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How Politicians Game the Pension System

There are few political gains from properly funding a defined benefit plan

No one questions that employers should pay the pensions that its employees earn. Yet in Michigan and across the country, government pensions systems have failed to set aside the money required to pay those pensions.

Michigan's recent discussion of education funding reiterates that there are few political incentives to ensure that pensions are properly funded.

The state has increased its support of government schools in Michigan. The school aid budget, which pays for government schools, increased by roughly $800 million from the budget passed before the Snyder administration to the most recently approved budget. Yet, some school administrators and union officials deny this by complaining that the money is not going into districts general coffers, but instead is going to pension funding.

The state runs the pension system and assesses the costs of the system on districts. Due to $24.3 billion in unfunded liabilities, these costs have been increasing and school officials have rightly complained about it. The complaints, however, are not about the long-term health of the plan, but about the contribution rates required by the state.

It's unclear exactly why so much emphasis is put on the annual contributions into the pension system. Perhaps the state's constitution, which makes the pensions earned by government employees a contractual obligation, provides apparent protection of pensioners. This would provide the contradictory effect of encouraging underfunding even though the intent of the provision is to adequately fund earned pensions.

Regardless, because the focus is on the short-term contributions into the pension system, there are few rewards or punishments for failing to properly fund pension benefits. There are some things that can be done to put off today's costs to the future.

Indeed, politicians have embraced attempts to manipulate the pension system to lower annual payments.

In 2007, the Legislature voted to mark their assets to market rates. This accounting gimmick allowed them to lower their annual payment into the pension system. Putting less money into the system has the obvious effect of leaving the system with less money. (Policymakers also marked the system's assets up to market rates in 1997.)

The state legislature approved an early retirement incentive for members in 2010. The idea was that it would save districts in their operating costs as employees on the higher end of the union salary schedules retire and are replaced with employees on the lower end. This gap doesn't account for the increased longer-term liabilities added to the pension system. State analysts expected $169 million to be saved on salaries, but the pension system added an additional $1 billion in unfunded liabilities to the pension system.

The new Legislature isn't immune to incentives to kick the can down the road. Normally, unfunded liabilities from early retirement incentives are paid off over five years. The 2012 reforms kicked those payments down the road by requiring them to be paid off in 10 years instead.

Another way policymakers can defer payments is by paying off unfunded liabilities over an extended period. If unfunded liabilities develop in a system, they don't have to be paid off all at once but can be paid off over a series of years. Policymakers chose 30 years for the school pension system, longer than the average working lives of the system's members.

Legislators face a different dynamic when the system is in the rare instance when it is overfunded. When the system is overfunded there is pressure to increase the benefits of retirees. This is politically appealing because an overfunded system requires no additional cash. They can score points with system beneficiaries without diverting funds from other priorities. Yet this decision costs plenty if markets drop later.

Indeed, while it's been a long time since the school pension system has been overfunded, legislators have increased benefits in the system. It happened from 1983 through 1986, and again in 1990. These were permanent increases in pension benefits not earned by service but delivered to pensioners anyway. Those actions have long-term effects since some of those increased liabilities remain part of the system today.

This "heads-I-win," "tails-you-lose" approach to pension funding is dangerous and Michigan is suffering the consequences.

A better approach would be to close the defined benefit system completely and switch to defined contribution retirement benefits, which do not put taxpayers and school districts on the hook tomorrow for political decisions made today.

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See also:

Michigan Still Underfunding Teacher Pensions

Pension Costs Mean Tighter Budgets For Taxpayers, Classrooms

Commentary: Shifting School Employees To a 401(k) Is the Most Important Thing

Teacher Pension System Hole Getting Deeper

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