Many U.S. cities are in poor fiscal shape, mainly due to an outdated relic of the retirement system: pension plans.
A report by Truth in Accounting found that 53 of the 75 largest U.S. cities don’t have enough funds to cover their pension obligations, and that doesn’t consider what would happen if pension funds lost their value in a market downturn. These obligations could kneecap cities in the event of true emergencies, making it more challenging to devote financial resources where they’re needed.
Take Atlanta as an example. A study in June found it to have the pension plan most exposed to losing value in a market crash. Meanwhile, it still has big-city woes to worry about. It recently had to delay renovations on the Metropolitan Atlanta Rapid Transit Authority on financial grounds. It spent much of early June in crisis after water mains broke, declaring a state of emergency and approving a $7.5 million recovery fund.
Paying pension funds in an uncertain investment environment can only take away from responding to actual crises that local governments are meant to handle or from needed improvements to public services like transportation.
Pensions are pricey and aren’t a great way to attract talent. While existing pension plans need to be honored, it’s time for states and municipalities to phase out pensions as a benefit in favor of defined contribution plans.
Pensions are superficially appealing: They offer an employee near-guaranteed payouts in retirement after several years on the job. Many don’t consider that they come with the hidden trade-off of a lower salary, as the employer sets aside cash to pay current and future retirees.
Evidence suggests modern workers would choose the flexibility and control of a higher salary over the future benefit of a pension. Employees can use that higher salary to contribute to a defined-contribution plan or their personal IRA. Pensions are often touted as a cushy job perk offering stability to workers. However, cold, hard cash does a better job of attracting and retaining talent while letting employees plan for retirement on their own terms.
This isn’t just a case of choosing instant gratification over delayed rewards. Defined-contribution plans are better for workers, allowing them to tailor their investments’ risk-reward profile to match their retirement timeline, personal risk tolerance and other factors.
As 98 percent of companies offering defined-contribution plans offer a contribution match, the payoff to the employee is more than just investment returns. A Yale study examining public schoolteachers in Wisconsin suggests boosting pension plans can hurt the salaries of older workers near retirement, as pension payouts are typically based on an average of the employee’s salary in the last few years before retirement. With defined-contribution plans, employers have no incentive to play such games at their employees’ expense, and workers retain final control over their funds in retirement.
Paying higher salaries upfront while phasing out pensions means the government’s only obligation after workers receive their paychecks is administering a retirement plan rather than managing a portfolio and accounting for further benefits to retired workers. Once a worker leaves a job after any timeframe, their defined contribution plan can be rolled over to a new job’s plan or their personal IRA.
An individual’s funds — salary or retirement investments — are theirs as soon as they’re paid, and the government’s bankruptcy, underfunding or poor investment choices cannot change that.
Some object that managing one’s investments is difficult, but that complaint belongs to a different era. Many plan providers offer managed account services, which would factor into the city’s choice of provider. When someone leaves and has the option of rolling over, choices increase even more. Balanced mutual funds and target-date funds provide a risk tolerance based on the simple metric of the approximate year one expects to retire.
America’s cities must take the final steps away from fossilized pensions and toward defined-contribution plans that better serve the government and its employees. That’s how things are trending, but policymakers must make it a reality.
