America's Public Retirement Systems: Stresses in the System

8/20/2019 America's Public Retirement Systems: Stresses in the System

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America’s Public Retirement Systems[ S t r e s s e s i n t h e S y s t e m ]

a s p e c i a l s e r i e s r e p o r t o f t h e s o u t h e r n l e g i a l t i v e c o n f e r e n c e

Sujit M. CanagaRetnaSenior Fiscal AnalystSouthern Legislative Conference


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America’s Public Retirement Plans[ S t r e s s e s i n t h e S y s t e m ]

a s p e c i a l s e r i e s r e p o r t o f t h e s o u t h e r n l e g i s l a t i v e c o n f e r e n c e

Sujit M. CanagaRetnaSenior Fiscal Analyst

Southern Legislative Conference

© Copyright October 2004Southern Office

The Council of State Governments

P.O. Box 98129Atlanta, Georgia 30359

404/633-1866www.slcatalanta.org

Colleen Cousineau, Executive Director


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ContentsIntroduction .............. .............. .............. ............... .............. .............. .............. .............. ............... .............. .............. .............. ... 2

Chapter 1: History and Origins of Public Sector Retirement Systems .............................................................................. 5 Table 1: Government vs. Non-government Securities Split in Public Retirement System Portfolios ............. ............ 6 Public and Private Sector Pension Plans: Major Differences .............. ............... .............. .............. .............. .............. ........ 6 Table 2: Characteristics of Employer Pension Plans .............. ............... .............. .............. .............. .............. .............. . 7

Types of Public Sector Retirement Systems .............. ............... .............. .............. .............. .............. .............. ............... ..... 8 Administering Retirement Systems in the Public Sector .............. ............... .............. .............. .............. .............. ............. 10

Chapter 2: Sources of Retirement Income: Social Security, Private Savings and Corporate Pension Plans ............... 11 Social Security .................................................................................................................................................................. 11 Table 3: CBO’s and the Social Security Trustees’ Long-term Economic Assumptions ............. .............. ............... ... 13 Personal Savings ............................................................................................................................................................... 13 Table 4: Personal Savings Rate and Disposable Income .............. ............... .............. .............. .............. .............. ...... 14 Figure 1: Personal Savings as a Percent of Disposable Income ............. .............. .............. .............. ............... .......... 14 Table 5: Homeownership Rates as a Percent of Total Households ............. .............. .............. .............. .............. ...... 15 Corporate Pension Plans ................................................................................................................................................... 15

Chapter 3: Economic and Fiscal Variables In uencing Public Sector Retirement Systems ..........................................20 GDP Growth....... .............. .............. .............. .............. ............... .............. .............. .............. .............. .............. ............... ... 20

Table 6: Percent Change From Preceding Period in Real GDP and Other Key Economic Indicators..... ............... ... 21 Unemployment Trends... .............. .............. .............. .............. .............. ............... .............. .............. .............. .............. ...... 22 Table 7: National Unemployment Levels... .............. .............. ............... .............. .............. .............. .............. ............. 22 Figure 2: National Unemployment Rate .................................................................................................................... 22 Federal Budget .................................................................................................................................................................. 23 Table 8: Federal Budget De cit/Surplus as a Percent of GDP.............. .............. .............. .............. .............. ............. 23 Consumer Con dence ............. .............. .............. ............... .............. .............. .............. .............. .............. ............... .......... 24 Figure 3: Index of Consumer Sentiment ............. ............... .............. .............. .............. .............. .............. ............... ... 24 Energy Prices ....................................................................................................................................................................25 Figure 4: Regular Gasoline Prices: Nominal and Real.......... ............... .............. .............. .............. .............. ............. 25 Interest Rates............. .............. .............. .............. ............... .............. .............. .............. .............. .............. ............... .......... 25 Figure 5: Federal Funds Rate .....................................................................................................................................26 Equity Markets ............... .............. .............. .............. .............. .............. ............... .............. .............. .............. .............. ...... 26 Table 9: Dow Jones Industrial Average ............. .............. .............. ............... .............. .............. .............. .............. ...... 28 Table 10: Signi cant Milestones: NASDAQ Composite Index Records.............. .............. .............. ............... .......... 28 Figure 6: S&P 500 Index.............. .............. .............. .............. ............... .............. .............. .............. .............. ............. 29 Figure 7: Russell 2000 Index............... .............. .............. .............. ............... .............. .............. .............. .............. ...... 30 Figure 8: National Unemployment Rate .................................................................................................................... 31 Table 11: Average Annual Unemployment Rate by State ............. ............... .............. .............. .............. .............. ...... 31 Table 12: Year-Over-Year Change in Quarterly State Tax Revenue............... .............. .............. .............. ............... ... 32

Chapter 4: Analysis of Federal Government Data on Public Sector Retirement Systems ............................................. 33 State and Local Government Retirement Plan Trends.............. .............. .............. .............. .............. .............. ............... ... 33 Table 13: National Summary of State and Local Government Employee Retirement System Finances............. ...... 34 Table 14: State and Local Government Employee Retirement System Finances Composition of

Cash and Investment Holdings by Percent ................ .............. ............... .............. .............. .............. .............. ...... 35

Figure 9: Selected Investment Types: State and Local Government Retirement Systems ............. .............. ............. 36 Table 15: State and Local Government Employee Retirement System Finances Breakdown of

Total Receipts and Payments by Amount ............... .............. .............. .............. .............. .............. ............... .......... 37 Figure 10: Receipts and Payments ............. .............. .............. ............... .............. .............. .............. .............. ............. 38 Table 16: Number and Membership in State and Local Government Employee Retirement Plans ................. ........ 38 Figure 11: Changes in Membership Pro le: State and Local Government Retirement Plans ............. .............. ........ 39 Table 17: Number and Membership of State and Local Government Employee Retirement Systems ............. ........ 40 Table 18: Cash and Investment Holdings of State and Local Government Employee Retirement Systems ............ 42 Table 19: Securities as a Percent of Total Cash & Investment Holdings .............. .............. .............. ............... .......... 44 Table 20: Percentage Breakdown of Government Securities vs. Non-government Securities .............. .............. ...... 45


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Revenues of State and Local Government Employee Retirement Systems........ .............. .............. .............. .............. ...... 46 Table 21: Revenues for State and Local Government Retirement Systems............ ............... .............. .............. ........ 47 Table 22: Revenues of State and Local Government Retirement Systems Percentage Differences

in Selected Criteria ...............................................................................................................................................49 Expenditures of State and Local Government Employee Retirement Systems ............. ............... .............. .............. ........ 50 Table 23: State and Local Government Retirement System Expenditures............ .............. .............. ............... .......... 50 Table 24: Percentage Differences in Total Payments, Total Receipts and Bene ts ............... .............. .............. ........ 51

Chapter 5: Analysis of Information in The Council of State Governments’ Southern Of ce Survey.......................... 52

Analysis of Information in CSG Survey ............. ............... .............. .............. .............. .............. .............. ............... .......... 52 Table 25: Five Plans with Lowest and Highest Market Value of Assets ............. .............. .............. .............. ............. 53 Table 26: Five Plans with Lowest and Highest Annuitants as a Percentage of Actives ............. .............. ............... ... 54 Table 27: Five Plans with Lowest and Highest Actuarial Funding Ratio......... ............... .............. .............. .............. . 55 Table 28: Five Plans with Highest and Lowest Actuarial Unfunded Liability or Surplus Amount .............. ............. 56 Public Sector Retirement Plan News from Across the Country......... .............. .............. ............... .............. .............. ........ 56 Alabama... .............. .............. ............... .............. .............. .............. .............. .............. ............... .............. .............. ........ 56 Arkansas ......................................................................................................................................................................57 California... ............... .............. .............. .............. .............. .............. ............... .............. .............. .............. .............. ...... 58 Connecticut....... ............... .............. .............. .............. .............. ............... .............. .............. .............. .............. ............. 59 Florida ......................................................................................................................................................................... 59 Georgia ........................................................................................................................................................................ 59

Illinois...... .............. .............. ............... .............. .............. .............. .............. .............. ............... .............. .............. ........ 60 Kansas ......................................................................................................................................................................... 60 Louisiana .....................................................................................................................................................................60 Maine..... .............. .............. .............. .............. ............... .............. .............. .............. .............. .............. ............... .......... 62 Maryland .....................................................................................................................................................................63 Mississippi.... .............. .............. .............. .............. ............... .............. .............. .............. .............. .............. ............... ... 64 New York... ............... .............. .............. .............. .............. .............. ............... .............. .............. .............. .............. ...... 64 North Carolina.............. .............. ............... .............. .............. .............. .............. ............... .............. .............. .............. . 65 Oregon ......................................................................................................................................................................... 66 Pennsylvania.......... .............. ............... .............. .............. .............. .............. .............. ............... .............. .............. ........ 66 South Carolina.............. .............. ............... .............. .............. .............. .............. ............... .............. .............. .............. . 66 Figure 12: South Carolina Retirement System, Plan Net Assets........ .............. ............... .............. .............. .............. . 67 Tennessee........ .............. .............. ............... .............. .............. .............. .............. ............... .............. .............. .............. . 67 Texas............... .............. .............. ............... .............. .............. .............. .............. ............... .............. .............. .............. . 68 Virginia.. .............. .............. .............. .............. ............... .............. .............. .............. .............. .............. ............... .......... 69 West Virginia .............. .............. .............. .............. ............... .............. .............. .............. .............. .............. ............... ... 69 Wisconsin ....................................................................................................................................................................70

Conclusion .............. .............. .............. .............. .............. ............... .............. .............. .............. .............. .............. ............... ... 71 Policy Options and Considerations .............. .............. ............... .............. .............. .............. .............. .............. ............... ... 73

Methodology ............. .............. .............. ............... .............. .............. .............. .............. ............... .............. .............. .............. . 75

Appendices Appendix A: Survey Device............. ............... .............. .............. .............. .............. ............... .............. .............. .............. . 78 Appendix B: Cash and Investment Holdings of State and Local Government Employee Retirement Systems....... ........ 80 Appendix C: Revenues for State and Local Government Retirement Systems ............. ............... .............. .............. ........ 83

Appendix D: State and Local Government Retirement System Expenditures........... .............. .............. .............. ............. 86 Appendix E: Market Value of Assets .............. .............. .............. .............. .............. ............... .............. .............. .............. . 89 Appendix F: Annuitants as a Percentage of Actives............. .............. .............. .............. ............... .............. .............. ........ 92 Appendix G: Actuarial Funding Ratio.......... .............. ............... .............. .............. .............. .............. .............. ............... ... 95 Appendix H: Actuarial Unfunded Liability or Surplus Amount ............. .............. .............. .............. .............. ............... ... 97

Endnotes .............. ............... .............. .............. .............. .............. .............. ............... .............. .............. .............. .............. ...... 99


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Stresses in the System, page 1

America’s Public Retirement Plans:

Stresses in the System“The long-term economic health of the United States is threatened by $53trillion in government debts and liabilities that start to come due in four yearswhen baby boomers begin to retire. . . The $53 trillion is what federal, state andlocal governments need immediately—stashed away, earning interest, beyondthe $3 trillion taxes collected last year—to repay debts and honor future bene ts

promised under Medicare, Social Security and government pensions.”USA Today, October 2004

“The public retirement system community has experienced a con uence ofevents that is probably unprecedented. . . . Pension funds went from a $245 billion over-funded condition in 2000 to a $366 billion shortfall in 2003.”

National Association of State Retirement Administrators, December 2003 andWilshire Associates, March 2004

“The Pension Bene t Guaranty Corporation, the federal organization that protects the pensions of 44 million American workers, [announced] that itsde cit reached a record $11.2 billion last year and warned that it is continuing tohemorrhage money.”

The Baltimore [Maryland] Sun, January 2004

“Tens of millions of Americans are seriously under prepared to meet theirnancial needs in retirement. As many as 40 percent of Americans have saved

almost nothing for retirement.” National Retirement Planning Coalition, February 2004

“In 2008--just four years from now--the rst cohort of the baby-boom generationwill reach 62, the earliest age at which Social Security retirement bene ts may

be claimed and the age at which about half of prospective bene ciaries chooseto retire; in 2011, these individuals will reach 65 and will thus be eligible forMedicare. At that time, under the intermediate assumptions of the Old AgeSurvivor and Disability Insurance (OASDI) trustees, there will still be morethan three covered workers for each OASDI bene ciary; by 2025, this ratio is

projected to be down to two and a quarter. . . . If this fundamental change in theage distribution materializes, we will eventually have no choice but to makesigni cant structural adjustments in the major retirement programs.”

Alan Greenspan, Chairman, Federal Reserve Board, Testimony before theCommittee on the Budget, U.S. House of Representatives, February 2004


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America’s Public Retirement Systems, page 2

Financial planners often recommend the“three-legged stool” concept in planning for retire-ment. Each leg of the stool is supposed to representa source of income in retirement, and the goal isto cumulatively attain a standard of living at leastcomparable to the one experienced prior to retire-ment. In this analysis, if the rst leg of the stoolis Social Security income, the other two legs ofthe stool refer to personal savings and retirementor pension system income. Unfortunately, a closereview of national nancial and demographic trendsreveals that all three legs of this metaphoricalretirement stool remain wobbly, a developmentthat threatens to seriously jeopardize the retirement

plans of a majority of Americans.

Any discussion of a comprehensive retire-ment system inevitably brings up the issue of thelong-term solvency of Social Security, particularlyin the context of the growing importance of SocialSecurity payments to retirees. For some years now,analysts have stressed that policymakers need toinitiate concrete steps to prepare for the “graying”of America and the increased number of retirees.The number of people in the United States over65 is expected to increase signi cantly by 2030;speci cally, that age group is forecast to grow fromabout 13 percent of the total population in 2000 to 20

percent in 2030 and to remain above 20 percent forat least several decades thereafter. 2 Consequently,a great deal of attention has been directed toward

revamping Social Security, which, since its inceptionin 1935, has become the country’s largest income-maintenance program. Social Security paymentsare essential for most retirees; these payouts makeup about 40 percent of the total income of peopleages 65 and over. In addition, about two-thirds ofthose people receive at least half of their incomefrom Social Security, and one-third receives at least90 percent. 3 (In 2003, annual Social Security bene-

ts averaged $10,740 per recipient. 4) Trustees ofthe Social Security and the Medicare trust funds (theother government program of critical importance tosenior Americans) predict that the programs willcontinue to run surpluses of more than $200 billiona year for at least the next decade. 5 However, basedon current projections, Medicare will start runningde cits in 2013 and run out of money in 2026, unlessremedial action is initiated. Commencing in 2018,Social Security starts paying out more than it takesin and will begin dipping into its trust fund. Simi-larly, without remedial measures, by 2044, this trustfund also will be depleted.

Unfortunately, alongside the tenuous long-term nancial viability of Social Security, thereare serious problems associated with the other twolegs of the symbolic retirement stool. In fact, it is

becoming increasingly clear that relying on personalsavings to bolster retirement income is not a realisticoption for most Americans. According to the federalgovernment, the nation’s personal savings rate has

Few other topics generate more spirited discourse and disagreement among policymakers than adiscussion on devising a comprehensive retirement system to account for the huge number of “baby

boomers” scheduled to retire in the next few years. 1 The primary goal of this retirement systemwould be to sustain participants with adequate bene ts for the duration of their retirement years.

However, a spate of economic setbacks in the past few years, such as the sputtering stock market, rising

de cits at the federal and state levels, rising fears over terror attacks, mounting corporate scandals affectingconsumer con dence, dwindling corporate pro ts resulting in severe cutbacks and a jobless economicrecovery, continues to cause stresses in the retirement plans of millions of Americans. Hence, it probably isnot a stretch to maintain that an increasing number of Americans, particularly those nearing retirement age,remain extremely apprehensive about their retirement situation in the years ahead.

Introduction


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plummeted from 11.2 percent of disposable incomein 1982 (the highest level in the past three decades)to 1.7 percent in 2001, a precipitous decline indeed. 6 In its 2004 National Retirement Con dence Survey,Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF),the giant nancial service provider, reported thatonly 58 percent of workers in the survey indicatedthat they currently are saving for retirement at all, a

proportion that has remained relatively unchangedsince 2001. 7 Moreover, nearly half of all workers(45 percent), and a third of those 55 and older (29

percent), indicated that they have household assets,excluding the value of their home, below $25,000.

Further compounding this rapidly shrinking personal savings rate is the mountain of debt accu-mulated by most American households in recentyears. In fact, even though consumer spending has

been critical in propelling the economy forward

in the aftermath of the 2001 recession, this hasresulted in the accrual of substantial debt. Since1999, household debt has leapt from 70 percentto nearly 83 percent of the current gross domestic

product (GDP), i.e., the total value of goods andservices produced in the nation. 8 Moreover,consumers racked up $1.1 trillion in new mortgageand consumer debt between the end of 2001 andthe third quarter of 2003, increasing total consumerand mortgage loans held by Federal Deposit Insur-ance Corporation (FDIC) insured institutions to $2.6trillion. 9

Finally, the remaining leg of the gurativeretirement stool, income ows from both publicand private pension plans, is rickety too. Given theserious setbacks experienced by the stock marketover the three-year period 2000 through 2002, both

public and private retirement plans hemorrhagedenormous amounts of cash. After a monumentalexpansion in the ve-year period 1995 through1999, where the year-to-year change in the DowJones Industrial Average (DJIA) catapulted forward

by almost 25 percent annually, in the 2000 through2002 period, the year-to-year DJIA shrank by anannual rate of 10 percent. 10 The other major stockmarket indices, from the S & P 500 Index to theRussell 2000 Index to the Nasdaq Composite, alldisplayed identical trends for these two periods. Infact, the technology-heavy Nasdaq Composite was

particularly affected by the severe declines on WallStreet during the same period.

These stock market developments and ongoingliability growth, according to the National Associa-tion of State Retirement Administrators, resultedin the actuarial funding levels of public retire-

ment plans plunging to lower levels in scal year2002 compared to scal year 2001. 11 Speci cally,

between the scal years 2001 and 2002, the actuarialvalue of public retirement systems’ assets increased

by 3 percent, or $57 billion; in contrast, liabilitiesgrew by $154 billion or 8.1 percent. Also, theannual studies released in March 2003 and 2004 bythe Santa Monica, California-based global advisorycompany Wilshire Associates con rmed this trend,indicating that the funding ratio (the ratio of pensionassets-to-liabilities) for all state pension planscombined declined from 106 percent in 2001, to 91

percent in 2002, to 82 percent in 2003; the median(50 th percentile) state pension plan had a fundingratio of 79 percent in the March 2004 survey. 12

In a further setback to the nation’s retirementsystems, the Pension Bene t Guaranty Corporation(PBGC), the federal organization that protects the

pensions of 44.3 million American workers, indi-

cated in January 2004 that it was running a de cit of$11.2 billion and warned about its ability to protect private pensions in the future. 13 The PBGC, estab-lished as a federal corporation in 1974, and funded

by insurance premiums set by Congress and paid bysponsors of de ned bene t plans along with invest-ment and other income, steps in to protect retireesin underfunded corporate pension plans. Given thewoes experienced by corporate America recently,the agency’s nancial burdens have increasedsigni cantly. In 2003, the PBGC assumed respon-sibility for more than 152 underfunded retirement

plans covering an additional 206,000 workers.Like the public retirement plans, underfundingamong private pension plans was rampant andexceeded $350 billion in 2003, the largest gureever recorded. 14

There are many reservations associated withthe different components of the nation’s retirementinfrastructure. Between the long-term viability ofthe Social Security trust fund, the low personalsavings rate and high household debt levels, theuncertainties about the nancial status of both

public and private pension systems, it is prudent for policymakers and citizens alike to assess the situ-ation and plot a suitable remedial strategy. Whenone factors in the sluggish nature of the currenteconomic recovery, particularly the anemic levelsof job creation between late 2001 and early 2004,the urgency for this remedial course becomes evenmore relevant.

In this context of the aforementioned brittle-ness in all three legs of the retirement stool, therehas been a growing level of interest and scrutinydirected toward the portfolios of state and local


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government employee retirement systems by state policymakers. Some examples of this increasingscrutiny illustrate the growing importance of thistopic. In Kansas, in February 2004, state leadersapproved the issuance of $500 million in pensionobligation bonds to shore up the public employees’

pension system in an attempt to narrow the nearly$3 billion gap between future pension obligationsand current assets. 15 In Maryland, investigationsand pressure from legislators resulted in radicalchanges at the State Retirement System. Thesechanges included the departure of senior executivestaff, including the state treasurer (the titular headof the system), the indictment of a number of high-level of cials on charges of defrauding the pensionsystem and the introduction of outside consultantsto improve internal policies and controls. 16 In NewYork, State Comptroller Alan G. Hevesi, the soletrustee of the New York State and Local Retire-ment Systems, indicated in January 2004 that he

would block New York Governor Pataki’s efforts toreduce the contributions state and local governmentsmust make to the Systems. 17 (Governor Pataki wasattempting to save $500 million by lowering thestate’s contributions to the Systems).

In July 2004, California Governor Schwar-zenegger’s proposal to borrow nearly $1 billionto cover payments owed public employee pensionfunds was termed to be “on shaky legal ground” bythe state Legislature’s chief attorney. 18 At the locallevel, the city of San Diego faces the prospect of a

bankruptcy ling, largely because of a $1.2 billionshortfall in its pension fund for municipal workers;consequently, of cials are scrambling to devisean adequate response to this looming nancialdisaster. 19 These examples are a sampling of theactions initiated by state policymakers across thecountry in their quest to enhance the nancial posi-tion of these public retirement systems.

The focus of this report is to provide policy-makers with another level of analysis to assist themin their deliberations as they devise methods to shoreup the retirement systems in their states. In the lastfew years, these public retirement funds have beenin the news, sometimes because of their shrinkingasset base and sometimes for other reasons. 20 Theimportance of payments to bene ciaries from thesestate and local government retirement systems is agiven and the onus is on policymakers to ensurethe solvency and nancial health of these plans.

Notwithstanding the $2.2 trillion in cash andinvestment holdings in these retirement systems atthe end of scal year 2002, more than 17.3 milliontotal members and payments to over 6.2 million

bene ciaries in 2002, there is considerable interest

in ensuring that this component of the U.S. retire-ment system remains on rm nancial ground andcontinues to ourish well into the future. 21

State and local government employee pension plans and retirement systems cover the entireswath of public sector employees, from uniformedworkers to teachers to members of the judiciary tolegions of administrative and managerial positions.Even though there is a great deal of variety in their

bene ts packages, investment policy and adminis-tration, given their divergent histories and constitu-encies, these public sector plans are driven bysimilar core values and challenges. In essence, theadministrators of all these plans seek to ensure the

nancial stability of the plans, in both the short andlong terms, and to provide retirees with stipulated

bene ts by managing the plans’ assets ef cientlyand effectively.

In order to provide an adequate backdrop tothe analysis owing from the U.S. Department ofCommerce and The Council of State Governments’surveys, this report contains ve chapters. Chapter1 provides a brief history on the origins of publicsector pension plans; highlights the differences

between public and private pension plans; describesthe different types of state and local governmentretirement systems; and enumerates basic informationon the administration of these retirement plans.Chapter 2 expands on some of the themes mentionedin the introduction, such as the long-term viabilityof the Social Security trust fund; the abysmally low

personal savings rate coupled with the high rate ofdebt accumulated by American households; and the

nancial woes associated with the federal PensionBene ts Guarantee Corporation, the governmententity charged with rescuing underfunded private

pensions. Chapter 3 documents the multipleeconomic challenges confronting states in the pastfew years, challenges that have negatively affectedtheir public pension funds. Chapter 4 presents awealth of statistical data and analysis owing fromthe latest federal gures on public sector pensionfunds and, nally, Chapter 5 provides more detailson the public sector retirement plans from aroundthe country, including data contained in The Councilof State Governments’ survey.


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The earliest public sector pension plan was established in New York City in 1857 to provide lump-sum bene ts to policemen injured in the line of duty. This plan was amended in 1878 to offer theretirement payment of one-half of nal pay to policemen completing 21 years of service. Eventhough a number of state and local entities followed New York City’s example and began providing

retirement payments to their former employees, it was not until the passage of the Social Security Act in 1935that the growth of public sector pension plans burgeoned across the country. The impetus for this growth

was the fact that the Social Security Act intentionally excluded state and local government employees fromcoverage. This was on the constitutional basis that the federal government did not have the right to tax stateand local governments. Hence, a number of state and local jurisdictions pursued retirement plans as a meansof covering their employees in the absence of Social Security payments to their retirees.

In tracing the growth of these plans, it is usefulto divide their development into three distinct timeframes. 1

» 1930-1950 : More than half of the nation’slargest public sector pension plans were estab-lished during this period, providing two-partretirement payments. The rst part was paid

by the employer based on the employee’ssalary and years of service at retirement, andthe second part was based on annuitizing theemployee’s accumulated retirement contribu-tions.

» 1950-1980 : In 1950, Congress amended theSocial Security Act to allow states to volun-tarily provide Social Security coverage fortheir employees after the state entered into anagreement with the Social Security Adminis-tration. Later on, Congress mandated Medi-care coverage for state and local employeeshired after March 31, 1986, another measureintended to boost the retirement incomes of

public employees. Congress’ decision toinclude states under the Social Security Actinitiated a number of changes in state andlocal government plan designs. For instance,for a number of years, many of the state andlocal plans joining Social Security offered asplit-bene t formula, with a lower unit bene t

percentage applying to the rst $4,200 of nalaverage salary and a higher unit percentage

applying to the amount over $4,200. ($4,200represented the Social Security covered earn-ings ceiling at the time.) However, in the 1980s,many of these plans dropped this split-bene tapproach and returned to a single-bene tapproach. The 1960s and 1970s witnessed agrowing consolidation among plans with thelarger plans enveloping the smaller ones to takeadvantage of economies of scale and improvedtechnologies.

» 1980 to the present : A major developmentduring this period involved the increasinglysigni cant role played by state legislatures inexpanding the investment options for publicsector pension plans. Beginning in the early1980s, state legislatures cleared the way for

pension plans to adopt “the general standardof prudence” to guide investment decisions incontrast to the severely restrictive “legal list”approach. In the former era, public pension

plans only could invest in certain types ofsecurities, investigated and approved by thestate legislature. For instance, many legal listslimited the maximum percent of assets held incommon stock to 30 percent or less. Table 1

provides a quick review of the governmentvs. non-government securities split held inthe portfolios of state and local governmentemployee retirement systems in 1993 and2002, as enumerated in the federal data.

Chapter 1History and Origins of Public SectorRetirement Systems


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As indicated in Table 1, after the relaxingof stipulations regarding these public retirementsystems pursuing investments in non-governmentalinstruments there was a marked difference in the

government vs. non-government securities compo-sition. After reaching a 22 percent and 62 percentsplit in 1993, the composition shifted to 10 percentand 76 percent in 2002. Under the new prudencestandard, the pension plans were free to invest alarger share of their assets in equities, most oftendomestic, a trend that enabled a vast majority ofthe pension plans to take full advantage of thetremendous surge in the stock market demonstratedin the mid- to late-1990s. While the movement tothe prudence standard contributed to solid nancialgains during this period, the steep market drop-off inthe rst three years of this decade also resulted in ashift to a more conservative investment strategy.

Public and Private Sector PensionPlans: Major Differences

The extension of the retirement period at theconclusion of the average American’s working liferemains one of the more striking features of the

past century or so. While this development speaksvolumes for the tremendous and much sought-afteradvancements in medical technology, it does posea fresh set of challenges for public policymakersat all levels. In response to this trend, the UnitedStates developed a number of government and

private sector pension plans, or long-term nancialcontracts, that promise to pay retiring workers a sumof money to meet their expenses during retirement.

An overview of state and local governmentretirement plans requires a description vis-a-vis their private sector counterparts. Public sector plansacross the United States tend to be of the De nedBene t (DB) variety, i.e., retiring vested employeesreceive a speci ed retirement bene t, based on age,years of service and salary, throughout the duration

of their retirement. In fact, de ned bene t plansare the primary retirement bene t for 90 percent ofthe full-time employees of state and local govern-ments. 2 It should be noted that until recently, private

corporations also offered these de ned bene t plansto their retirees. These traditional pension plans are becoming extremely rare in the private sector and inthe past ve years, no rm has launched an old-style

pension plan; in fact, a number of companies haveterminated them. 3

In these public sector DB plans, requiredcontributions are computed by actuarial evaluationswhile the plan’s investments are managed by nan-cial experts selected by the public sector entity’s

pension board or board of trustees. DB plans are not“pay-go” plans, i.e., where in ows match out ows,

but plans where the liabilities are amortized over aspeci ed period, similar to a mortgage.

On the other hand, in the private sector, alarge number of employees are covered by De nedContribution (DC) plans, in which the amountcontributed to the plan is speci ed even though the

bene t payout is not. Under this system, privatesector plan participants maintain a great dealof leeway on where to direct their investments,within certain investment parameters, or options,

pre-selected by the employer. Bene t payouts to private sector retirees ow from the contributionsand investment income that accrue in participants’accounts. In the event that funds in these accountsare insuf cient to pay bene ts for the duration ofretirement, private sector retirees have to rely onalternate income sources.

About 57 percent of full-time workers in the private sector are covered by some sort of companyretirement plan, a proportion that has not changedsubstantially in recent decades. What has changedis the type of coverage provided by companies: in

table 1

Type of Security

FY 1993 FY 2002

Dollar Value% ofTotal Dollar Value

% ofTotal

Government $203,452,928 22% $225,584,917 10%

Non-government∗ Corporate Bonds∗ Corporate Stocks∗ Mortgages∗ Funds Held in Trust∗ Foreign Securities∗ Other

$571,391,516$174,446,987$301,315,623

$19,458,912$28,682,820

0$47,487,174

62%19%33%

2%3%

05%

$1,649,810,584$352,193,553$814,835,143

$20,765,586$70,422,530

$254,662,228$136,931,544

76%16%38%

1%3%

12%6%

Source: U.S. Department of Commerce, Bureau of Economic Analysis, 1993 and 2002

Government vs. Non-government Securities Split in Public RetirementSystem Portfolios 1993 vs. 2002


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1980, 60 percent of plans were traditional, DB plans.By 2000, that proportion had slumped to 13 percentas more and more companies resorted to 401(K) andDC plans. 4 In terms of the public sector, some 43

percent of public workers are unionized and as notedearlier, 90 percent are participants in xed-bene t,DB plans. Meanwhile, in the private sector, whereonly about 9 percent are unionized (less than halfthe percentage of 20 years ago), the availability ofDB plans has been shrinking as noted above. Inaddition, public employees typically collect higher

bene ts as a percentage of nal pay than do those in private-sector xed-bene t plans. 5

Cash balance plans and other so-called hybrid plans are geared toward capturing the advantagesof both DB and DC plans and have emerged asa strategy for rms to offer pensions often at alower cost. 6 These cash balance plans work in thefollowing manner: while the company regularly

allocates money aside for employee retirement,unlike the popular 401-K retirement plans, thecompany, not the employee decides how that moneyis invested. In essence, these cash balance plans,legally classi ed as DB plans because the employerowns the assets, makes the investment choices,

bears the direct investment risk and maintainsadequate reserves, as required by law. At retirement,employees have accumulated a nest egg to drawdown during retirement without the responsibilitiesof managing a portfolio of stocks and bonds. Yet,the employee’s accrual of pension rights resemblesthat of DC plans; hence, the terming of these cash

balance plans as hybrid. A number of private rmshave switched to these cash balance plans in recentyears to economize on their payments to retirees,including Aetna, Inc. (in 1999), American Express

(1995), AT&T Corporation (1998), Avon Products(1998), Citigroup, Inc. (1996), Goodyear Tire &Rubber (1998), IBM (1999) and Owens Corning(1996).

While the employer contributes to the employ-ee’s retirement account, typically as a percentageof current earnings, workers who switch jobs

prior to retirement may withdraw or transfer theaccount balance to other tax-sheltered accounts.The employer also provides a credit based on theaccount balance at an interest rate speci ed inadvance, rather than depending on the performanceof nancial markets (like DC plans). The interestcredit rate may change over time at the discretionof the employer.

As indicated, DC and DB plans differ inseveral ways and both the private and public sectorretirement plans in contemporary American society

sometimes incorporate various aspects of these DCand DB plans. Table 2 provides a comparison ofsome of these differences.

There also are major differences in public sectorand private sector plans in the actual implementationor logistical stages. For instance, most public sectoremployees tend to be included in their pension plansat the point of employment, while private sectoremployees generally must meet an age and/or lengthof service requirement in order to be eligible forcoverage. It should also be noted that being legallyeligible to receive retirement bene ts only occursafter an employee, either private or public, is vestedin the retirement system. In general, public sectoremployees take longer to vest in their retirementsystems (43 percent of public employees have to

table 2

Traditional De nedBene t (DB) Plans

De ned Contribution (DC)/401(k) Plans Cash Balance Plans

Funding Employer Employee and Employer Employer

Financial Market Risk Borne By Employer Employee Employer

Bene ts Determined ByYears of Serviceand Final or HighestAverage Pay

Contributions (based oncurrent wages) and InvestmentReturns on those Contributions

Pay Credits (basedon current wages andinterest credits)

How Bene ts Are TypicallyPaid at Retirement Annuity Lump Sum

Annuity orLump Sum

Access to Funds for CurrentWorkers Prior to Retirement No

Yes (through loans andhardship withdrawals) No

Guaranteed by PBGC Yes No Yes

Source: Gale and Orszag, April 2003 7

Characteristics of Employer Pension Plans


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work 10 years before becoming legally entitled toa bene t) while private sector employees typicallyvest after ve to seven years of employment.

The federal Employee Retirement IncomeSecurity Act of 1974 (ERISA) requires private

pension plans to provide plan members and theU.S. Department of Labor with periodic reportsabout plan performance and new developments.Even though the state and local government plansare not bound by these ERISA requirements, the

plans’ administrative entities seek to comply withthe nancial measurement and reporting mecha-nisms speci ed by the Governmental Accountingand Standards Board (GASB). As a result, publicsector plan participants and other interested partiesand regulatory agencies can review the performanceof these public sector plans against the relevantGASB standards.

It also is important to note that about one-fourthof state and local government employees do not participate in Social Security, opting to channel theirSocial Security payroll deductions to their state orlocal government retirement plans. 8 This trend raisesthe importance of the adequacy of their income owsfrom the state or local government retirement planduring retirement given that they will not receive amonthly check from the Social Security Adminis-tration. In fact, 40 percent of teachers in state andlocal government plans, including all or mostly allin California, Connecticut, the District of Columbia,Florida, Illinois, Kentucky, Maine, Missouri andTexas do not make Social Security contributions.Similarly, some 75 percent of public safety workersand most public employees in Alaska, Colorado,Louisiana, Massachusetts, Nevada and Ohio do notmake Social Security contributions either.

Even though state and local government planstend to be of the DB model, there are several publicsector plans that have adopted the DC model. Forinstance, the State Employees Retirement System of

Nebraska, the Teachers’ De ned Contribution Planof West Virginia, and Michigan’s State EmployeePlan (for workers hired after 1997) have opted forthe DC variety. There also has been interest inadopting plans that have taken on characteristics of

both the DB and DC plans. In sum, these efforts area direct consequence of the changing economic and

political environment in the country and re ect thedesire of plan administrators to cultivate the most

nancially viable scenario for their participants.

Types of Public Sector RetirementSystems

A review of the different public sector retire-ment systems quickly reveals the tremendousvariations among the numerous plans, includingthe level of bene ts provided, type of employeescovered, structure of the entity administering the

plan, number of contributing employees, size of the plan’s portfolio and investment philosophy drivingthe plan. In addition, these variations contributetoward distinguishing the public sector plans fromthose adopted by the private sector. The followingsection highlights some of the features of the retire-ment plans of major public sector professions.

One of the more common variations among public sector plans is that they cover employeeswith radically different employment characteris-tics. For instance, the physically demanding andvery often dangerous nature of law enforcement

and re ghting enables these employees to retireat an earlier age in comparison to other publicsector employees. (These professions also seek aworkforce with an average age that is younger thanother public sector professions; hence, the highernumber of retirees at an earlier age.) Consequently,the retirement bene ts extended are very differentfrom other public service positions. Typically,retirement bene t formulas for these professionsare linked to the speci c plan’s vesting require-ments. Most plans that require 20 years of servicefor vesting purposes operate on bene t formulas thatspecify a at percent of nal average salary, mostoften 50 percent, to be paid upon retirement. Plansthat allow vesting after ve or 10 years calculate

bene ts based on formulas derived from single-rateor variable-rate multipliers for each year of service.As opposed to the single-rate approach by which the

bene t percentage remains unchanged. In the vari-able-rate approach, a participant may accumulate aretirement bene t of a certain percentage for the rst

ve years of service and another percentage for theremaining years of service.

In comparison, the retirement bene t formulafor teachers’ retirement plans usually involves asingle-rate bene t calculation with the same bene tmultiplier applying to all years of service under the

plan. Many teachers’ pension plans offer an earlyretirement option by which employees can retire,with unreduced bene ts, before reaching the speci-

ed age and service requirements. Most often, thisoption is available after the employee puts in 20years of service. A large number of the teacher

pension plans add an automatic cost-of-livingadjustment to their bene t payouts to ward off thenegative effects of in ation.


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With regard to the general employee retirement plans, age and service requirements are very similarto those extended to participants in the teachers’

plans. Similar to the teachers’ plans, single-rate bene t calculations are used with many systemsoffering unreduced retirement bene ts at age 55,with 25 or 30 years of service. Like the teachers’

plans, retirement payouts are computed using thenal average salary, typically based on the highest

three or ve years of service.

Several interesting developments are apparentin recent times including the movement away fromthe integration of bene ts with Social Security, atrend that is re ected in both the public and privatesector plans. As a result, the U.S. Bureau of LaborStatistics notes that the proportion of public planswith a bene t formula linked with Social Security

bene ts declined from 10 percent to 4 percent between 1992 and 1994; for private plans, the

proportion declined from 63 percent to 51 percent between 1989 and 1995. A plausible explanationfor this trend may be the perceived uncertaintyregarding the solvency of the Social Security TrustFund. As noted earlier, one-fourth of state and localgovernment employees do not participate in SocialSecurity, opting to channel their Social Security

payroll deductions to their state or local govern-ment retirement plans.

Another important development involves theevolution of Deferred Retirement Option Plans(DROPs), a development traceable to certaindemographic and economic pressures. This type of

pension bene t, spurned by corporations but oftenembraced by state and local governments, has beenhailed as a mechanism to retain hard-to-replaceteachers, engineers and other public workers on the

job as they near retirement. 9 In essence, employeeseligible to retire are allowed to continue workingwhile their retirement bene ts are placed in a funduntil they retire for “real.” However, since DROPsallow for a very early retirement at high levels of

nal wage replacement, high guaranteed rates ofreturn and lucrative cost-of-living adjustments,the negative implications on the nances of thesegovernment entities during a scal downturn remainsigni cant. During the booming 1990s, when equitymarkets roared forward, these negative develop-ments did not surface but in the current era, whenstate nances and public retirement systems remainunder tremendous pressure, these DROP plans are

proving to be immensely costly.

The genesis of DROPs may be traced to ahandful of police of cers and re ghters in BatonRouge, Louisiana, coming up with the idea (in 1982)

of tapping their pension funds to create individualescrow accounts before they retired. Their pension

plans, like most traditional ones, paid their bene tsin a ow of checks every month, i.e., an annuity.These of cers, working with an actuary, deviseda system where if they turned down the longevityraises they were entitled to just prior to retire-ment, their pension fund could deploy that moneyto establish individual accounts. In the currentcontext, when an employee becomes eligible toretire, the individual opens an escrow accountand keeps on working at normal pay. While theemployee’s pension bene t stops growing—as if theemployee had retired—the pension fund forwardsmonthly annuity checks to the previously mentionedescrow account. Not only does this escrow accountaccumulate interest, certain government entitiesguarantee a speci ed rate of return on these funds.When the employee nally retires, the employee ishanded a lump sum, i.e., the proceeds of the escrow

account, and then the employee gets the monthly pension check, which are based on the bene t level before the escrow account was created. Very soon,the concept of DROPs (numerous variations on theDROP, such as the DRIP, the PLOP, the BACK-DROP also surfaced in ensuing years) caught onmore and more with re ghters, police of cers andspread to teachers, judges and many other categoriesof public employees. While pension fund of cialsassumed that the costs of the “sweeteners” that wereadded onto these plans could be paid for by the ever-surging stock market, the downturn in the market

between 2000 and 2002 resulted in these public pension plans having to absorb enormous costs.

One government entity facing these negative pressures--the city of Houston-- introduced a veryattractive early retirement plan for city employees

back in the early 1990s. Employees were permittedto retire at 45 years of age (after completing 25years of service) with a guarantee of 90 percent oftheir nal salary. Consequently, 44 percent of thecity’s workforce opted for retirement in a ve-year

period, forcing the introduction of a DROP plan toretain some of these employees. The carrot offeredto employees who enrolled in the DROP plan was aguaranteed 8.5 percent rate of return on their retire-ment funds that were not drawn, a rate of returnthat seemed reasonable at that time but exorbitantin the current environment of wilting equity marketsand interest rates. In fact, while hundreds of olderworkers will qualify for million-dollar payoutsfrom these accounts, when their monthly pensionchecks start arriving, some actually will have higherincomes than they did when they were working. Asan example, the director of human resources forthe city of Houston (who has 30 years service)


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will receive a $1.5 million check from the city’sDROP and then, when he turns 60 in seven years,will receive monthly pension checks totaling about$110,000 a year.

To further complicate matters in Houston, thecity’s pension fund faced a $1.9 billion shortfallalong with the huge nancial burden of the DROP

plans. In response, Houston’s voters exercised theirrights to opt out of this guaranteed public employee

pension bene t in a referendum--authorized by theTexas constitution--that allows cities a single oppor-tunity to withdraw from such guarantees. In fact, the

nancial burdens associated with the pension fundshortfalls and the extremely high payouts associ-ated with the DROP plans resulted in the rejectionof the pension guarantee provision in the May 2004referendum.

Alongside Houston, the cities of Philadelphia,

San Diego and Milwaukee also face serious nan-cial dif culties in meeting the overall pension obli-gations as a result of these DROPs. In San Diego,the generous DROP plan may have contributed toa $1.2 billion shortfall in the city’s pension system,a shortfall that triggered downgrades in the city’s

bond rating and a federal investigation. 10

Even at the state level, certain states soughtto re ne their retirement bene ts. During its 2004legislative session, lawmakers in South Caro-lina considered trimming a program the GeneralAssembly had created in 2000. The Teacher andEmployee Retirement Incentive (TERI) programin South Carolina allowed employees to continueworking for ve years after retiring with theirmonthly pension checks being assigned to a specialaccount; as in the DROPs, employees could accessthe funds in these accounts when they nally retire.House Bill 4888 in South Carolina sought to removethe earning limitation for a retiree and then eventu-ally phase out the entire program. Yet, there was agreat deal of opposition to this proposal and the bill’sauthor requested that the bill be removed from thelegislative agenda for the year.

Administering Retirement Systems inthe Public Sector

Policymakers continue to play an importantrole in the administration of public sector retire-ment plans for the obvious reason that these fundsinvolve substantial amounts of public money. Inrecent years, the enormous growth of these plans,

both in terms of asset size and participants, hasincreased the level of scrutiny as well. In general,state and local retirement systems are managed bya retirement board or board of trustees that maintain

responsibility for investment policy and asset allo-cation. These board members act as duciaries andare required to use their best judgment and prudencein investment decisions so that the nancial viabilityof these plans is secured. A survey conducted bythe Florida Retirement System several years agoindicated that 93 percent of the retirement systemsor funds across the country are governed by such a

board. In addition, 67 percent of these boards retainauthority over investment decisions, 62 percent haveauthority over bene ts and 85 percent have authorityover actuarial assumptions. 11

According to the U.S. Department ofCommerce, in 2002, there were 2,670 publicemployee retirement systems or plans in theUnited States. Nationally, Pennsylvania (931),Illinois (371) and Florida (158) were the top threestates in terms of number of plans. Two additionalstates—Michigan (142) and Minnesota (146)—also

ranked high in this connection. It appears that insome states, local and state government employeesare consolidated in a few plans while in other states,there are a large number of plans also serving localgovernment entities.

As noted earlier, even though public sector plans are not subject to the standards of the federalERISA law, a vast majority of these plans includelanguage extracted from this federal law in theirguidelines. For instance, public retirement fundsare required to be invested using the “prudent personrule.” Speci cally, the prudent person rule statesthat “ duciaries discharge their investment dutieswith the same degree of diligence, care and skillwhich a prudent person would ordinarily exerciseunder similar circumstances in a like position.” 12 The daily administration of these plans often is theresponsibility of the retirement system’s staff, or ofthe government controlling the system, operatingunder the supervision of an executive director who,in turn, reports to the board of trustees.


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Clearly all three gurative legs, i.e., Social Security, personal savings, and public and private

pensions in the nation’s metaphorical retirement stool face challenges, and policymakers at alllevels of government continue to tussle with adequate policy responses to these challenges. Priorto delving into a detailed analysis of public retirement plans across the country, including the

results of The Council of State Governments’ Southern of ce survey, this chapter performs a quick scalreview of the remaining sources (Social Security, private savings, and corporate pension plans) from which

America’s retirees secure their income.

Chapter 2Sources of Retirement Income: SocialSecurity, Private Savings and Corporate

Pension Plans

Social SecurityThe industrialization of the American economy

began in the latter half of the 19 th century, trans-forming the nation into a land of employees increas-ingly dependent on a ow of money income for theirsurvival and their families’ survival. 1 During thiseconomic and social transformation, the federaland a number of state governments concluded thatsome of the inherent risks involved in ensuring thissurvival could be mitigated through a social insur-ance approach to public welfare. Hence, the conceptthat social insurance programs based on contributory

nancing, available as a matter of right, in contrastto public assistance programs earmarked only forthose in need, gathered momentum in the early yearsof the 20 th century. In the initial decades of the lastcentury, there was movement, both at the federal andstate levels, to provide compensation for workers,or their survivors, injured or killed in connectionwith their jobs. Retirement plans for certain groupsof state and local government employees (mostlyteachers, police of cers and re ghters) emergedduring these early decades. The onset of World WarI also resulted in the federal government providing

bene ts and services for persons who served in thearmed forces.

The need for federal action became a vital neces-sity given that neither states nor local communitiesnor private charities had the nancial resources tomeet the desperate needs of a vast number of Ameri-cans confronting the rigors of the Great Depressionin the late 1920s. Consequently, in 1932, the federalgovernment delivered loans and then grants to statesto pay for direct relief and work relief to deserving

individuals. Eventually, in August 1935, in responseto President Franklin D. Roosevelt’s economic secu-rity proposals, Congress enacted the Social SecurityAct, undoubtedly one of the most important laws inthe history of the nation. 2

Speci cally, this law established two socialinsurance programs on a national scale designedto meet the needs of the aged and the unemployed:a federal system of old-age bene ts for retiredworkers who had been employed in industry andcommerce, and a federal-state system of unemploy-ment insurance. 3 While these bene ts rst becameavailable in 1940, two years ahead of schedule,Congress then expanded the old-age program toinclude bene ts to dependents of retired workersand surviving dependents of deceased workers aswell. While there were no major changes in the

program until the 1950s, the ensuing decades sawvarious amendments to the program, including theaddition of disability insurance, automatic cost-of-living increases and computing bene ts to ensurestable replacement rates.

Perhaps the most important piece of legisla-tion enacted under the rubric of the Social SecurityAct involved the establishment of the Medicare

program in 1965. This program pays for thehospital bills of bene ciaries, 65 years and older,regardless of income. (In 2003, a prescription drugcoverage program also was included in the Medi-care program.) Major changes were enacted to theSocial Security program in 1983 when an amend-ment provided for gradual increases in the age of


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eligibility for full retirement bene ts from 65 to67, beginning with persons reaching age 62 in theyear 2000. For certain higher income bene ciaries,

bene ts became subject to income tax too.

In terms of its nancing, the Social Security program is primarily a pay-as-you-go system. A bulk of the payroll taxes collected from today’sworkers are deployed to pay bene ts to today’srecipients. The ability of the system to continuemeeting its nancial obligations has been underincreasing scrutiny in the past two decades, an issuethat has captured the attention of policymakers andcitizens alike. In fact, the unprecedented economic

boom experienced in the country during the 1990s,when the U.S. economy grew uninterrupted for 10consecutive years (March 1991 to March 2001),signi cantly boosted the Social Security trust fund’s

bottom line. As a result, the year at which the fundwould start paying out more than it receives was

postponed. Yet, government of cials have beenforecasting for some years now that the retirementinsurance and healthcare funds for the elderly, both

nanced through payroll taxes, will approach insol-vency as more post-World War II baby boomersapproach 65.

According to the latest (2004) annual report ofthe Board of Trustees of the Federal Old-Age andSurvivors Insurance and Disability Insurance TrustFunds, the entity charged with administering theSocial Security trust fund, the following ndingsremain important. 4

» At the end of 2003, 47 million people werereceiving bene ts: 33 million retired workersand their dependents, 7 million survivors ofdeceased workers, and 8 million disabledworkers and their dependents. During the year,an estimated 154 million people had earningscovered by Social Security and paid payrolltaxes. Total bene ts paid in 2003 were $471

billion. Income was $632 billion, and assetsheld in special issue U.S. Treasury securitiesgrew to $1.5 trillion.

» The Old-Age and Survivors Insurance (OASI)and Disability Insurance (DI) trust funds, indi-vidually and combined, are adequately nancedover the next 10 years under the intermediateassumptions. The combined assets of the OASIand DI trust funds were projected to increasefrom $1,531 billion at the beginning of 2004, or306 percent of annual expenditures, to $3,584

billion at the beginning of 2013, or 442 percentof annual expenditures in that year. In the 2003report, combined assets were projected to rise

to 309 percent of annual expenditures at the beginning of 2004, and 461 percent at the beginning of 2013.

» Under intermediate assumptions, the combinedOASI and DI trust funds are projected to becomeexhausted in 2042. For the 75-year projection

period, the actuarial de cit is 1.89 percent oftaxable payroll, 0.03 percentage point smallerthan in last year’s report. The unfunded obli-gation for OASDI (both the Old-Age andSurvivors Insurance and Disability Insurance

programs combined) over the 75-year period is$3.7 trillion in present value, $0.2 trillion morethan the obligation estimated a year ago.

» The OASDI annual cost rate is projectedto increase from 11.07 percent of taxable

payroll in 2004, to 16.83 percent in 2030, andto 19.29 percent in 2078, or to a level that is

5.91 percent of taxable payroll more than the projected income rate for 2078. Expressed inrelation to the projected gross domestic product(GDP), OASDI cost is estimated to rise fromthe current level of 4.3 percent of GDP to 6.3

percent in 2030 and to 6.6 percent in 2078.

» Between about 2010 and 2030, OASDI costswill increase rapidly due to the retirement ofthe large baby-boom generation. After 2030,increases in life expectancy and relatively lowfertility rates will continue to increase SocialSecurity system costs, but more slowly. Annualcost will exceed tax income starting in 2018,at which time the annual gap will be coveredwith cash from redeeming special obligationsof the Treasury, until these assets are exhaustedin 2042. Separately, the DI fund is projectedto be exhausted in 2029 and the OASI fund in2044.

» Under the long-range intermediate assump-tions, the combined OASDI trust funds are

projected to become insolvent, i.e., unableto pay scheduled bene ts in full on a timely

basis, when assets are exhausted in 2042. Atthat point, payroll taxes and other income will

ow into the fund but will be suf cient to payonly 73 percent of program costs. 5

» In the area of demographic challengesconfronting the program, the number of retiredworkers is expected to expand rapidly begin-ning in 2008. This is the year when membersof the post-World War II baby boom begin toreach early retirement; then, the number ofretired workers will double in less than 30


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years. Also, compounding this trend are thetwin facts that Americans are living longer andthat American birth rates are lower comparedto earlier times. Consequently, the ratio ofworkers paying Social Security taxes to peoplecollecting bene ts will drop from 3.3 to 1,currently, to 2.1 to 1 by 2031. Unfortunately,at that ratio, there will be insuf cient workersto pay scheduled bene ts at current tax rates. 6

» For the trust funds to remain solvent throughoutthe 75-year projection period, the combined

payroll tax rate could be increased during the period in a manner equivalent to an immediateand permanent increase of 1.89 percentage

points, bene ts could be reduced during the period in a manner equivalent to an imme-diate and permanent reduction of 12.6 percent,general revenue transfers equivalent to $3.7trillion (in present value) could be made during

the period, or some combination of approachescould be adopted. Signi cantly larger changeswould be required to maintain solvency beyond75 years.

Further roiling the retirement plans of seniorAmericans was the revelation in late March 2004that the Medicare program, the other program ofcritical assistance to seniors, will be completelydepleted by 2019, seven years sooner than predicted

just last year. 7 Without changes in a program that israpidly being overrun by skyrocketing health costs,the trustees’ annual report notes, “raises seriousdoubt about the sustainability of Medicare undercurrent nancing arrangements.” 8

When Federal Reserve Board chairman AlanGreenspan, in testimony before the U.S. Congressin February 2004, urged lawmakers to slash future

bene ts in Social Security and Medicare, a series ofalarm bells ricocheted through the federal govern-ment. Chairman Greenspan’s recommendation to

push up the age at which bene ciaries could beginreceiving Social Security and Medicare furtherunderlined the feeble foundation on which a vastnumber of Americans continue to build their retire-ment dreams.

In June 2004, the Congressional Budget Of ce(CBO) issued a report on the long-term nancialviability of Social Security. 9 In general, the conclu-sions reached in the CBO study mirror those reached

by the Social Security Trustees and described earlier.Perhaps the most important conclusions reached inthis study include the fact that annual outlays forSocial Security are projected to exceed revenues

beginning in 2019 (the Social Security Trustees

expect this to occur in 2018) and the fact that CBO projects that the trust funds will become exhaustedin 2052 (the Social Security Trustees expect this tohappen in 2042). These differences spring fromthe more optimist economic assumptions made byCBO in making these long-term predictions. Table3 documents these differences.

As depicted in Table 3, there is a slight varia-tion in the long-term assumptions made in the tworeports resulting in the CBO providing a slightlymore optimistic forecast for Social Security’sfuture. In conclusion, despite the slight variation inthe numbers, they do point to the same conclusion:“that under current law, the program will generatea sustained and signi cant demand for budgetaryresources” in the future. 10

Personal SavingsRetirement planners are quick to point out that

personal savings should be an important contributorto the income of retirees. Yet, for nearly threedecades now, the total personal saving rate of U.S.households has been falling. It should be mentionedthat this trend is not a phenomenon unique to the

baby boomer generation; it is a trend re ectiveof American society in general. In fact, there isresearch published in the last 10 years demon-strating that the nancial behavior of baby boomershas not been fundamentally different than that of

previous generations. 11 Table 4 provides informa-tion on personal savings rates for the past 30 years,1973 to 2003.

table 3

CBO (June2004)

Social SecurityTrustees

(March 2004)

Real Earnings Growth 1.3% 1.1%

Real Interest Rate 3.3% 3.0%

In ation 2.2% 2.8%

Unemployment Rate 5.2% 5.5%

Source: Congressional Budget Of ce

CBO’s and the Social Security Trustees’Long-term Economic Assumptions


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As indicated in Table 4, during the past 30

years, savings as a proportion of disposable incomehas declined steadily. For the period represented,from a high of 10.5 percent of disposable incomein 1973, this proportion declined to 7.3 percent by1988, and to a mere 2 percent by 2003. Of note, thesavings rate reached a high of 11.2 percent in 1982and a low of 1.7 percent in 2001, the two book-ends of this statistic for the time period reviewed.Figure 1 further illustrates this trend by graphically

presenting personal savings as a percent of dispos-able personal income for the period 1973 through2003.

Even though the baby boomers, people born between 1946 and 1964, comprise one of the largestand most af uent generations in American history,there is concern that a cohort within these boomershas not accumulated suf cient private savings tofully nance their retirement. 12 Even though these

baby boomers are on track to secure higher incomelevels than their parents, it is estimated that a quarterof these households have failed to accumulatesigni cant savings to last them through retirement.

Another factor affecting the ability of Ameri-cans to draw on their personal savings during retire-ment is the crushing level of debt accumulated inrecent years. According to the Federal ReserveBoard, total consumer credit at the end of 2003amounted to a staggering $2 trillion, up from $1.5trillion, a scant four years before that in 1999. Totalconsumer credit, including both the revolving andnon-revolving varieties, to such entities as commer-

cial banks, nance companies, credit unions,savings institutions, non- nancial businesses and pools of securitized assets, rose from $1.5 trillionin 1999, to $1.7 trillion in 2000, to $1.8 trillion in2001, to $1.9 trillion in 2002 before topping off atthe aforementioned $2 trillion last year.

For many Americans, the last few yearssignaled the onset of a huge borrowing spurt asthey accumulated debt to purchase new homes,computers, cars, other big-ticket items and refur-

table 4

Year

DisposablePersonalIncome

PersonalSavings Percent

1973 $978.3 $102.7 10.5

1978 $1,608.3 $142.5 8.91983 $2,608.4 $233.6 9.0

1988 $3,748.7 $272.9 7.3

1993 $4,911.9 $284.0 5.8

1998 $6,395.9 $276.8 4.3

2003 $8,202.9 $165.6 2.0

Source: U.S. Department of Commerce, Bureau ofEconomic Analysis

Personal Savings Rate and Disposable Income(Billions of Dollars) 1973-2003

figure 1Source: U.S. Department of Commerce, Bureau of Economic Analysis

Personal Savings Rate as a Percent of Disposable Income 1973-2003


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bish their homes with home equity lines. In addi-tion, given the fact that in the aftermath of the 2001recession millions of Americans lost their jobs, anincreasing number of them used credit cards to payfor essential expenditures during this time of unem-

ployment. Furthermore, by spring 2004, long-termunemployment was the worst it had been in morethan 20 years--22.1 percent of all unemployedworkers were out of work for six months or morein 2003--the worst annual rate since 1983, 13 and asa result, an increasing number of families have hadno recourse but to accumulate greater levels of debtin order to stave off bill collectors and meet basicexpenses.

Yet this accumulation of debt has resulted ina robust rate of consumer spending, often toutedas the mainstay of the economy in recent years,

particularly in the aftermath of the 2001 recession.Consumer spending expanded at a 4 percent annual

rate in the nal quarter of 2003, after spurting aheadat an 8.2 percent annual rate in the third quarter of2003. However, this borrowing binge has resultedin household debt reaching nearly 83 percent ofgross domestic product (GDP), up from 70 percentin 1999. 14 Alongside the accumulation of thiscolossal level of debt, another disconcerting factconcerns the possible implications to consumerswhen interest rates rise from their historically lowcurrent levels, particularly for those consumerslocked into variable rates.

Notwithstanding the declining personal savingsrate and the overwhelming increase in householddebt, a related trend should be mentioned here:the increase in home ownership statistics. Datashow that in recent decades, an increasing numberof Americans have devoted resources to purchasetheir own homes. Hence, an argument could beextended that even though, in general, Americanhouseholds are saving a smaller proportion of theirdisposable income, the increase in home ownershiprates partially offsets these shrinking savings efforts.The diversion of disposable income to pay downmortgages could be construed as a form of savings;undoubtedly, the purchase of a home for mostAmerican households amounts to the purchase oftheir largest asset. So, even though American house-holds allocated diminishing amounts of disposableincome toward personal savings, the fact that therewas a marginal increase in home ownership ratesin the past several decades remained a positivedevelopment. As demonstrated in Table 5, nationalhomeownership rates remain at an all-time high,currently up from 62.1 percent of all households in1960 to 68.3 percent in 2003, some 43 years later.

As displayed in Table 5, reforms related tothe mortgage application process and the recordlow interest rates experienced in the past few yearshave propelled an increasing number of Americansto purchase homes. This has enabled a stunning

number of American households to take that all-important step of owning their own homes. Animportant corollary in this impressive expansion inthe number of American homeowners involves therecord low mortgage rates prevalent in recent years,the lowest in more than four decades, and the ex-ibility and ease at which prospective home buyersmay apply and qualify for a mortgage.

Corporate Pension PlansThe announcement in 2004 from the executive

director of the Pension Bene t Guaranty Corpora-tion’s (PBGC), the federal entity that protects the

pensions of 44 million American workers, that whilehis agency has “suf cient assets to pay bene ts toworkers and retirees for a number of years, thegrowing gap between our assets and liabilities putsat risk the agency’s ability to continue to protect

pensions in the future,” 15 only con rmed what agrowing number of analysts had been stating forthe prior few years. This gloomy outlook was onlycorroborated when the PBGC assumed trustee-ship of the Bethlehem Steel pension plan in 2003,absorbing not only the largest single plan (95,000

participants) in its history up to that point but alsothe largest loss from one company (about $3.6

billion). 16 For the rest of 2004, the outlook doesnot appear any cheerier, a development con rmedin Congressional testimony in October 2004 by thePBGC’s executive director who noted that “we will

be reporting a signi cantly increased de cit for the2004 scal year.” 17

For the past three years or so, certain analystshave been drawing attention to the fact that Amer-ica’s corporate pension system was a ticking time

bomb with the potential to explode like the savings-

table 5

Year Percent Year Percent

1960 62.1 1990 63.9

1965 63.3 1995 64.7

1970 64.2 2000 67.4

1975 64.6 2001 67.8

1980 65.6 2002 67.9

1985 63.9 2003 68.3

Source: U.S. Department of Commerce, Bureau of theCensus

Homeownership Rates as a Percentof Total Households 1960-2003


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and-loan crisis of the 1980s. 18 The nation’s agingworkforce and the decimation of the stock marketsin the 2000 through 2002 period created a massiveunderfunding of corporate pension funds. Theseanalysts had been drawing attention to the fact thatif policymakers, primarily at the federal level, didnot initiate corrective action, the PBGC, in its roleas the insurer for these corporate pension plans,would be forced to meet the de ned bene t obliga-tions of millions of retirees. In mid-2003, the levelof underfunding at these corporate plans (de ned

bene t) was estimated to be in the $300 billionrange 19 and by late February 2004, it was estimatedthat employers would need to add $350 billion to

pension funds. 20 In mid-August 2004, Standard &Poor’s announced in its latest Pension Status Report that while improving from the prior few years, atyear-end 2003, the overall position of the 362 S&P500 companies offering de ned bene t pensionsimproved from an underfunded level of $219

billion at year-end 2002 to an underfunded levelof $165 billion. For year-end 2004, Standard &Poor’s estimates that the level of underfunding willimprove but still record a shortfall of $112 billion.

Nevertheless, the current level of underfunding isa far cry from the $280 billion surplus recorded atyear-end 1999 for the 362 companies in the PensionStatus Report .21

Undoubtedly, the combination of problemsailing the Social Security and Medicare systems,along with the scal problems of numerous corpo-rate pension plans, coalesced to create a veritablewitches brew of nettlesome issues for policymakers.Once again, a familiar list of “structural” culpritscontinues to plague the underfunded pension plansin corporate America today. The same inter-gener-ational con ict that confronts the Social Securityand Medicare programs presently remains the mostimportant factor here: the proportion of workers toretirees has been dropping in recent decades. Forinstance, in 1985, there were about three workersfor every retiree in pensions insured by the PBGC;in mid-2003, this ratio was in balance, and it is esti-mated that by 2006, bene ciaries are expected tooutnumber workers by nearly 12 percent. Anotherexample from General Motors further illustrates this

point. At the end of 2002, General Motors alreadyhad substantially fewer U.S. workers (177,000) thanretirees (437,000), a startling ratio differential. 22

Other demographic trends play a role too, suchas the fact that Americans are living longer in retire-ment as a result of earlier retirement and longer lifespans. According to the PBGC, an average maleworker spends 18.1 years in retirement comparedto 11.5 percent in 1950; consequently, an additional

seven years of retirement must be funded with adiminishing pool of workers. 23 Rising healthcarecosts in America, often at staggering double-digitannual growth rates, are a trend that has been exten-sively documented, a development that erodes theresources of both private and public pension plans.As mentioned earlier, since Americans are nowliving much longer, their healthcare needs alsoincrease exponentially, a trend that further taps intothese pension funds.

Another major structural impediment to thefunding levels of corporate pension plans relatesto the steep, concurrent drops in both equity valuesand interest rates. Companies with these de ned

bene t plans invest in stocks and bonds to ensurea ow of income to meet future retiree payments,factoring in such criteria as workers’ salaries, ageand life expectancy. Using actuarial calculations,among other techniques, assumptions are then

made about the earning potential of these instru-ments. As is often the case, these investment earn-ings can deviate from the initial assumptions andthe corporate pension funds are either underfundedor overfunded. During the booming equity marketscenario of the mid-to-late 1990s, a majority of thesede ned bene t corporate pension plans were ush;that scenario changed radically during the next fewyears, particularly in the precipitous collapse of theequity markets between 2000 and 2002.

A report, released by Wilshire Associates inMay 2003 on the de ned bene t plans of S & P500 companies, documented this alarming trend. 24 Accordingly, 2002 was the worst year ever for thesecorporate pension plans with their assets falling

by $106 billion to $892 billion, while liabilitiesincreased by $105 billion to $1,069 billion. As aresult, the funding ratio (assets divided by liabilities)for all plans combined dropped from 104 percent to83 percent; a $34 billion surplus at the beginning ofthe year

Documents

America's Public Retirement Systems: Stresses in the System