James Hohman is a director of fiscal policy at the Mackinac Center. Carol Park is a senior policy analyst in the Center for Business & Economic Competitiveness at the Maryland Public Policy Institute.
When Detroit declared bankruptcy in 2013, city officials found that its largest creditors were not banks or bondholders but the city’s own employees and retirees. That’s because city officials had shortchanged its pension system for years and neglected its growing liabilities. The Detroit experience became a cautionary tale for other cities and states facing their own pension crises.
Ironically, the government of Michigan, the home state of Detroit, is a leader in addressing pension problems. It became the first state to convert its employees to 401(k)-style benefits in the 1990s, and it has protected its remaining pensioners with better funding assumptions.
In contrast, Maryland faces a looming public pension crisis. Maryland has promised government employees and retirees $21 billion more than lawmakers have saved. For Maryland to avoid Detroit’s fate, Maryland can follow Michigan’s lead in strengthening its workers’ pensions.
According to a recent study of the 30 largest government pension funds, Maryland lost out on $7 billion in returns over a decade just by underperforming other state pension funds in investment. Over the 10 years ending in June 2017, Maryland earned just 4.2 percent annual return on the money it set aside for pensions. Maryland’s pension plan overseers disguised this shortfall by assuming a 7.5 percent discount rate in calculating its liability figures, making the pension fund appear closer to being fully funded.
Over the years, Michigan pension officials lowered the plan discount rate in response to weak investment returns, despite consistently earning higher returns compared with Maryland. Michigan officials had assumed 8 percent and have gradually lowered it to 7 percent and to 6 percent for some new employees.
Lowering the discount rate increases the projections of how much money government policymakers must add to pension plans today to pay for pensions tomorrow. The lower the rate, the more carefully the pension plans are funded. Not surprisingly, politicians rarely reduce these rates, because not doing so frees up spending for more conspicuous programs that could help them get reelected. Maryland lawmakers need to admit they have a perennial problem keeping pensions properly funded.
One way to address the underfunding problem would be for governments to stop offering retirement benefits that allow them to kick the costs of today’s workforce onto tomorrow’s taxpayers. Instead of providing underfunded pensions, they should contribute to individual retirement funds and put retirement in employees’ hands.
This is what Michigan did for its state employees in the 1990s. New employees participate in a generous 401(k) plan that politicians cannot underfund because the money must be paid upfront. This has prevented the state from owing billions more in underfunded pension benefits.
Maryland should follow this move. In 2017, Maryland Gov. Larry Hogan (R) proposed the State Retirement Choice Act for the 21st Century Workforce . This legislation did not pass, but if it had, it would have given the option for new state employees to choose between the existing defined-benefit pension plan and a 401(k) plan.
Another legislative session has passed without action on Maryland’s pensions. But lawmakers should reintroduce and adopt this idea.
The 401(k) plans keep the state from making its employees and retirees major creditors like those in Detroit, and let people keep building their retirement funds even if they switch employers. At least 37 percent of Maryland workers leave their jobs before they vest in any pension at all.
Whether it is in Michigan or Maryland, pension reform is hard for politicians. There are too few political incentives to producing a well-funded pension system. Pushing off the pension debt to the next generation allows government officials to spend more money elsewhere. This is the main reason almost every state has underfunded pensions.
It takes strong political will to make these long-term reforms that keep pension plans from being debt factories. But if Michigan lawmakers could overcome these barriers, Maryland lawmakers can, too.