Monday, March 22, 2010

Pension Woes May Deepen Financial Crisis

Global pension tension is on the rise again:
But it's in the US where pension tension is really on the rise. Andrew Biggs of the American Enterprise Institute reports in the WSJ, Public Pension Deficits Are Worse Than You Think:

Pension plans for state government employees today report they are underfunded by $450 billion, according to a recent report from the Pew Charitable Trusts. But this vastly underestimates the true shortfall, because public pension accounting wrongly assumes that plans can earn high investment returns without risk. My research indicates that overall underfunding tops $3 trillion.

The problem is fundamental: According to accounting rules adopted by the states, a public sector pension plan may call itself "fully funded" even if there is a better-than-even chance it will be unable to meet its obligations. When that happens, the taxpayer is on the hook. Yet public pension plans ignore market risk even as they shift into risky foreign investments, hedge funds and private equity.

A simple example illustrates the flaw. Imagine that you borrowed $100, which you absolutely, positively must repay in 20 years. How much money would you need today to consider that debt "fully funded?"

Here are two correct answers, followed by an incorrect one. All three rely on "discounting," a method of calculating the sum of money needed today to fund a given liability in the future.

First, discount $100 at the 4.5% yield on safe, 20-year Treasury notes. This produces a present value of $41.46, which you invest in Treasury securities. Barring federal government bankruptcy, you can repay your debt with certainty.

Second, discount $100 at the expected return on stocks—say 8%. This produces a present value of $21.45, which you invest in equities. Next, purchase a "put option" giving you the right to sell your portfolio 20 years hence for no less than $100. This option would cost $20.08, for a total cost today of $41.53. Barring the collapse of the options exchange, you also can be certain of repaying your debt.

But here is a third answer: discount $100 at an 8% interest rate. Invest $21.45 in stocks. Declare yourself "fully funded." This doesn't work because there's a very good chance your risky assets won't appreciate in value enough to cover the debt. Yet this is how public sector pension accounting operates.

Vested pension benefits are constitutionally guaranteed in eight states and protected by law in two dozen more. And in most every state politics makes accrued benefits impossible to cut. Orange County, Calif., in the 1980s and New York City in the 1970s effectively made pension obligations senior to government debt by paying full retirement benefits even as they inflicted losses on bondholders.

Yet public pensions discount ironclad liabilities at the high rates of return they project for risky investment portfolios. Consider New York state's Employees Retirement System (ERS), which assumes an 8% return on its assets. Discounted at this interest rate, ERS's liabilities had a present value of $141 billion as of 2008. ERS assets at that time were $152 billion, making the program overfunded by 7%.

But New York's portfolio is hardly likely to produce a steady 8% each year. Since 1990 its returns have varied widely, ranging from 30.4% in 1998 to -26.4% in 2009. A "Monte Carlo" computer simulation (a standard technique for modeling financial risks) incorporating fluctuating asset returns shows that New York's ERS has only around a 45% probability of meeting its liabilities. Instead of an $11 billion surplus, the ERS is almost $100 billion shy of funding its benefits with certainty.

In a recent AEI working paper I've shown that the typical state employee public pension plan has only a 16% chance of solvency. More public pensions have a zero probability of solvency than have a probability in excess of 50%. When public pension assets fall short, taxpayers are legally obligated to make up the difference. The market value of this contingent liability exceeds $3 trillion.

Public pension plans are hiding behind unrealistically low deficit figures. This allows policy makers to dodge difficult choices today at the cost of a much heavier burden on taxpayers in the future.

There is no question in my mind that public pension funds are deluding themselves if they think they will make up the shortfall by investing more in hedge funds and private equity, or by leveraging up their bond portfolio.

In his state of the state speech earlier this year, Gov. Arnold Schwarzenegger said California is "about to get run over by a locomotive." Schwarzenegger was talking about the future costs of funding pensions for public employees. Currently, the tab is running at more than $3 billion a year at a time when California is trying to close a $20 billion deficit, fueling growing anxiety as the shortfall is plaguing pensions.

On Monday, New Jersey Gov. Chris Christie signed three bills designed to save taxpayers billions by making pensions and health benefits for government workers less generous. Still, the state pension plan is woefully underfunded and these measures are like band-aids on a metastasized tumor. Moreover, nothing was done to shore up the governance of the plan (don't forget that governance matters!).

Finally, Tamara Keith of NPR reports, Pension Woes May Deepen Financial Crisis For States:

There's a looming U.S. financial problem that's big, is getting larger and could threaten the solvency of some states. From Connecticut to California, pension funds for teachers, firefighters and other public employees are severely underfunded.

"Generally, they're in an abominable state," says Joshua Rauh, an associate professor of finance at the Kellogg School of Management at Northwestern University.

A recent report from the Pew Center on the States put the tab for unfunded pension liabilities at $452 billion. But Rauh and others say pension funds are using unrealistic assumptions about investment returns, meaning the pension funding hole is likely much deeper.

"Our calculation is that it's more like $3 trillion underfunded," Rauh says.

And the kicker is that taxpayers are on the hook.

Stuck With The Bill

"People say, 'Well that's ridiculous. We're just not going to pay it. Let [the pension funds] go broke,' " says Robert Gentzel, policy director for the Pennsylvania State Employees' Retirement System. "That's not what would happen. The taxpayers are ultimately going to have to pay the bill."

That's because public employee pension funds are backed by the full faith and credit of the government. Over the past several decades, many states and local governments made pension promises that will be expensive to keep. Now, they're struggling to fund their obligations.

Take Cranston, R.I.

"Right now, the unfunded liability is $240 million," Cranston Mayor Allan Fung told NPR's Jim Zarroli. That's more than double the city's annual budget.

Fung added, "It's a big obligation, and it's basically a ticking time bomb for the city of Cranston that we are trying to get a handle on."

Underfunding Becomes Next Generation's Problem

The Pew report found state pension obligations nationwide were 84 percent funded. That doesn't sound so bad, but that figure does not include the full impact of the 2008-2009 market collapse, which hit pension funds hard.

Disappointing returns isn't the only funding challenge pension funds face. Many local and state governments haven't been putting enough money into the funds. When budgets are tight, shorting pension funds is a lot more politically palatable than raising taxes or having to make painful cuts.

"Underfunding is very easy because all you're doing is making this the next generation's problem," says Rick Dreyfuss of the free market-oriented Commonwealth Foundation in Harrisburg, Pa. "The next generation doesn't understand the magnitude of this, and they're too young to vote, so there's not a lot of political opposition to that."

Dreyfuss says there's a high political rate of return for increasing benefits, and there's basically no political upside to actually paying for those benefits.

Playing Catch Up

This table shows how many years it would take for each state to make good on its pension promises if it spent all its tax revenue on pensions -- and nothing else.

StatePlans analyzedAssets (in billions)Years to catch up
Ohio5$115.68.7
Colorado129.38.3
Rhode Island16.07.7
Illinois465.77.2
Alabama322.36.4
Wisconsin162.26.3
South Dakota16.06.0
Missouri327.05.8
Mississippi315.15.7
Oregon146.15.7
New Mexico216.25.5
South Carolina221.85.4
Kentucky321.65.4
Oklahoma412.05.2
New Jersey460.55.0
Arizona325.04.9
Connecticut320.44.7
Texas4125.34.7
Georgia253.74.6
New Hampshire14.44.5
Maine18.34.4
Nevada117.84.2
Minnesota436.24.2
California3330.04.2
Montana25.94.1
Arkansas38.14.1
Louisiana217.74.0
Maryland127.84.0
Hawaii18.33.9
Pennsylvania270.93.9
Iowa118.13.7
Kansas110.33.7
Wyoming44.83.7
Alaska211.73.7
Idaho18.13.6
Utah318.63.4
Indiana215.53.4
Florida197.23.3
Washington744.33.2
Virginia141.33.2
Michigan443.43.1
Massachusetts237.82.9
Tennessee125.82.8
West Virginia26.62.7
New York3189.82.6
North Carolina259.12.6
Nebraska25.42.1
North Dakota22.92.1
Delaware16.22.0
Vermont32.41.7

Notes:

Pension assets are taken from Pensions and Investments for September 2008 and projected forward to December 2008 using asset allocation data and realized asset class investment returns. Tax revenue data used to calculate the years of tax revenue each state would need to devote to pension funding to catch up on its pension promises is based on 2007 data from the U.S. Census Bureau Census of Governments. Pension assets and liabilities are aggregated to the state level.

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