By Matt Kelly
With their swampy humidity and world famous theme parks, Florida’s cities seem a world away from the frigid cold and automotive factories of Detroit, Michigan. Yet the two states have at least one commonality: underfunded pension liabilities. Such liabilities can potentially put a state or municipality into budgetary crisis, even bankruptcy. Reforming Florida’s state and municipal pension systems from ones with defined benefit plans to defined contribution plans could help avoid such pitfalls.
To understand why defined benefit plans are vulnerable to underfunding, consider how benefits are calculated. They are based, in part, on projected rates of return on investments. Governments contribute to employees’ pension accounts on a regular basis, but promising a reliable return thirty years into the future is difficult, if not impossible. Even if the best economic forecasters failed to predict the 2008-09 recession, the most severe downturn since the Great Depression.
Defined benefit plans guarantee that the amount promised to retirees be paid regardless of actual returns. If asset values are lower than expected, governments are obligated to make up the difference with taxpayers’ money.
On the other hand, defined contribution plans merely stipulate that employers contribute a certain amount into retirement accounts every year. Rather than promise a future benefit now for some distant date, employees receive employer contributions plus returns. This would operate as in any investment account. While this exposes employees to investment risks, taxpayers are protected from having to cover potentially large liabilities in the event of an economic downturn.
DeVoe Moore Center Professor of Economics Randall Holcombe has pointed out that incentives of unions and lawmakers align to guarantee sizeable pensions for government employees now and push the present cost of government into the future. However, if a fund underperforms, it’s taxpayers who foot the bill.
The Florida Retirement System, which serves state workers, has a $22 billion unfunded liability, with assets equal to about 86% of overall liabilities. Compared to the national average of about 72%, this is really quite good. However, a study by the National Center for Policy Analysis argues that every state underestimates its unfunded pension liability because they project unrealistically high rates of return.
This only scratches the surface of Florida’s pension liabilities. Florida cities fare worse. Some see Florida municipalities like Hollywood or Cooper City, where pensions are only 30% to 50% funded, as canaries in the coal mine; warnings of future calamities. Around 30% of municipalities in Florida are under 70% funded, the threshold that investment management firm Morningstar Fund defines as solvent. This underfunding could foretell future statewide problems. In 2013, the state of Florida spent $500 million to bolster the underfunded Florida Retirement System, the program for state workers.
Enacting reforms that shift public employees into defined contribution programs and away from defined benefit plans would ensure Florida avoids future budgetary crises during economic downturns and protect the long term solvency of the state pensions system. Past bills have proposed to allow municipalities to shift future hires and current employees into defined contribution plans. Already about 25% of the newly hired state workers opt for defined contribution plans. A future blog will discuss possible policy changes that could help ensure the health of Florida’s state and municipal pensions.