Traditional retirement planning often speaks of a “three-legged stool” for providing retirement income based upon (1) Social Security; (2) a defined benefit pension from an employer; and (3) personal savings. However, pensions are quickly disappearing (pdf). Defined benefit pensions in the U.S. have decreased from 175,000 plans in 1983 to fewer than 25,000 today. That number is still falling and will continue to fall. To make matters worse, many public and private pension plans, among the relatively few pension plans still in existence, are in real trouble – and that’s a major problem for those who rely or will rely on those pensions and for the taxpayers who guaranty their adequacy.
A recent report (linked at the bottom of this post) from the Center for Policy Analysis indicates that pension funds of state and local governments are drastically underfunded. That isn’t exactly news, but the extent of the problem is even worse than had generally been thought. State and local governmental pensions are underfunded by about $3 trillion. That’s a really big number and isn’t a typo. Of course, some states are much worse off than others, as the following graph from the report, showing unfunded liabilities as a percentage of state GDP, illustrates.
But the problem is enormous.
In most states the law does not allow for the adjustment of pensions. Thus, in the event that a pension fund is inadequate, taxpayers are completely liable for making good on the pensions the fund was set up to support. Such expenditures will necessarily come at the cost of higher taxes and/or reduced services (such as schools, roads, and police). Moreover, the problem is getting worse every day. Most pension funds assume they are going to realize an 8% return on their investments. That assumption has been wrong for much of the last decade and there is little reason to be optimistic for at least the next several years going forward. To the extent that fund returns fall short of the target, unfunded liabilities will continue to grow.
You may be asking why that 8% assumption is used. It’s a great question with a simple (if disconcerting) answer. If state and local governments used more conservative numbers, as the academic studies suggest, they would have to make much larger current contributions to the pension funds. Since these governments are typically in fiscal trouble already, they don’t think it is politically expedient for them to raise taxes to fund their pension liabilities properly. Those of us who live in San Diego are particularly aware of these realities, as Roger Lowenstein’s excellent While America Aged points out.
This crisis isn’t going to end well for many states and municipalities. Pension funding in some states will be required by law to consume 25-30 percent or more of tax revenues, which will (again, obviously) mean much higher taxes and/or dramatically reduced services.
Beyond influencing your expected tax obligations and where you consider retiring, how does this problem impact you and your business? Most fundamentally, it provides yet another basis for the crucial need to provide your clients with guaranteed retirement income. As many independent studies have pointed out, annuities are crucial for effective retirement planning. For example, per the Wharton Financial Institutions Center (pdf):
“Lifetime income annuities may not be the perfect financial instrument for retirement, but when compared under the rigorous analytical apparatus of economic science to other available choices for retirement income, where risks and returns are carefully balanced, they dominate anything else for most situations. When supplemented with fixed income investments and equities, it is the best way we have now to provide for retirement. There is no other way to do this without spending much more money, or incurring a whole lot more risk coupled with some very good luck.”
Annuities have never been more necessary. Their retirement planning role should only increase with time. The pension crisis we face, while obviously unfortunate and troublesome, provides yet another opportunity for our industry. Public pensions will have to be reduced for future employees and, if legally permissible, for current employees. The need for retirement income solutions, already great, will only get greater. We have products that can best meet the problems retirees face and will continue to face. We have a crucial message to offer in difficult times. Let’s make sure we’re heard.
Unfunded Liabilities of State and Local Government Employee Retirement Benefit Plans