Wednesday, March 2, 2011

Bill Gates Worried About Public Pensions?

Robert Guth and Michael Corkery of the WSJ report, Gates Says High Pension Costs Hurt Education:

Billionaire philanthropist Bill Gates will step into the national debate over state budgets Thursday with a call for states to rethink their public-employee benefits systems, which he says stifle funding for the nation's public schools.

Mr. Gates in an interview said he will use a high-profile conference Thursday in Long Beach, Calif., to urge that more attention be paid to how states calculate their employee-pension funding and health-care obligations. "These budgets are way out of whack," Mr. Gates said. "They've used accounting gimmicks and lot things that are truly extreme."

The comments come after Mr. Gates spent more than a year studying the issue and enlisting the advice of leading academics and others.

The talk will be at a meeting of leading thinkers called the TED conference. Mr. Gates will outline how, as he sees it, rising state health-care costs and flawed pension accounting hamper the ability of states to pay for education. He said he'd use California as an example to illustrate his point.

"I'm just very worried about the investments we make for kids' education and what that means for the future," he said. "It's going to take voters to really look at that." Without that, he said, "The default course—where the health care costs are squeezing out education — is quite bleak."

Dennis Van Roekel, president of the National Education Association, which has 3.2 million members, said U.S teachers have been trying to make up funding shortfalls by raising their contributions to their pension plans. He added that pensions are one of the reasons schools can attract quality teachers.

"People within public services know they are not going to make a high salary but they know that you have some semblance of retirement security," Mr. Van Roekel said in an interview.

As co-chair of the Bill & Melinda Gates foundation, Mr. Gates focuses most of his efforts on three areas: global health; overseas development; and U.S. education.

Yet he occasionally uses his stature in the service of other causes, and when he does, it's very deliberate. Two years ago, Mr. Gates used the same TED conference to outline his views on energy. That talk was the start of an increasingly higher profile by Mr. Gates in national discussion on the state of government investment into energy-related research and nuclear power. His involvement has stirred debate on streamlining the licensing process for U.S. nuclear-power facilities.

He said he is concerned that states' public employee-benefit costs could now stand in the way of broader changes. These include programs Mr. Gates's foundation backs that aspire to use technology (including cameras that monitor classrooms) and strengthened teacher evaluations to improve K-12 education.

"Those goals will never be met with the kinds of cuts that we're seeing right now" in education, he said.

One focus of Mr. Gates is public pension funds' use of a relatively high discount rate to calculate obligations. The discount rate is an assumed rate of return used to calculate the current value of a future liability.

The higher the rate, the smaller a fund's obligations appear—and the less that states need to contribute to their pension funds. Critics blame this accounting approach for contributing to state pension shortfalls, estimated nationwide to total more than $1 trillion.

Pension funds say their discount rates are prudent when considering investing returns over several decades.

Mr. Gates downplayed any suggestion that his view on pensions will court controversy. "The only position I'm taking you could call a political position is that I wish education spending can go up," he said.

Over two days last September, Mr. Gates hosted experts in state pensions and health care at his office near Seattle. Several of the participants continue to advise Mr. Gates.

Among the participants in the meetings were Jeremy Gold, an independent actuary, who argues that state and local government accounting methods understate the true size of pension liabilities; Robert Clark, a North Carolina State University professor who has written a book on the history of public pension funds in the U.S.; and Alicia Munnell, director of the Center for Retirement Research at Boston College, whose research has focused lately on the cost of state and local pension plans.

Along with his comments Thursday, Mr. Gates will unveil a new set of tools to his personal Web site, "The Gates Notes."The tools allow visitors to click through U.S. maps that show state-by-state the funding status for pension obligations and retiree health-care benefits.

There is also a feature on Mr. Gates's site that ranks how much each state spends on programs such as higher education and prisons, as a percent of its total budget. "A lot of society's resources go into state budgets and yet it has been made complicated enough and the accounting is bad enough that people haven't had a sense of what's going on," Mr. Gates says in a video on the Web site.

I applaud Bill Gates for bringing this issue out in the open and giving it the publicity it deserves. He's absolutely right that US public pension funds need to use a more realistic discount rate to gauge future pension obligations. It's silly to use a discount rate based on rosy investment projections (typically 8%) when interests rates are at historic lows. But the assumed discount rate isn't the only driver of pension shortfalls (see discussion below).

You should all go back and read the study released last February by The Pew Center on the States, The Trillion Dollar Gap. On page 23 there is a discussion on "the roots of the problem" where Pew examined four of the most significant: (1) the volatility of pension plan investments; (2) states falling behind in their payments; (3) ill-considered benefit increases; and (4) other structural issues. The study estimated $3 trillion in unfunded legacy liabilities from state-sponsored pension plans.

Another study ,“The Crisis in Local Government Pensions in the United States,” by Joshua Rauh of the Kellogg School and Robert Novy-Marx of the University of Rochester, estimated an additional $574 billion in unfunded liabilities from pension plans at the city and county levels:

“This new paper calculates the present value of local government employee pension liabilities for about two-thirds of total local government employees, and estimates the unfunded obligation for the remaining one-third of workers covered by municipal plans not in our sample,” said Rauh, associate professor of finance at the Kellogg School. “In total, we estimate that municipal plans in the U.S. are carrying $574 billion in off-balance-sheet debt in the form of unfunded pension obligations.”

In many cities, these unfunded promises will be a long-standing and substantial burden for municipal revenues. For example, even if all other spending was shut down, the city of Chicago would need to allocate about eight years of dedicated tax revenues to cover pension promises it has already made.

Six major cities have current pension assets that can only pay for promised benefits through 2020: Philadelphia, Boston, Chicago, Cincinnati, Jacksonville and St. Paul. An additional 18 cities and counties, including New York City, Detroit, Cook County in Illinois and Orange County in California would be solvent through 2020 but not past 2025.

“Philadelphia has the most immediate cause for concern, as the city can pay existing promises with existing assets only through 2015 — less than five years from now,” Rauh said.

Rauh and Novy-Marx estimate that each household already owes an average of $14,165 to current and former municipal public employees in the 50 cities and counties they studied, only including the unfunded portion of benefits that have already been promised based on work performed. In New York City, San Francisco, and Boston, the total is more than $30,000 per household. In Chicago, the total is more than $40,000 per household.

“The situation is especially dire for taxpayers in these areas,” Rauh said. “In addition to being exposed to the prospect of severe local government tax increases and spending cuts, they also will be called upon to pay for their share of the $3 trillion unfunded liabilities at the state level.”

According to Rauh, it is clear that state and local governments in the U.S. are not far from the point where these pension promises will impact their ability to operate. Once the funds themselves are liquidated, the extent to which promised pension payments are competing with other local resources will skyrocket, eroding a large portion of many municipal budgets.

“The fact that there is such a large burden of public employee pensions concentrated in urban metropolitan areas threatens the long-run economic viability of these cities, as residents can potentially move elsewhere to escape the situation,” he explained.

“What is yet to be seen is how this burden will be distributed between state and local governments, and whether the federal government will be called upon for bailouts. If these issues are left unresolved, fiscal crises on the state and local levels may translate into significant losses for municipal bondholders,” he concluded.

Professor Rauh recently testified before members of the U.S. House Judiciary Committee on the role of public employee pensions and the risk of state bankruptcy from these underfunded liabilities.“This hidden debt will eventually force states and localities to choose among the unpalatable options of cutting services, raising taxes, attempting to reduce benefits owed to public employees, defaulting on other obligations, or seeking a federal bailout,” Rauh testified.

But not everyone agrees with the findings of these studies. In early February, Kaitlin Meehan reported,
Pension experts disagree on how states should calculate unfunded pension liabilities:
Some experts peg the size of states’ unfunded pension liability at $3 trillion, while others value it at a much lower $700 billion. The discrepancy is due to different opinions on the appropriate rate of return on investments that states use to calculate their pension contributions.

One thing nearly everyone agrees on: There are dangerous policy implications for getting this figure wrong.
To calculate how much to contribute to the pension funds of public employees, states must assume a rate of return on their investments. Most states currently use a so-called “discount rate” of between 8 percent and 8.5 percent. Some experts say that’s too optimistic. They argue that states should be using a “riskless rate” that is a more conservative 4 percent to 5 percent.

The $3 trillion figure is calculated using the lower rate of return. Prominent advocates for the conservative approach include Joshua Rauh of Northwestern University and Robert Novy-Marx of the University of Rochester.

Novy-Marx said the discount rate is so named because states use the expected return on pension investments to lower the amount they pay in contributions to the fund. In other words, states calculate the amount they need to invest in pension funds based on an assumed 8 percent rate of return. This is irresponsible accounting, he argues.

“The way states do the accounting is that they think if they take a dollar out of the bank account and put it into the stock market, they somehow owe a dollar less,” Novy-Marx said. “That doesn’t make sense. Their debt is their debt.”

The riskless rate is so named because it eliminates the risk assumed by investing in a diversified market basket and uses a rate comparable to that on U.S. Treasury bonds. The rate of return on a 30-year Treasury bond was 4.6 percent as of Feb. 2.

Treasury bonds are considered safe investments because they are guaranteed by “the full faith and credit of the United States.” Likewise state pensions are usually guaranteed to retirees by a state’s constitution. The Illinois constitution, for example, calls its pension plans “an enforceable contractual relationship.”

“I’ve talked to lots and lots of people and the only people who think discounting liabilities by the expected return on assets is the right thing to do are pension actuaries,” Novy-Marx said. “No one in business would let you do this. No one in finance or economic academics would let you do this.”

However, others argue that overstated pension obligations could cause unnecessary policy changes to state budgets at a time when they are under extreme scrutiny.

Elizabeth McNichol, a state budget researcher with the Center on Budget and Policy Priorities, thinks the $3 trillion liability figure for the states is too high. According to her calculation, which uses an 8 percent return rate, the states’ pension liability is closer to $700 billion. Because public pension managers invest in more risky vehicles than Treasury bonds, they can reasonably expect a higher rate of return than 4 percent, McNichol said.

For example, the Teachers’ Retirement System, one of Illinois’ five public pension programs, currently has an 8.5 percent target rate of return. In 2010, the fund had a 12.8 percent rate of return after all fees had been subtracted, according to a TRS spokesman.

“I don’t think it makes sense to assume a rate that you’re not likely to get,” McNichol said. “This means states would think they have to put aside more money than they need to in order to have enough money to fund their pension commitments.”

The downside of overstating pension obligations is that states may be forced to cut spending to meet their actuarially required contributions.

In a Jan. 20 report that McNichol co-authored, she said excess payments into state pension funds take away money that would otherwise “support public services, resupply reserve funds, invest in infrastructure or return to taxpayers in the form of tax cuts.”

Bukola Bello, director of the Illinois Retirement Securities Initiative in Chicago, said she thinks the discount rate is a safe assumption for the Teachers' Retirement System, for example.

“The retirement systems are filled with experts and chief financial officers and trustees who take their fiduciary responsibility very seriously,” Bello said. “If they are comfortable with the rate of 8.5 percent, then we really need to trust those numbers.”

Novy-Marx said it is not a matter of meeting or missing return expectations, but a matter of the states being allowed to hide the actual size of their pension debt.

“This accounting is essentially letting states take on a lot of off-balance sheet debt,” he said. “States want to be able to do what the federal government does, which is run big deficits and the way they’re doing that is by borrowing from their pensioners.”

Illinois currently has $63.4 billion in unfunded pension liabilities, according to a Reuters report. Experts agree that it is not the rate at which public pension liabilities are calculated that has led to the Illinois’ major shortfall, but the fact that the state has underfunded its pension plans in recent years and had to borrow money meet its actuarial requirements. In fact, the state has plans to sell $3.7 billion of eight-year general obligation bonds this month to make contributions to its pension funds for the 2011 fiscal year.

“I think the general assembly really needs to concentrate on No. 1, making sure we meet our pension obligations again,” Bello said.
Illinois pension plans are severely underfunded and it concerns me that they decided to sell "general obligation bonds" to make contributions to pension funds for FY2011. Pension bonds are not a long-term fix for chronically underfunded state pension plans. Only meaningful pension reforms can address this issue which include changing the whole governance structure at state pension plans. Importantly, state pensions need more accountability, transparency and they need to properly compensate pension fund managers for delivering risk-adjusted returns.

As for Mr. Gates and the TED conference, I look forward to hearing the discussion. I got my own ideas on how the US and other developed nations should be addressing the pension crisis, but Mr. Gates is right to be concerned about how public pension costs will impact public education. No matter what discount rate you assume, the pension tsunami is coming and it will impact the prosperity of the United States and other countries for many years.


Please read Roberth Guth's follow-up report
Gates Calls for 'Clear and Honest' Accounting of State Budgets:
Billionaire Bill Gates on Thursday agitated for state governments to adopt "clear and honest" accounting of their budgets, saying states' true finances are being obscured from voters and threaten America's public-education system.

Speaking at a meeting here of leading thinkers known as the TED conference, Mr. Gates said that state budgets need more scrutiny and should follow more-transparent accounting principles, such as those used by Google Inc. and Microsoft Corp, which Mr. Gates co-founded.

"It's riddled with gimmicks," Mr. Gates said of the "tricks" states use to balance their budgets. Citing moves such as selling state assets and deferring payments, he said some methods are "so blatant and extreme," that "Enron would blush," referring to the energy company that collapsed a decade ago amid an accounting scandal.

The biggest concerns nationwide, he said, are the growing cost of state-funded health-care programs and public workers' health-care coverage, as well as the way states account for their pension funding. Those obligations threaten the ability to invest in education, Mr. Gates said.

"It is an increasingly difficult picture even assuming the economy does quite well," Mr. Gates said of the costs.

Through his philanthropy, the Bill & Melinda Gates Foundation, Mr. Gates is a major donor to educational programs in the U.S. including pilot projects to better measure the effectiveness of teachers. But while he has billions of dollars at his disposal, his wealth can't counter the effects of broader cuts to education funding.

Mr. Gates said states are stuck in a system that pays out vast amounts for early retirement, health care and pension obligations while education suffers as teachers are laid off, class sizes increase and tuition increases.

"It really is the young versus the old, to some degree," he said. "You're going to be de-investing in the young."

His comments were tinged with sarcasm as he outlined the tattered state of some state budgets. "The games they play to hide that actually obscures the topic so much people don't see what are really straightforward challenges," he said.

Again, I wish Mr. Gates or someone working with him would contact me so I can share my thoughts on this important subject.

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