Saturday, July 10, 2010

No Garden-Variety Public Pension Crisis?

Andrew G. Biggs of the American Enterprise Institute writes, No Garden-Variety Public Pension Crisis (HT: Bill Tufts):

I've been thinking about New Jersey's troubled public pension funds lately, as part of collaboration with the Mercatus Center's Eileen Norcross for a new working paper on potential pension reforms in the Garden State. The June 25 New York Times mentioned our principal finding: using the accounting rules required for private-sector plans, which economists almost universally think are superior to current public-pension accounting, New Jersey's unfunded pension liabilities would rise from a reported level of $46 billion to around $170 billion.

But a recent discussion of the working paper with some New Jersey lawmakers raised a question we didn't investigate closely in the paper: When will New Jersey's pension funds run out of money? Our paper cited figures from Northwestern University's Joshua Rauh that New Jersey's funds could go under as soon as 2019, a figure at least one lawmaker found implausible. I found no reason to doubt Rauh’s figures, but being an inquisitive sort I offered to try replicating Rauh's numbers.

The short story is that a 2019 go-broke date for New Jersey pensions seems very reasonable. While Rauh assumed that funds earned an 8 percent return going forward, which is typical of most public plans' projections, New Jersey projects an 8.25 percent average return, which I adopted. Using this, New Jersey's funds would run out of gas in 2021. Given the uncertainties involved in these kinds of estimates, that's close enough for me.

But I tried to go one step further: New Jersey's public-sector plans, like pensions around the country, are investing in increasingly risky assets—first it was a shift toward stocks, from less than 40 percent of their total portfolios in 1990 to around 60 percent today, followed by moves into "alternative investments" such as hedge funds and private equity. New Jersey leads in this regard, with $11 billion of their $67 billion in total assets held in alternative investments. The point is that these investments are risky, yet public-sector pensions totally ignore this risk and the cost it imposes on taxpayers.

I simulated the risk of New Jersey's investments through a simple "Monte Carlo" simulation, where annual investment returns vary from year to year in a manner consistent with New Jersey's investments. I simulated New Jersey's pension investments 500 times this way; the chart above reports the results.

All the simulations begin with the $68 billion in assets that the New Jersey trust fund holds today. The bright red center line represents the median result of the simulation—that is, the distribution’s center. Other lines show the interquartile range (that is, from the 25th to 75th percentiles) and give the most likely range of outcomes, the 10th and 90th percentiles, and the 5th and 95th percentiles. These latter are the extreme ends of what might happen.

The median outcome of these simulations is fund insolvency in 2021. If returns are higher than projected, the fund could last longer—25 percent of the time projections show it lasting beyond 2023, 10 percent of the time it lasts beyond 2027, and there's a 5 percent chance of solvency through 2031. Of course, things could be worse than expected, as well: there's a 25 percent chance of the fund running out prior to 2019 and a 10 percent chance of insolvency by 2017.

New Jersey's lawmakers, led by Governor Chris Christie, are considering reforms to public pension funding and benefit rules. But they will need to go beyond the current proposals, the effects of which are limited. And time is running short.

And that's not just the case for New Jersey, but for states around the nation. Rauh projects that, in addition to the New Jersey, Illinois, Connecticut, and Indiana pensions that could run short before 2020, another 16 states could run out of funds by 2025.

I'm not feeling optimistic that states will get on top of this problem, so the key may be for investors and members of the public to think about which states they would live in, pay taxes to, or hold bonds belonging to, if they take seriously the need for state-level bailouts or defaults.

Mr. Biggs is well informed on the mounting problems state pension funds face. From 2008 to 2009 he served as principal deputy commissioner of the Social Security Administration and as secretary of the Social Security Board of Trustees. Biggs most recently questioned whether we should “Tax to the Max?” on Social Security and said, “Should We Raise Taxes on the Middle Class? We Already Are,” and “Are Government Workers Underpaid? No.” His other work includes a look at “The Market Value of Public-Sector Pension Deficits” and a forecast for the “Entitlement Apocalypse.”

Of course, Biggs is a resident scholar at the American Enterprise Institute, so we shouldn't be surprised with his "apocalyptic" scenarios. But he makes a valid point that using unrealistic and rosy investment projections forces funds to take increasingly higher risks to achieve their objectives and exposes them to serious downside risk.

I don't know when the day of reckoning will come, but we are on a major collision course and as long as the stock market keeps heading higher, nobody seems to be noticing. But this is long-term structural issue that won't go away, and will require some difficult political choices ahead (look at the UK & Greece). To think otherwise is highly irresponsible and just plain old wishful thinking.

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