature

of retirement itself would be much easier to explain. The problem with an ignorant population is that it

will be swayed more by how an official portrays their agenda than why and what they are actually

proposing.

As the bankruptcy of Detroit and the underfunding of pension funds grow more and more severe,

hopefully the national dialogue for a topic that has been pushed aside for years will finally come to

surface. As Peter Drucker wisely said, “Unless commitment is made, there are only promises and

hopes, but not plans.” There is no time left for municipal governments to wait, as the time of decision

is upon them. Hopefully, this tale of broken promises will be the initiative to form a system where

individuals have the power over their own futures and blind dependency on governments will become a

phantom of the past.

CONTACT INFORMATION

Page 24

Contact Information

ALLIE

PERRY

Tel (305)-608-4454

allieperry@ufl.edu

University of Florida

Master of Science in Finance: Hough Program in Finance

321 Stuzin Hall

PO BOX 117168

Gainesville, FL 32611

Tel 352-392-9249

Fax 352-392-0301

http:/www.warrington.ufl.edu/graduate/academics/msf

SOURCES

Page 25

Sources

i http://www.ssa.gov/history/ottob.html ii http://www.wisconsinhistory.org/turningpoints/tp-036/?action=more_essay iii http://www.ssa.gov/history/tally1972b.html iv http://www.ssa.gov/history/1983amend.html v http://www.presidency.ucsb.edu/ws/?pid=16381 vihttps://www.acli.com/Issues/Retirement%20Plans/Documents/Building%20Retirement%20Security%20through%20Defined

%20Contribution%20Plans%20February%202014.pdf vii http://www.newyorklife.com/nyl/v/index.jsp?vgnextoid=9cd02f5a919d2210a2b3019d221024301cacRCRD viii http://www.dol.gov/dol/topic/health-plans/erisa.htm ix http://www.pbgc.gov/about/how-pbgc-operates.html x http://www.ebri.org/pdf/publications/facts/0205fact.a.pdf xi http://www.ssa.gov/oact/progdata/fundFAQ.html xii http://www.ssa.gov/oact/progdata/intrateformula.html xiii http://www.ssa.gov/policy/docs/ssb/v45n1/v45n1p3.pdf xiv http://www.heritage.org/research/reports/2004/09/misleading-the-public-how-the-social-security-trust-fund-really-works xv http://www.investmentnews.com/article/20140324/BLOG05/140329957 xvi http://www.standardandpoors.com/ratings/definitions-and-faqs/en/us xvii http://www.pewstates.org/uploadedFiles/PCS_Assets/2012/Pew_Pensions_Update.pdf xviii http://www.bloomberg.com/visual-data/best-and-worst/most-underfunded-pension-plans-states xix http://www2.census.gov/govs/retire/2011summaryreport.pdf xxxx http://www.martin.uky.edu/centers_research/Capstones_2011/Truesdell.pdf xxi http://www.dol.gov/ebsa/pdf/rdguide.pdf xxii http://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/120xx/doc12005/12-09-municipalities_brief.pdf xxiii http://www.blackrock.com/corporate/en-us/literature/whitepaper/corporate-pension-funding-update.pdf xxiv http://www.bls.gov/opub/mlr/cwc/multiemployer-pension-plans.pdf xxv http://dealbook.nytimes.com/2014/04/12/thought-secure-pooled-pensions-teeter-and-fall/ xxvi http://www.pbgc.gov/documents/2013-annual-report.pdf#page=31 xxvii http://www.smart401k.com/Content/retail/resource-center/retirement-investing-basics/company-match xxviii http://thecapitolforum.com/wp-content/uploads/2014/01/DETROIT-2013.12.09.pdf xxix http://www.twincities.com/national/ci_23715666/detroit-retirees-worry-about-possible-pension-cuts xxx http://www.ssa.gov/slge/sect_218_agree.htm xxxi http://www.ssa.gov/pubs/EN-05-10045.pdf xxxii http://www.freep.com/article/20130226/OPINION02/302260136/How-pension-costs-could-crush-Detroit xxxiii http://www.usatoday.com/story/news/nation/2014/04/15/detroit-bankruptcy-pensions/7728569/ xxxiv http://www.freep.com/article/20140415/NEWS/304150147/Obama-Michigan-talks-free-up-100M-aid-Detroit-pension-

deal xxxv http://www.freep.com/article/20140127/BUSINESS06/301270105/Detroit-bankuptcy-bondholders-pensions-DIA xxxvi http://www.harkin.senate.gov/documents/pdf/5011b69191eb4.pdf xxxvii http://blogs.wsj.com/washwire/2014/01/29/nine-things-to-know-about-obamas-myra-accounts/ xxxviii http://www.fedsmith.com/2014/01/31/obamas-myra-proposal-makes-g-fund-lookalike-available-to-general-public/