Politicians May Cut Your Pension Benefits

Last Updated Jun 15, 2010 9:50 AM EDT

Most public employees like the concept of a pension because they believe the benefits are guaranteed. But there's a growing debate over what sort of benefits are guaranteed, and how much flexibility government entities have to change benefits. If you have a public pension, politicians may have more say over your retirement lifestyle than the financial markets do.

Here's the problem. Many public pension plans are underfunded. That means the plans currently don't have enough money to pay out the benefits promised to their employees.

How did we get here? For years, politicians have been increasing pension benefits for public employees without adequately increasing the contribution requirements. Times were good, markets were rising, and increasing pension benefits without increasing contributions was a nice way to keep a certain block of voters happy. This led to an eventual mismatch between what was going into the plans and what is supposed to come out of them.

But now the tables are turning. Politicians are realizing that governments may not have the money to meet all of these promised benefits and they're beginning to explore ways to adjust the payments. Recently, two states, Colorado and Minnesota, have taken steps to scale back public pension benefits. Initially, both states are looking to shrink pension benefits by reducing the cost of living benefit formulas. Expect to see similar actions from other states. You can also expect to see lots of lawsuits filed over whether this can be done. And it may take years to resolve these issues.

Why are politicians changing their tune? First, the global economy is forcing them to do so. I expect that if we never had the credit crisis, they'd still be increasing benefits without increasing contributions, and just kicking the problem down the road. But the credit crisis has caused governments to deal with some hard financial realities sooner rather than later.

Second, politicians are realizing that there are more voters who don't have public pension plans than who do have them. That means it'll be tough to solve the funding shortfall by asking taxpayers to foot the bill.

  • It's unlikely the average voter without a pension will be willing to pay more in taxes to guarantee the retirement benefits of government workers. Plus, more labor market data has come out indicating that the average government worker makes more than the average private sector worker for comparable positions. That's not good news if you're asking the worker who makes less to contribute to the benefits of the worker who makes more. Thus, politicians can't look to voters to solve this problem.
That means politicians need to go back to government workers for increased pension contributions, reduced benefits or some combination of the two. It's unfortunate that the system has come to these crossroads, but that's the reality of where we are.

If you're concerned about the long-term sustainability of your pension plan, there are a couple of things you can consider:

First, many public employers allow employees to also contribute a portion of their pay to their own retirement plans, such as a 401(k) or 457 plan. Building up your own nest egg will provide a good hedge against potential reductions in your pension benefits.

Second, depending on the terms of your pension plan, some employees have an opportunity to take an IRA rollover of their retirement benefits when they quit working. The rollover allows you to get control over the money and manage it as you see fit.

  • The lump-sum rollover option is a complex decision from both an investment and a tax standpoint, and you should consult your own advisor before making any pension choices. But if the option exists, it's probably a good idea to go through the numbers.
Bottom line: It's hard enough to deal with the risks in the financial markets. But political risks may be even harder to manage. Consider ways to get control over your money and build alternative sources of retirement money.

Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.