Retirement Case Study

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
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
politicians 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.
Page 1
BIRTH AND EVOLUTION OF RETIREMENT

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 Marxs
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 Bismarcks 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
Page 2

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 governments 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 definedcontribution. 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
Page 3

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 companys 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 ERISAs 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.
Page 4

Prior to the 1800s, 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 Mechanics 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 wouldnt 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
couldnt 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 cant 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.
Page 5

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 babyboomer 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.
Page 6
STRUCTURE AND FUNDING
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 programs 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 shortterm, 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
Page 7

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 SECs 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 Illinoiss 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.
Page 8

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
Illinoiss true financial condition into account since Illinois had a credit rating of A2 by Moodys and
A+ by Standard & Poors rating scale a year before the SEC accused the state of fraud. According to
Standard & Poors 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
Page 9

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.
Page 10
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 states general obligation debt rate. General obligation (GO) debt consists of municipal bonds
secured by the states 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 states zero-coupon bond rate, corrected for the
personal investors 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 riskfree, 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
Page 11

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, Illinoiss 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.
Page 12

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.
Page 13
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 dont 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
Page 14

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 BlackRocks 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
Page 15

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 ones retirement is through the use of a definedcontribution 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
Page 16

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 employers contribution limit is dependent on the
employees contribution, meaning that all contributions made by the employee and the employer
cannot exceed $51,000 or 100% of the employees 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 employees 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 definedcontribution 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.
Page 17
DETROIT
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
Detroits 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
Page 18
DETROIT
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
workers 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, Detroits 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 Detroits 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 Detroits 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 Detroits 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 Detroits 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 Detroits blight, abandoned buildings. In fact, the aid would be coming directly from the US
Department of Treasurys 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
Page 19
SOLUTIONS TO RETIREMENT
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 Detroits 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 Detroits 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 Detroits 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
persons 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
Page 20
SOLUTIONS TO RETIREMENT
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 Harkins 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.
Page 21
CONCLUSION
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 its
not about the money, its 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.
Page 22
CONCLUSION
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.
Page 23
CONTACT INFORMATION
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
Page 24
SOURCES
Sources
i
http://www.ssa.gov/history/ottob.html
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-pensiondeal
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/
ii
Page 25

Retirement Case Study

Hochgeladen von

Dokumentinformationen

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Retirement Case Study

Hochgeladen von

Copyright:

Verfügbare Formate

PUBLIC

BIRTH AND EVOLUTION OF RETIREMENT

BIRTH AND EVOLUTION OF RETIREMENT

HISTORY OF PENSIONS AND RETIREMENT SAVINGS ACCOUNTS

BIRTH AND EVOLUTION OF RETIREMENT

BIRTH AND EVOLUTION OF RETIREMENT

BIRTH AND EVOLUTION OF RETIREMENT

STRUCTURE AND FUNDING

Structure and Funding

STRUCTURE AND FUNDING

STRUCTURE AND FUNDING OF PUBLIC PENSIONS

STRUCTURE AND FUNDING

STRUCTURE AND FUNDING

STRUCTURE AND FUNDING

STRUCTURE AND FUNDING

To explore how underfunded these state plans are, it is

STRUCTURE AND FUNDING

STRUCTURE AND FUNDING

FUNDING OF CORPORATE PENSIONS

STRUCTURE AND FUNDING

STRUCTURE AND FUNDING

PERSONAL FUNDING OF DEFINED-CONTRIBUTION PLANS

STRUCTURE AND FUNDING

DETROIT & SOCIAL SECURITY

DETROIT FIRE & POLICE PENSIONERS

Master of Science in Finance: Hough Program in Finance

Das könnte Ihnen auch gefallen