In 1972, NBC News aired a long-form investigation titled “Pensions: The Broken Promise,” which highlighted the many ways in which traditional “defined benefit” (DB) pensions – now held out by some as the gold standard of retirement savings vehicles – had let down workers and retirees. Plans were allowed to set strict vesting requirements, which made more difficult for employees to collect retirement benefits. A Congressional analysis found that 92% of employees who participated in a traditional pension failed to receive a benefit when they retired. Funding rules for pensions were also lax, putting workers’ benefits at risk if their employer went out of business.

The prototypical case was the Studebaker auto company’s plant in South Bend, Indiana, which closed in 1963. Though Studebaker itself was not bankrupt, the company shut down the plant’s pension plan, which covered roughly 10,500 plant workers and retirees. While retired workers continued to receive their full benefits after the plan was shut down, employees aged 40 to 59 received just 15 cents for each dollar of benefits they were owed, despite averaging over 20 years on the job. Employees who had less than 10 years of service received nothing.

In response to cases like Studebaker, Congress in 1974 passed the Employee Retirement Income Security Act (ERISA). ERISA made benefit vesting rules more reasonable and tightened funding standards. In short, employers could no longer promise employees pensions without funding them and while denying benefits to many workers. ERISA also established the Pension Benefit Guaranty Corporation (PBGC). In exchange for premiums paid by employers, the PGBC provided employees with protection against benefit cuts, up to a limit, if a pension became insolvent. For 2020, the PBGC guarantees the first $69,750 of annual pension benefits for individuals who retired at age 65.

ERISA set a basic standard: do it right or don’t do it at all. If an employer wished to sponsor a DB pension, it needed to offer benefits employees could actually qualify for and then fund those benefits to ensure they could be paid. If the employer couldn’t or wouldn’t follow those standards, it could instead offer a 401(k) plan. And many employers in fact chose to switch to defined contribution plans. But the DB pensions that remain in the private sector are generally well-funded. Going into the Covid-19 downturn, corporate pensions in January 2020 were on average 85% funded assuming a low 2.85% interest rate.

But at the time ERISA was passed, state and local government pensions were exempted from regulation. While some had discussed including state and local government plans in ERISA, at the time excluding governmental plans may have seemed reasonable. Regulation of private pensions was seen as necessary because, while employers may run pensions on behalf of their employees, employers and employees sometimes have different goals and different incentives. As a result, private firms may not always keep employees best interests at heart, such as by not fully funding a retirement plan. But government is often seen as a model employers that, lacking a profit motive, would act on behalf of its employees. Moreover, at the time, pensions were a small portion of government budgets: in 1972, pension benefit payments were equal to only 3.6% of state and local government budgets. Finally, half a century ago Americans had different views of the relationship between the federal government and state and local governments, such that federal regulation of pensions offered and run by the states may have been seen as improper. All-in, the benefits of regulation state and local government pensions probably just weren’t seen as worth the political effort.

Nearly five decades later, things are different. State and local government pensions are three times larger as a share of government budgets today as they were in 1972, with rising pension costs putting pressure on resources for education, public safety, health and infrastructure. A major market downturn has reverberating impacts throughout public budgets, due to the need to make up for pension investment losses.

Worse, state and local government have not turned out to be the model employers one might have supposed at the time of ERISA. Governments have used overoptimistic investment return assumptions, taken excessive investment risk, and often failed to make their full annual contributions. Pension trustees often have not acted as true fiduciaries on behalf of pension participants, collaborating with government officials – often the very people who appointed them – to reduce current contribution costs, even if doing so left fewer resources available to pay future pension benefits.

In the face of rising public pension underfunding, some governments have increased benefit vesting requirements as way to prevent short-career employees from qualifying for benefits. A teacher in Connecticut or Massachusetts, for instance, who left her job just short of ten years would have accrued neither a state pension benefit nor Social Security benefits. Public pensions have taken excessive investment risk, so much that the President of the Society of Actuaries scolded “public sector plans [for] making choices about risk taking that go against basic risk management principles.” Moreover, the constitutional arguments against federal regulation of state and local government pensions today seem quaint. The federal government regulates state and local government labor practices in myriad way: federal rules dictate minimum wages, working conditions, the provision of health care insurance and other actions that state and local governments undertake as employers. It is no stretch to believe that federal regulation of state and local government pensions would be constitutional.

All of these problems with public employee pensions have existed for years. And all of them speak against the decision not to include state and local government plans under ERISA’s regulation of employee pensions. Perhaps policymakers could not have known at the time, but in 2020 the substantive case for allowing state and local government pensions to be effectively self-regulated is weak indeed.

Today, public sector pensions face more pressing problems. The COVID-19 pandemic has both hit pension investments and, perhaps more crucially, undermined the tax revenues state and local governments must use to make up for those investment losses. Before the crisis, Truth in Accounting found that the states had set aside only 66 cents to pay each dollar of promised benefits, with Illinois having only 39 cents and New Jersey having only 34 cents. Worse, the Center for Retirement Research at Boston College projects that seven major public pension plans could exhaust their assets by 2028, forcing governments to maintain benefit payments on a “pay-as-you-go” basis that would generally be substantially higher than the payments governments are making – or cannot even afford to make – today. Looking at the full universe of public plans, the Center for Retirement Research projected that average annual government contributions will rise from 19.7 percent of employee wages today to 29.1 percent of pay in 2025. Back in 2001, the average employer contribution was only around seven percent of pay. It is highly likely that the most fiscally-stressed state and local governments will fail to make their full pension contributions this year – or perhaps any pension contribution at all – which is the only way for plans to maintain funding amidst low interest rates and unstable stock market returns.

Over the last two decades, pension benefits have generated a fundamental change in the costs and composition of public employee compensation, one that many governments are ill-prepared to handle. Indeed, in a April 14 letter to Illinois’s U.S. Congressional delegation, the president of the state senate requested $10 billion in federal money to bail out the state’s underfunded public pensions.

What then? If Illinois formally requested federal assistance for its pensions – a request that surely would be followed by New Jersey, Kentucky, Connecticut and other fiscally-stretched states – how should the federal government respond?

The most tempting answer, and one that would hardly be unjustifiable, is “Forget about it.” COVID may have been unforeseen, but state and local government pension funding problems have been brewing for ages, the result of decades of bad stewardship and denial of financial and fiscal realities. Just as a poorly-managed private firm must face bankruptcy, there is nothing inherently wrong with a poorly-managed state or city also doing so. And just as private investors lose money, municipal bond holders in an insolvent state would take a substantial financial hit. And that market discipline might cause municipal bond markets to pay closer attention to public pension funding and general fiscal health, using interest rates as a way to reward well-run governments and punish malefactors. Congress would need to pass legislation to set up a bankruptcy process for states, but that’s possible: in 2016 Congress passed legislation establishing a bankruptcy-like process for Puerto Rico, a U.S. commonwealth of three million residents that defaulted on its debt in that year. More recently, Senate Majority Leader Mitch McConnell has spoken approvingly of establishing bankruptcy procedures for states.

But it is the Puerto Rico experience that causes at least some pause with letting states fall into insolvency. After four years, the island still has not resolved its bankruptcy, amidst ongoing trench warfare between a reform-minded oversight board – of which one author is a member – and a succession of governors concerned more with their own re-elections than with resolving the government’s financial problems and establishing fertile ground for economic growth. During this time the economy has weakened and outmigration has continued. The burden on federal means-tested welfare programs such as Medicaid and Food Stamps has increased. In short, allowing governmental bad actors to go insolvent is surely not unjust, but it also is not a panacea for states’ financial problems.

For that reason, a pensions-only approach might make sense. To the degree a state’s pension plan is what drives it toward insolvency, addressing pensions separately before things fall apart might avert a larger economic catastrophe. We propose, at least for discussion purposes, that if a state requests and receives federal aid for pension funding, then the state must agree to bring that public pension under federal regulation that was qualitatively similar to what private pensions work under.

Obviously federal pension assistance would be seen as a “bail out,” and perhaps rightly so. But no one should pretend that a bailout isn’t otherwise possible. During the 2008 crisis banks were deemed “too big to fail.” Would states with millions of residents be seen differently? In addition, most Congressional Democrats – and a few Congressional Republicans – currently favor a bailout of so-called “multi-employer pensions,” which are union-run plans that serve employees across industries such as trucking and mining. If Congress will bail out truckers and miners, what are the chances they won’t propose the same for school teachers?

But unlike the proposed bailout of multiemployer pensions and the bailouts of the banks, our proposal has a flip side: much stricter funding rules and greater flexibility for pension sponsors. In return for financial assistance, states would need to demonstrate a plan to fund their pensions under the stricter federal rules that apply to private sector pensions. That means assuming much more prudent returns on pension investments and addressing any unfunded liabilities much more quickly. It’s those rules that make private sector pensions so much better-funded than state and local plans.

But there’s a second part as well. ERISA sets rules that private pensions sponsors must live by. But it also gives employers who can’t live by these rules other options, in particular the option to sponsor a defined contribution 401(k) plan. For some private sector employers a defined benefit pension still makes sense, and those plans are by and large well-funded. But for many other employers a 401(k) is the better option and ERISA sets rules for running those plans.

Many state governments effectively don’t have those options. State constitutions and legal interpretations often state that, from the very first day an employee sets foot on the job, the terms of his pension cannot be changed. These rules make it very hard for states like Illinois or California to reform their plans, since even eliminating all retirement benefits for newly-hired employees would take decades to put a dent in their costs. In the private sector, by contrast, ERISA rightly forbids employers from taking back pension benefits that employees already have earned, but allows flexibility in changing the rate at which employees earn future benefits. As with any other form of employee compensation, private-sector employers may strike a balance between pensions that are too costly for them to afford and pensions that are insufficient to attract and retain the employees they need. It is bizarre that states assume much stronger pension protections than ERISA explicitly states for private sector employees, since ERISA strengthened pension protections for private sector workers.

Since federal law pre-empts state laws, a state government plan that were made subject to ERISA would not only have stricter funding rules but also greater flexibility to change the plan if elected officials decided that the existing benefit formula was unaffordable. Again, benefits already earned by employees could not be taken away, but the states would gain flexibility in setting the rate at which employees earn future benefits.

Put in simple terms, in exchange for near-term financial assistance, states would accept the same deal that federal law requires of private sector employers: Run your pensions right or don’t run them at all. If a state choses to continue running a defined benefit pension plan, it must do so using more prudent funding rules and more rapid repayment of unfunded liabilities. If the state can’t run a traditional pension on those terms, federal law would give the state the leeway to shift its employees to defined contribution retirement plans. That may be a better option than waiting for states to declare bankruptcy.

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