3 Reasons Cities Should Switch to 401ks

401k, pension, debt, municipalities,Orange County, California's debt picture wasn't always so pretty.

Debt-laden pension obligations continue to weigh on state and city governments around the country, with Chicago, Illinois as the most recent example.

All told, municipalities and states owe a combined $3.85 trillion in unfunded pension liabilities, The Hill recently reported. One solution to prevent such situations in the future is, of course, switching from defined benefit to defined contribution 401k-style plans, as seen with their private sector counterparts.

While once feared for the political fallout, voters are now stamping ballot-box approval on reform-minded candidates willing to address these massive retirement shortfalls, as they place entire budgets at risk (see aforementioned Illinois). Scott Walker’s contentious reign in Wisconsin comes to mind, as does Gina Raimondo in Rhode Island.

Wayne Winegarden with EfficientGov, a website that “tracks innovative solutions to fiscal and operational challenges facing cities and towns,” offers up three reasons to consider a defined contribution move and save municipalities that are “headed to pension-derived bankruptcy.”

No. 1: Funding falls short

State and local governments have only contributed 88 percent of the required annual contributions into their public pension funds between 2001 and 2015 Winegarden writes, citing stats from the Brookings Institution.

Additionally, according to the Pew Charitable Trusts, public pension plans in total need an additional $1.1 trillion just to meet current expected obligations.

“This 28 percent funding gap understates the problem because it does not account for the unfunded repayment risks that taxpayers are bearing on behalf of public employees,” Winegarden adds.

No. 2: Unrealistic returns

Public pension funds currently assume an unrealistic return on their investments.

“Compared to their private sector counterparts who assume an annual return a bit over 4 percent, public sector funds are, on average, assuming they can annually earn around 7.5 percent. Assuming a better outcome does not make it so. Should the overly optimistic returns not come to fruition, then the dire financial state of the state and local public pension systems is even worse.”

No. 3: Risky business

Public pension funds are carrying too much risk in their investment portfolios.

“During the 1970s, public pensions used to invest one-quarter of their assets in riskier ‘equity-like’ investments such as stocks, real estate, hedge funds and other assets subject to substantial investment risk,” Winegarden writes. “Today, public pension systems invest two-thirds of their assets into these types of riskier investments.”

He concludes by arguing that in order to start the transition to 401k plans, “all new employees should be ineligible for the current defined benefit programs, and should instead be enrolled in a defined contribution retirement system that meets the average standards of large company defined contribution plans. These standards should include no minimum length of service requirement for eligibility, immediate vesting on matching contributions, and the government’s matching and non-matching contributions equal to 6.5 percent of pay.”

“For current employees,” he adds, “the current defined benefit programs should be frozen, specifically a hard freeze. Under a hard freeze, no public employee would accrue any more benefits in the defined benefit program.”

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