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Understanding America’s Multi-Trillion Dollar Public Pension System: An Interview with Jean-Pierre Aubry

Image via the Center for Retirement Research

Jean-Pierre Aubry is the Associate Director of State and Local Research at the Center for Retirement Research (CRR) at Boston College. He oversees and conducts research and data collection, develops new analytic techniques for evaluating retirement benefits, and secures funding support. Aubry, who is recognized as a leading expert on public pensions, has co-authored numerous studies that have received broad attention and is co-founder of the Public Plans Data. He has presented to professional and academic groups such as the Municipal Analysts Group of New York, Moody’s, Standard & Poor’s, and the National Bureau of Economic Research.

Miles Munkacy: Can you explain what funded ratios are and their importance for pension funds?

Jean-Pierre Aubry: The funded ratio compares the level of assets that a pension fund has today to the total promises it has to pay out in the future. The idea behind a funded ratio is if the pension fund were to stop promising benefits today and were to stop receiving any more contributions into their fund, how much of the benefits could they pay out? If a pension fund is 78 percent funded, what it means is that they have assets on hand today to pay about 78 percent of the promises they have made to date. At some point, the money would run out if more money did not come in to pay the promises they’ve made.

The important thing about that number is it’s just a snapshot. It represents the state of a pension fund if you were to freeze its finances. But that’s not the reality of the system because they’re constantly receiving contributions from employees and from governments. Our data shows there’s very minimal risk of any pension fund, even the worst ones, running out of money.

MM: Many pension funds were able to ease their unfunded liability problems because of high returns during the pandemic. What happens when the economy returns to normal and they can no longer rely on high returns from, say, the stock market?

JPA: It’s sometimes important to step away from abstract notions like funded ratio and unfunded liabilities and just look at pension fund cash flows over time—money going in, money going out, and investment returns. If a pension fund has more money going out than it has going in, the pile of assets goes down. You do that for enough years, you have no assets. That is very simply the catastrophe everyone is worried about.

We’ve found in our analysis that for pension funds to get into that downward spiral, for there to be an actual solvency problem, they have to earn less than about 4.5 percent of their assets regularly. So, yes, pension funds may be expecting unreasonably high returns, but if a professional investor can’t make 4.5 percent a year then they shouldn’t be in that business. We therefore see pension funds as quite sustainable from a solvency perspective.

MM: Why are there concerns about pension funds investing in private equity? Do you think the unease is warranted?

JPA: We’re pretty skeptical of their place in government pensions. Initially, when there weren’t many players in the market, there might have been higher returns. But now, on average, private equity does just as well as equity over the long term. This is not surprising. It’s hard to imagine that the aggregate profile of private equity investment would look that different from public equity markets in the long haul.

The one benefit you do get, which pension funds may appreciate but is less valuable from a researcher’s perspective, is a smoothing effect. It’s not as volatile because private equity isn’t valued in public markets. Still, you have a lot more heartache in terms of opaqueness, fees, and public scrutiny. From the standpoint of us researchers, they should probably have a lesser role in pension fund portfolios—not no role, but definitely a lesser role than we see today.

MM: Is this connected with the poor performance of Illinois’ pension system? They have the sixth highest amount of alternative investments—like private equity—in their portfolio, yet their funded ratio is at 50 percent. 

JPA: There’s not a clear, direct relationship. As I alluded to before, our most recent findings on private equity were prior to the Global Financial Crisis. When private equity and alternatives were a new space, they outperformed public equities and other core assets like basic bonds. Following the Global Financial Crisis, they underperformed. So, overall, it was a net zero for pension funds. This means that those who invested in them early did alright. Those who followed the pack, once the field was crowded, did worse off.

However, the Illinois story has less to do with investments. Pension funding in general has a lot less to do with investments than you might think. For most of the worst-funded plans, the problem has been not contributing enough when they should have. Illinois didn’t start putting money aside to fund their pension until the mid-1990s, even though they had a pension system since 1930. They were just accruing benefits and paying it out through tax revenue. To be clear, that’s not totally uncommon. Pension funds have existed since the 1920s and most started out as PAYGO systems where they didn’t pre-fund their liabilities. Many transitioned away from that funding model in the 1980s, and the states that made that decision later did worse. Obviously, risky or low investment returns don’t help, but that history explains a lot of the differences in the funding of plans today.

MM: Many pension funds are converting from defined benefit plans to defined contribution plans. What does that mean and how does it affect the individuals receiving the pensions?

JPA: A defined benefit pension is the pension you may think of your grandfather or great-grandfather having. They worked in, say, manufacturing, and when they retired they were promised a payment each month for the rest of their life. Most state and local government workers still basically have that promise with their employer. These plans are really great for individuals because they provide almost complete protection from all the risks around income in retirement. They’re basically savings accounts.

The shift to defined contribution is very challenging for individuals because you just define what you put in and hope it’s enough for what you need. The benefits aren’t defined. This puts investment risk—whether the contributions you put in grow as fast as you think they will—longevity risk—which is where you outlive your assets—and other challenges on the individual. At the same time, there are some benefits to defined contribution. It’s more portable, for example. Defined benefits are great if you’re going to work for the same employer for your whole career. If you leave halfway through, your benefits are based on your salary when you leave, so they might be smaller than expected. Money in defined contribution plans will keep growing if you leave because the things they’re invested in will continue growing. This is particularly valuable for a workforce that transitions more, which we’re increasingly experiencing. Defined benefit plans are designed to keep workers around, which economists sometimes gripe about because they love an economy where everyone can go wherever they want and select the job that’s best for them, not just the one they’re locked into just because their benefits are good.

I should say that defined contribution plans are much better designed in the public sector than they are in the private sector. They’re optional in the private sector, so a lot of people don’t use them at all. They tend to only be offered by big employers, not small businesses, so a lot of employees don’t even have access to them in America. Then, when you retire, there’s no way to really draw down your assets to annuitize them. You have to figure out how much you can afford to take out each month, which is a very hard and complicated decision to make. The public sector plans don’t have a lot of those issues and are generally more beneficial to the retiree. Everyone is automatically enrolled in them, the contributions are a lot higher, and there’s automatic annuitization. Oftentimes when you retire, they give you an easy way to turn it into an annuity if you’d like.

MM: Why is it difficult for politicians to reform pension plans?

JPA: I think the big reason is that the entities that benefit from pensions have strong and unified political support. The public sector is one of the last bastions of unions, which means politicians need to negotiate with a very mobilized group that can make its demands known.

I also think something that needs to be understood is that pensions aren’t happening in a vacuum. They’re part of total compensation. Our studies have shown again and again that, in general, state and local workers don’t earn more than private sector workers with similar educations. If you cut pension benefits, you lower compensation relative to what someone could get in the private sector. That means you’re going to get worse workers and worse government services. It’s just a difficult structure to maintain, and cutting benefits without thinking about the whole picture runs into all these workforce issues.

MM: Without considering political feasibility, is there anything the federal government can do to help states with their unfunded pension liabilities? 

JPA: I’m not sure. I think the most interesting thing is that states aren’t asking for it; you don’t see states clamoring for federal assistance or oversight in this arena. A large part of this is because of the point I made earlier, that most pension funds can survive in their current manner in perpetuity. Also, most pension funds have already made benefit changes where future workers are getting less than prior workers, so the system is kind of shrinking. State and local governments see this and believe they can handle their problem as they exist now. Some states will need to make hard choices going forward—Connecticut and Illinois, for example—but even those states will likely be okay in the long run.

Governments are also definitely doing better about funding. They’ve gotten the message that all the shenanigans that helped them grow the unfunded liabilities, Illinois included, need to stop. In recent years, unfunded liabilities have basically leveled off and even declined if you look at them relative to revenue. The Titanic is a bad analogy because it ultimately crashed, but pension funds move like steamships. They’re very, very slow and massive institutions. They’ve made small adjustments each year since the Global Financial Crisis and our sense is they’ve turned the ship in the right direction. It just takes a long time to see results with these kinds of entities.

MM: I really hope it’s not the Titanic.

JPA: Yeah, me too.

*This interview has been edited for length and clarity.