Last month, the New Jersey Senate took a much-needed first step to reform the state’s pension system in a series of bills that the Assembly will likely take up later this month. These bills represent a step in the right direction, but they are hardly the comprehensive overhaul that the state pension system needs. If New Jersey is to pull the state back from the precipice of bankruptcy, the Assembly must consider much more significant reforms than those currently on the table.
New Jersey is not alone in this problem. States across the country, with some notable exceptions such as Florida and Oregon, have massively underfunded state pension funds. A recent report from the Pew Center on the States estimates, conservatively, that total nationwide state pension and benefit plans are underfunded by some $2.73 trillion—20 percent of GDP.
Public sector pensions generally—and the pension fund in New Jersey especially—are troubled because they make unrealistic assumptions about the rate of return to expect from pension investments, and what the size and makeup of future public sector workforces will be. And why not? After all, public officials and union leaders can promise lavish benefits today, leaving the next generation of taxpayers and workers on the hook.
The size of that tab is so significant, it’s not clear the state will be able to pay it. The only way for New Jersey to make its pension system sustainable, and to keep its promise to public sector workers, is to follow the private sector’s lead and move to a defined contribution pension system. Such a move would be difficult, but it will pay off in the long term.
New Jersey’s public pension system is among one of the most troubled in the country. As of today it is officially underfunded by at least $46 billion, due in large part to a series of deferred contributions through the 1990s and 2000s. The problem is not one of high finance, but simple mathematics: the pension fund will have to pay out much more than it has. Pensions will have to be decreased, contributions will have to increase, and taxpayers will be in for a huge shock. There are no simple—or painless—solutions.
This is not state’s first attempt to face the music. In 2002, with the stock market down sharply in the wake of the 9/11 terrorist attacks, New Jersey established a commission to make recommendations to reform the pension system, which offered an in-depth analysis of the system’s problems. But the commission failed then, just as the Senate is failing now, to address the underlying problem: the state’s defined benefit pension structure.
In a nutshell, there are two types of pensions: defined benefit plans and defined contribution plans. The former give pension recipients a set amount per month, for life, based on a formula established while they are working. The latter, by contrast, are effectively savings accounts for employees to put aside some of their wages to cash out in retirement. Defined contribution systems—which the majority of Americans under 50 now have—are what the majority of private sector employers in the United States offer their employees.
Defined contribution pensions eliminate the risk to taxpayers, while giving ownership to workers. In a defined contribution plan, workers pay into a personal retirement fund that they draw down in retirement. Since workers own their own retirement accounts in a defined contribution plan, they don’t have to worry that a future legislature will curtail or manipulate benefits.
And defined contribution plans—like the 401(k)—give workers portability—retirement savings can be carried to another job. Defined benefit plans incentivize workers to stay put in order to collect a fixed pension, or to try to game the system by pole-vaulting to a higher-paying job for the last few years of their careers in order to pad their retirement payments.
Unfortunately, nobody has yet articulated a clear way for New Jersey to make such a move. But the state would not be traveling down a new road. Michigan moved to a defined contribution system in the 1990s.
That same decade the United States federal government began offering a defined contribution plan. In fact, New Jersey already offers a defined contribution plan—the Alternative Benefit Plan. But it’s only available for state university faculty and administrative staff.
New Jersey must stop piling more people onto a pyramid scheme where the base is unsustainable, and future benefits are no longer a sure bet. The only way to do that is to move public sector employees to a defined contribution pension system.
The Senate’s unanimous vote last month is a huge step in the right direction: it admits that New Jersey has a problem. But the prescription is far from complete. In order to fundamentally address New Jersey’s pension system—and by extension the state’s entire fiscal regime—officials in Trenton will have to look towards more sweeping and more lasting changes.
Daniel M. Rothschild is the managing director for the State and Local Policy Project at the Mercatus Center at George Mason University. Eileen Norcross is a senior research fellow and research director for the State and Local Policy Project at the Mercatus Center at George Mason University.