As everyone by now must know, state and local defined benefit pension funds are broke and are not sustainable in their present form. So, what should be done?
Most states are creating Rube Goldberg machines to "reform" their state pension systems. Virginia is a good example. The proposals by the McDonnell Administration recently unveiled have the potential to make a bad system even worse.
What should state pension funds look like?
If you lump defined benefit pension funds in with social security, it is easy to see the overall problem -- the absence of saving. Social security is a net dis-saver (that's really the meaning of the "social security trust fund") and defined benefit systems have the effect of encouraging state workers to dramatically reduce their personal savings because of the expectation of future benefits. The result is that the national savings rate plummets effectively to zero (except for the savings done by the wealthy and by the corporate sector).
If savings are negligible, then there are no assets to support retirees (or to support young folks either). That's the problem in the US. Our assets are declining (Mostly by being purchased by non-US entities). It is as if the squirrels quit gathering acorns to prepare for the winter. When the winter comes, there are no acorns. For a while, you might be able to borrow acorns from the squirrels down the road, but that will only postpone the inevitable disaster.
Retirement plans should be about accumulating savings. The rationale behind defined benefit plans was that states would do the accumulating (ditto with social security), but we know that didn't work. States, all of them, use various accounting tricks and political excuses to avoid providing the necessary accumulation of assets to support future retirees. Early retirees win, but later retirees have no hope of winning.
Here is what a state retirement system for employees should look like: Employees should be required to put away five percent of compensation. The state can kick in another 2 1/2 percent. The total 7 1/2 percent should be exempt from current taxation so that it would essentially be structured like an IRA. Individuals should not be permitted to withdraw anything until age 65. Period. Individuals should be permitted to invest the money however they choose.
On top of the 7 1/2 percent the state could provide a 1 for 3 match up to some maximum. For example, if the employee chooses they could save another three percent of income and the state would match that with an addition one percent contribution. Imagine that you capped this at 9 percent (with a 3 percent kick-in by the state). Adding it all up, an employee could potentially end up saving 7 1/2 plus 9 plus 3 for nearly 20 percent annual, tax-deferred saving.
Notice that system would cost the state, at most 5 1/2% (or a mere 2 1/2 % if no one opts to go for the match) of total payroll. The employee would end up with annual savings of between 7 1/2 percent and 19 1/2 percent depending upon how much they choose to take advantage of the "free-money" match).
People could then choose the lifestyle they want in retirement: minimal or maximal. The state could lock in its liability to current contributions. Unfunded liability would be impossible in this system.
Best of all, aggregate savings would increase without question. Thus, the acorns would be available when winter comes as opposed to the almost complete absence of acorns that the current system promises.
The only objection to this is the old and tired excuse that employees cannot competently invest their own money. TIAA-CREF is the largest pension fund in
America and the most successful. The employees choose their own investments in TIAA-CREF and I doubt that any participant has ever voiced any real complaint about this system. So, individual investing works, contrary to popular myth. People do learn.
A similar structure could be used for social security. Together these reforms would create adequate savings for comfortable retirements for all Americans and get government out of the "unfunded liability" business.
These are the reforms needed, not the half-baked measures that are currently under review.