While the real world has switched from defined benefit pension plans to defined contribution plans (e.g. IRAs, 401k), much of government still uses defined benefit plans where retirees receive regular pension checks based on a formula. The problem today is that many public systems are underfunded and are having difficulties remaining viable. The economic crisis is a culprit in that there are fewer people working and contributing, but more importantly the assets of the plans, such as bonds, are earning less. This is the money that is used to pay retirees. One solution is to increase the rate the plans collect from governments to fund the pension system (i.e. the percentage of wages), but that competes with other uses of tax dollars such as roads and schools.
Government pension plans have a host of political problems associated with them. However, the biggest problem faced by these pension plans today is that the investment return (interest, dividends, etc.) they can earn in the market on their assets is low and headed lower. This problem is the result of Ben Bernanke’s low interest rate policy. Like everyone else, pension plans earn little interest income on bonds and as a result they have less money to pay retirees. Initially, this was not a problem because most of the plans have long term investments at higher rates of return. However, with rates remaining low the earning power of the pensions assets continues to slip. Some states such as Pennsylvania are already in deep trouble. Most state and union pension plans, as well as health care plans for retirees are underfunded.
Every economic crisis tends to reduce government tax revenue, but in the past pension plans could find high yield investment opportunities and hedge their bets by investing in a big assortment of these investments. With contribution rates now near their maximum sustainable levels and the army of government retirees growing how much longer can such plans survive Bernanke’s low interest rate policy?