The Pressing Need for Pension Reform

JULY 30, 2012

At the MPPI, we’ve focused on the problems with the state’s retirement system for a long time (see, for instance, the great report Passing the Buck). We’re not alone in scrutinizing the state’s retirement fund woes, however. The headline on today’s Maryland Reporter is “Maryland Pension System Earns Close to Nothing in the Past Year.” This is one more piece of evidence that our state’s pension system needs a major overhaul.

So what are the problems that Maryland Reporter found?

Maryland’s $37 billion state retirement and pension system for employees and teachers earned only .36% on its investments in the fiscal year that ended June 30. This is far below the 7.75% that is the system’s target….

Aside from double-digit returns in 2010 and 2011 (14% and 20%), you have to go back a full 25 years to match the current assumed rate of return over the long term.

Why such an unrealistically optimistic rate of return? As Veronique de Rugy of the Mercatus Center explains:

Pension funds need to assume a certain rate of return on their current assets in order to gauge whether or not the assets held today will be enough to pay future benefits. Obviously, the assumed interest rate or rate of return has a major impact on whether a pension plan is adequately funded. Most pension plans would rather play it conservatively and assume a lower rate of return, so that they ensure that the assets they have today will be enough to cover tomorrow’s promised benefits. But the states would rather put less money up front today, so they’re pinning all their hopes of being able to pay benefits tomorrow on an 8.5 percent annual growth rate. If that 8.5 percent growth rate doesn’t come to fruition, either tomorrow’s beneficiaries will see a cut in their benefits or taxpayers will be asked to pick up the tab. It would be much more prudent to assume an adequate risk-adjusted rate of return closer to the rate offered on 15-year Treasury bonds—3.5 percent, say—and fund their plan accordingly.

Obviously the pension plan being discussed by de Rugy assumes an even more unrealistic rate of return than does Maryland, but the principle is the same. A high assumed rate of return is less politically painful for politicians even if it is bad news for taxpayers in the long-run.

So what should the state do? MPPI’s Gabriel Michaels has a few ideas:

Unlike some of those advocating reform, I don't view a switch to a defined-contribution system as a panacea. That strategy is plagued by the same sort of transition costs that affect proposals for privatization of Social Security. It would also face serious legal and political hurdles, delaying reform when time is of the essence. But defined contribution does have a place; the General Assembly would do well to permit new employees to choose a defined-contribution system when they start work. Given that vesting periods are increasing, a portable defined-contribution system could well have a more immediate positive effect on recruitment than future promises of payments from a struggling pension system.

It’s growing obvious to more and more people that the state’s current pension system needs to undergo major reform. The governor was able to enact limited reforms a few years ago, but much more needs to be done. This issue is far more important than whether the state gets another casino. Maybe instead of calling a special session to deal with gambling expansion, the governor should call a special session to deal with pension reform. This isn’t an issue that should be pushed off any longer.

Start with eliminating ANY compensation for elected officials once they are out of office.

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