Reforming American Public-Sector Pension Plans: Truths and Consequences

Abstract

Most public-sector pension plans in the United States provide quite generous defined benefits. Long-term projections show that full payment of these promises threatens the finances of many state and local employers, which implies that taxes will have to be increased or pensions and/or other public expenditures reduced. This article analyzes the effectiveness of measures aimed at improving the sustainability of these plans. We consider the impact of contribution increases, benefit reductions, and adjustments in the pension fund’s investment strategy. Since a pension fund can be seen as a zero-sum game, these interventions imply value redistributions among current and future plan participants and current and future tax payers. We use the value-based asset-liability management (ALM) method to estimate the value of those transfers. These imply massive value redistributions from taxpayers to plan participants that could exceed 20% of American GDP. Hence, plan sustainability may be achieved only through either substantially higher contributions or lower benefits.

Keywords: Amortization Period, Conditional Indexation, Funding Ratio, GASB Standards, Pension Fund, Value-Based ALM