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Another Trillion Dollar Bailout?

Nicole Bullock and Hal Weitzman of the FT report, US state pensions becoming federal issue:

Illinois used to have a plan to pay off the gaping shortfall in the pension funds that pay retired teachers, university employees, state workers, judges and politicians, Dan Long recalls.

Mr Long, director of the Commission on Government Forecasting and Accountability, the non-partisan auditing arm of the Illinois state legislature, remembers that, back in 1994, the state laid out a proposal that would have paid off most of what was then a $17bn gap by 2011.

But Illinois could not stick to the plan.

With financial year 2011 less than six weeks away, the pension arrears of the 1990s look quaint. Instead of a balanced system, the state faces unfunded liabilities of about $78bn, the biggest pension hole in the US, and contributions of more than $4bn for 2011, the largest single element of its $13bn budget deficit.

Illinois is the poster child of unfunded pensions in the US. But state retirement systems could become a national concern, new research shows.

Joshua Rauh, associate professor of finance at the Kellogg School of Management at Northwestern University said that, without reform, some state pensions might run out within the decade. By 2030, as many as 31 states may not have the money to pay pensions. And, if these funds exhaust their assets, the size of payments for the benefits they have promised will be too large to cover through taxes, putting pressure on the federal government for a bail-out that could potentially cost more than $1,000bn, he says.

“It is more than a local problem,” Mr Rauh said. “The federal government could be on the hook.”

Estimates put the unfunded liabilities at between $1,000bn and $3,000bn after years of states promising benefits but not contributing enough in both good times and bad to cover them.

Many states base their calculations on an 8 per cent annual return and use an accounting method called smoothing, which staggers gains and losses over several years, two factors that some observers warn could mask the size of the shortfalls. The problem has come to the fore with the financial crisis and recession. Pension funds, like most money managers, suffered losses. The tax revenues that fund annual contributions to pensions, along with essential services such as healthcare and education, have plummeted, leaving little room to reimburse the losses.

States have begun reforms, with some lowering return expectations and raising employee contributions and retirement ages.

Mr Rauh said such measures were cosmetic and states needed comprehensive, federally sponsored reform that would require closing the systems to new members, shifting state workers to Social Security and individual plans similar to those that are used by the private sector in order to obtain incentives to borrow to bridge the gaps.

Mr Rauh said subsidising pension borrowing would cost a net $75bn with new contributions to the national Social Security programme offsetting some of the subsidies.

By his calculations, which assume the 8 per cent return, Illinois would run out by 2018 followed by Connecticut, New Jersey and Indiana in 2019. Some 20 states will have run out by 2025.

Five states would never run out, including New York and Florida, and 17 other states have a horizon of 2030 or beyond.

Robert Megna, New York’s budget director, said his state had had to make “tough choices” to keep funding its pensions despite budget shortfalls over the past few years. On March 31, the state made a nearly $1bn payment for the last fiscal year.

“We had to make cuts: education, healthcare, local government support and not-for-profit providers,” Mr Megna said of the last year’s budget process.

New York’s governor has proposed borrowing from the pension system, which is about 94 per cent funded, as the state did after the September 11 attacks, and repaying it with interest if low tax collections persist, Mr Megna said.

For fiscal 2010, Illinois sold $3.5bn of bonds to pay for its annual contribution.

But in an election year, there is no political support in Springfield, the capital of Illinois, for another bond issue, particularly since it requires a two-thirds majority in the state legislature.

The most likely outcome is that the state will defer the issue to next year. “That’ll have an impact in terms of lost investment opportunities, and they’ll have to sell some of the portfolio to pay the pensions,” said Mr Long.

David Graham of Newsweek's Gaggle asks, Will State Pension Funds Need a $1 Trillion Bailout?:

The federal government could face another economic disaster and massive bailouts within a decade if it doesn't force state pension funds to revamp their operations soon, an economist says.

Even if they meet "aggressive" 8 percent growth targets, several states will see the reserves in their pension funds dry up by the end of 2020, with many more running out of cash within another decade, says Joshua Rauh, an economist at Northwestern University's Kellogg School of Management. Broke states are likely to go begging to the federal government, which would probably have to bail them out to the tune of more than $1 trillion, he argues in a new paper. The funds are under legal obligation to pay out to state employees, and they're way behind. For example, New Jersey—one of the states in the most trouble—is chipping in only about 6 percent of what it needs to remain solvent.

"This is really a problem of promises having been made that cannot be met," Rauh says. "It's less demographics and more just that employees have been compensated using these promises, and these promises have not been adequately funded. Politicians have been able to promise benefits that don't come due until long after their political horizon, beyond their term [in office]."

If and when states run out of reserves, they'll have to dip into their annual budgets to pay out benefits. But most states are required by law to have balanced budgets, and pension benefits could equal up to half a state's annual revenues. To reach that mark, they'd have to make cuts as large as the brutal measures California is taking to balance its budget.

More likely, they'd ask for a bailout. Letting state governments fail just isn't really an option for the feds. Cash from Washington is already helping to float many states' budgets, but it's likely that state and local governments will be in for more pain over the next few years because their budgets tend to be a lagging indicator. Tax revenues typically slip more than a year after an economic shock, when property values sink and citizens pay taxes on diminshed incomes. Furthermore, the federal government already backs private companies' pension plans through the Pension Benefit Guaranty Corporation, but that fund is running large and growing deficits, and it would likely be forced to back states, as well.

Rauh suggests that the government instead offer tax incentives for states to reform their pensions' structures, moving from a system that promises set benefits in the future to a model of giving employees money to invest now, and putting public workers into Social Security. He calculates that the government would end up spending around $75 billion—a far cry from a $1 trillion bailout.

But is anyone listening? Rauh is presenting his paper today in Washington, D.C., but the most important audience might be his friend and former colleague Austan Goolsbee. Goolsbee is now a member of President Obama's Council of Economic Advisers, but both were professors at the University of Chicago's Booth School of Business until recently. Rauh decided to write the paper after discussing the looming pension problem with Goolsbee.

Rauh said: "He [Goolsbee] said, 'State and local problem,' and I convinced him that we do need to worry about it. So he said, 'OK, you convinced me. So what do we need to do about it?'"

I'm not sure how easy it is to shift public workers into Social Security, which has its own problems, but it's clear that these state pensions are living on borrowed time.

Here in Canada, the Canadian Federation of Independent Businesses (CFIB), came out on Tuesday saying public service pensions are too generous:

The Canadian Federation of Independent Business says the federal government is too generous in subsidizing public service pensions. The CFIB says federal civil servants only contribute 34 per cent of the cost of their pensions, compared with a target of 50 per cent for many provincial plans.

The CFIB says hard-working lower- and middle-class Canadians in the small business sector should not be subsidizing the generous retirements of public servants. Besides raising the pension contributions of federal workers, the federation says Ottawa should be offering incentives to help improve private-sector pensions.

You can read CFIB's statement, Unfair federal government pensions detract from small business retirement savings, and their report Securing the Future.

I've been talking about securing the future for a long time. Pensions are not a sexy topic, but they're increasingly becoming one as more and more people worry about securing a decent retirement.

One last point I do want to make is that everything is related. We can't talk seriously about securing the future without securing the integrity of our capital markets, making sure that all investors - not just large institutions - have a level playing field.

As I watch financial oligarchs get richer and richer while pensions get poorer and poorer, I worry that regulations have done little to protect average workers, and ultimately they will pay a heavy price for all the nonsense going on in our capital markets. Casino Capitalism is destroying the integrity of our capital markets, and left unhindered, it will ultimately destroy our pensions and economies.