Despite recent stock market highs, Arizona's pension systems remain dead men walking. Officially, the state's major pension funds are 72 percent funded, just 7 percentage points above what the federal government defines as the "red zone," or in critical condition. This means they are short at least $14.5 billion, or $2,300 for every man, woman, and child in the state.
But these official numbers are far rosier than reality. The state's numbers assume pension funds can consistently earn an 8 percent return on investments, a rate of return not seen over the last decade. Based on a more realistic 5 percent rate of return, all of the state's pension funds are in critical condition, with combined unfunded liabilities shooting over $33 billion. That works out to almost $5,000 for every man, woman, and child in the state. And the assumption of a more conservative 10-year Treasury rate would reveal that pension fund insolvency is on the horizon -- in 2009, Arizona's funds would have been less than 34 percent funded.
In light of this reality, it is plain that Arizona's pension systems, like those of other states, assume that taxpayers will make up the difference. But developing case law shows there is likely no taxpayer backing for any "independent" pension fund. For this reason, policymakers must enact reforms before the system becomes insolvent.
New employees should be required to join defined contribution plans; old employees should be enticed to do the same. Policymakers should enact a maximum combined contribution rate of no more than 16 percent of an employee's paycheck. To prevent future abuses, state constitutions should be amended to require a legislative supermajority to increase pension benefits. And pension funds should adopt a more realistic rate of return, one that equals or approaches a Treasury rate, to support future benefit and contribution reforms.
At the same time, the 47 states that have constitutional gift clauses should bar pension funds from giving public employees grossly disproportionate compensation for their work. Specifically, to counteract the practice of "spiking," pension benefits for any employee should be capped at an amount that is not grossly disproportionate to that employee's pension contributions. Further, to protect taxpayers from paying multiple times for the same work, pension funds should be prohibited from increasing employer contributions to replenish pension fund losses or to increase benefits for current retirees.
Finally, policymakers should authorize pension funds to file for Chapter 9 bankruptcy. The mere existence of such legislation will encourage trustees and pensioners to voluntarily reform the system. If voluntary reforms fail to materialize, bankruptcy will allow for pension funds to be restructured in an orderly fashion. Such reforms need to begin now to ensure a sustainable and solvent pension system for both taxpayers and employees.