Will Pension Gaps Spur a Tax Revolt?

Henry and Aaron of Yahoo Tech Ticker ask, This Is Progress? GM Loses $4.3B, Needs $12.3B to Fund Its Pension (see discussion below):

General Motors is out of bankruptcy but the troubled car giant still can't turn a profit. The company lost $4.3 billion in its first six months since emerging from bankruptcy. GM Chief Financial Officer Christopher P. Liddell is confident the road ahead will be smoother, saying "there's a chance of achieving profitability in 2010."

Let's hope so. The U.S. government owns 61% of the company.

GM is also struggling with its pension obligations; a large portion of GM's loss was due to a settlement with the United Workers Automobile Workers union over retiree health care liabilities.

According to a report by the Government Accountability Office, GM will need to add $12.3 billion into its pension fund by 2014. If GM and Chrysler (which is in the hole $2.6 billion) terminate their pensions, the Pension Benefit Guaranty Corporation – funded by, you know who - would then become responsible for as much as $14.5 billion in unfunded liabilities. However, if GM starts making money the company will be able to pay into the pension, the GAO reports.

Underfunded pensions are a widespread problem, not just for the private sector, as Henry and Aaron discuss in the accompanying clip.

The New York Times reports, an independent report of California's three big pension funds found a shortfall of more than half a trillion dollars. This could lead to a major political problems, especially when and if states raise taxes to bridge the gap. As Aaron points out, this could enrage taxpayers fed up with paying for government worker benefits at a time when the average government employee is making more than private sector workers and receives better benefits.

If you read the NYT article on the half-trillion pension gap, you get a sense of how public pension fund deficits will come back to haunt taxpayers:

An independent analysis of California’s three big pension funds has found a hidden shortfall of more than half a trillion dollars, several times the amount reported by the funds and more than six times the value of the state’s outstanding bonds.

The analysis was commissioned by Gov. Arnold Schwarzenegger, who has been pressing the State Legislature to focus on the rising cost of public pensions.

Graduate students at Stanford applied fair-value accounting principles to California’s pension funds, using a method recently devised by two economists working in Illinois, Joshua D. Rauh of Northwestern University and Robert Novy-Marx of the University of Chicago.

The Stanford group’s finding does not suggest that California has to come up with half a trillion dollars all at once; pensions are paid slowly over time. But the possibility that the state’s public pension funds are much deeper in the hole than reported could help explain why the required contributions to the funds have been rising every year, contributing to California’s annual budget drama.

The finding also raises vexing legal issues, because public debts in California are supposed to be approved by the voters. The voters have, in fact, duly authorized all of the state’s general obligation bonds, but the much larger pension debt is appearing out of nowhere.

The researchers offered six recommendations for closing the gap between what is owed to the state’s retirees and how much has been set aside, including less volatile investments and a revamped benefit structure.

Governor Schwarzenegger issued a statement on Monday, warning that unless state lawmakers tackled pension reform, “increasingly large portions of state funding for programs Californians hold dear, such as schools, parks and health care, will be diverted to pay for this debt.”

Mr. Schwarzenegger pointed out that he proposed pension initiatives a year ago, but lawmakers never followed through.

“We cannot wait any longer,” he said. “Without reform, pension debt will only grow.”

The Stanford project focused on California’s big state-run employees’ pension fund, known as Calpers; a second large fund for teachers, known as Calstrs, and the University of California Retirement System. The three funds serve more than 2.6 million public employees and retirees.

Smaller public pension funds in California, run by cities and some counties, were not included in the analysis.

Public pension funds in all states and cities normally report their financial status with numbers prepared by actuaries, who keep track of assets and liabilities while calculating required contributions every year. Increasingly, though, economists and other authorities say that the actuarial numbers give an unacceptably distorted picture.

That is because pension actuaries are trying to plan a budget of smooth, predictable contributions over the years, regardless of market volatility. Their job is not to provide a current financial picture.

Companies are no longer allowed to use actuarial numbers when reporting their pension values to the Securities and Exchange Commission. For governments, the board that issues accounting rules has been contemplating whether to change its pension standard, but while it deliberates, economists like Mr. Rauh and Mr. Novy-Marx are recalculating public pension numbers on their own.

The primary complaint about the method used by states and cities is how they gauge the value of the pensions they owe in the future in today’s dollars — a widely accepted financial calculation known as discounting.

Currently, governments discount pension values by using the return they expect their pension investments to earn over the long term. For most public pension funds, that means about 8 percent. In California, the teachers’ fund uses 8 percent, Calpers uses 7.75 percent, and the University fund uses 7.5 percent.

The Stanford team found fault with that approach. The researchers wrote that in today’s economic climate, such rates are associated with more speculative securities that carry some degree of risk, like those of emerging markets. Pensions, by contrast, are constitutionally protected and therefore the payments to public employees and retirees should carry almost no risk.

After the researchers applied a risk-free rate of 4.14 percent, equivalent to the yield on a 10-year Treasury note, the present value of the promised benefits ballooned. The researchers came up with a $425 billion shortfall for the three funds.

As of July 1, 2008, the funds officially reported they were $55 billion short. They have not issued financial statements since then, but have said informally that they lost a total of $110 billion.

The researchers concluded that their estimate of the gap would also have grown by roughly $110 billion, to more than half a trillion, today. Their full report is expected to be released this week on the Stanford Institute for Economic Policy Research Web site.

Calpers challenged the research, saying it was “out of sync with governmental accounting rules and actuarial standards of practice.”

I noted that smaller public pension funds in California, run by cities and some counties, were not included in the SIEPR analysis. Most of these smaller plans are a total disaster, so the gap is likely a lot bigger than half a trillion dollars.

But wait, isn't all this talk of pension deficits and pension crisis just exaggerated scare mongering by conservative governments who want to curb public deficits? Is there an agenda by capitalists to weaken labor further?

Not necessarily. There are reasons to fear that public pension deficits will get much worse in the next decade. Moreover, Attorney General Andrew Cuomo recently launched an investigation on pension padding where state employees manipulated salaries and overtime payments to inflate pensions.

If state governments ever do resort to higher taxes to bridge the pension gap, many people who worked in the private sector and saw their retirement dreams evaporate will demand curbing these public sector pensions. If you think this is never going to happen, think again.

Of course, public sector workers and teachers will not just sit idly by. Just look at what is going on in the UK where teachers are threatening to strike alongside public sector unions after the general election in opposition to pay freezes and pension cuts.

It's a huge mess, akin to watching a slow motion train wreck and when it comes home to roost, there will be a tax revolt and strikes from public sector workers. I hope I'm wrong, but praying for private and public markets to bail us out of this mess is a fool's paradise.