Are Fully-Funded US Pensions Worth It?

John J. McTighe, Jim Baross and David A. Hall wrote an op-ed for The San Diego Union-Tribune, Why full funding of pensions is a waste of money:
Stark headlines have appeared over the past few years proclaiming that public pension plans in California are woefully underfunded and that basic services like police, parks and libraries may suffer as a result.

In fact, full funding of public pension plans isn’t necessary or even prudent for their healthy operation, according to a recent analysis by Tom Sgouros of the Haas Institute in Berkeley.

In the private sector, pension systems need to be 100 percent funded to protect the pensions of workers in case of bankruptcy. In the public sector, however, while governments may encounter periodic budget ups and downs due to economic cycles and fluctuating revenues, they are not going away. Public employees are hired and begin contributing to the pension system during their working lives. Their contributions help pay the benefits of retirees who worked before them. Once they retire, contributions from employees who replace them will help pay their retirement benefits, and so on, indefinitely.

Full funding of a public pension plan amounts to covering the total future benefits of all current workers. The Hass Institute analysis describes this as a waste of money because it equates to insuring against a city or county’s disappearance. According to the report, the real question of a pension plan’s fiscal viability is whether it can continue to pay its obligations each year, in perpetuity — not whether it can cover all future obligations immediately. This is why some fiscal credit rating agencies consider a 70-80 percent funded ratio adequate for public pension systems.

Imagine you sign a lease to rent an apartment for 12 months at $1,000 a month. Your ultimate obligation is $12,000, but should the landlord refuse to rent to you if you can’t show you have $12,000 available at the outset of the lease (100 percent funding)? No, the landlord simply wants assurance you can pay your rent each month.

If you’re a homeowner, you probably have a 30-year mortgage. Your mortgage allows you to own your home without fully funding the purchase. If, for example, you have a $300,000 home with a $150,000 mortgage, it might be said that your homeownership is at a 50 percent funded ratio. That’s not reckless; it’s prudent use of debt.

Each of these examples involves an ultimate obligation to pay off all the debt by a specific date. Public pensions are different in that the obligation is open ended, but so are the income sources.

Let’s consider a pension fund that has 70 percent of what it needs to pay all retirees decades in the future. During any given year, the pension fund must pay promised benefits to current retirees. Provided that annual contributions from the employer and current employees, combined with investment returns, are equal to benefit costs, the fund operates at break-even.

If at the end of the year the fund is at 70 percent, it’s a wash. The fund can go on indefinitely under these conditions. According to the Haas report, America’s public pension systems were, on average, 74 percent funded as of 2014.

There are two strong reasons not to move to 100 percent funding.

First, doing so would require significant, unnecessary expense to employees, employers and taxpayers.

Since public pensions can exist indefinitely at 70 percent or 80 percent funding, why not use those funds for more immediate needs?

There’s a larger concern, though.

Historically, when pensions in California approached 100 percent funding due to unusually high investment returns, policymakers reduced or skipped annual contributions, under the flawed assumption that high market returns were the new normal. They also increased benefits without providing adequate funding, again expecting investment returns would cover the cost. When investment returns returned to normal, these decisions had long-term negative consequences.

Some people speculate that future investment returns will be lower than past returns, requiring higher contributions from workers and taxpayers to sustain pension funds. In truth, no one knows.

The prudent course is to review returns each year and make gradual course corrections, as needed. That’s why independent auditors regularly evaluate and advise public pension funds on necessary course corrections.

So when you hear concerns about public pensions being underfunded, understand that ensuring 100 percent funding isn’t critical to the healthy functioning of a public pension system, and it can be very expensive.

Both the city and county of San Diego pensions systems are quite stable at a 70-80 percent funding ratio.

Wouldn’t the tax dollars required to get them to 100 percent funding be better spent on other needs — like police, parks and libraries?


McTighe is president of Retired Employees of San Diego County. Baross is president, City of San Diego Retired Employees’ Association. Hall is president, City of San Diego Retired Fire and Police Association.
Back in February, Ryan Cooper of The Week wrote an article on this, Public pensions are in better shape than you think:
The beleaguered condition of state and local pension plans is one of those ongoing disaster stories that crops up about once a week somewhere. The explanation usually goes something like this: Irresponsible politicians and greedy public employee unions created over-generous benefit schemes, leading to pension plans which aren't "fully-funded" and eventual fiscal crisis. That in turn necessitates benefit cuts, contribution hikes, or perhaps even abolishment of the pension scheme.

But a fascinating new paper from Tom Sgouros at UC Berkeley's Haas Institute makes a compelling argument that the crisis in public pensions is to a large degree the result of terrible accounting practices. (Stay with me, this is actually interesting.) He argues that the typical debate around public pensions revolves around accounting rules which were designed for the private sector — and their specific mechanics both overstate some dangers faced by public pensions and understate others.

To understand Sgouros' argument, it's perhaps best to start with what "fully-funded" means. This originally comes from the private sector, and it means that a pension plan has piled up enough assets to pay 100 percent of its existing obligations if the underlying business vanishes tomorrow. Thus if existing pensioners are estimated to collect $100 million in benefits before they die, but the fund only has $75 million, it has an "unfunded liability" of $25 million.

This approach makes reasonably good sense for a private company, because it really might go out of business and be liquidated at any moment, necessitating the pension fund to be spun off into a separate entity to make payouts to the former employees. But the Government Accounting Standards Board (GASB), a private group that sets standards for pension accounting, has applied this same logic to public pension funds as well, decreeing that they all should be 100 percent funded.

This makes far less sense for governments, because they are virtually never liquidated. Governments can and do suffer fiscal problems or even bankruptcy on occasion. But they are not businesses — you simply can't dissolve, say, Arkansas and sell its remaining assets to creditors because it's in financial difficulties. That gives governments a permanence and therefore a stability that private companies cannot possibly have.

The GASB insists that it only wants to set standards for measuring pension fund solvency. But its analytical framework has tremendous political influence. When people see "unfunded liability," they tend to assume that this is a direct hole in the pension funding scheme that will require some combination of benefit cuts or more funding. Governments across the nation have twisted themselves into knots trying to meet the 100-percent benchmark.

While all pensions have contributions coming in from workers, the permanence of those contributions is far more secure for public pensions. Plus, those contributions can be used to pay a substantial fraction of benefits.

Indeed, one could easily run a pension scheme on a pay-as-you-go basis, without any fund at all (this used be common). That might not be a perfect setup, since it wouldn't leave much room for error, but practically speaking, public pension funds can and do cruise along indefinitely only 70 percent or so funded.

This ties into a second objection: How misleading the calculation for future pension liabilities is.

A future pension liability is determined by calculating the "present value" of all future benefit payments, with a discount rate to account for inflation and interest rates. But this single number makes no distinction between liabilities that are due tomorrow, and those that are due gradually over, say, decades.

Fundamentally, a public pension is a method by which retirees are supported by current workers and financial returns, and one of its great strengths is its long time horizon and large pool of mutual supporters. It gives great leeway to muddle through problems that only crop up very slowly over time. If huge problems really will pile up, but only over 70 years, there is no reason to lose our minds now — small changes, regularly adjusted, will do the trick.

Finally, a 100-percent funding level — the supposed best possible state for a responsible pension manager — can actually be dangerous. It means that current contributions are not very necessary to pay benefits, sorely tempting politicians to cut back contributions or increase benefits. And because asset values tend to fluctuate a lot, this can leave pension funds seriously overextended if there is a market boom — creating the appearance of full funding — followed by a collapse. Numerous state and local public pensions were devastated by just this process during the dot-com and housing bubbles.

I have skipped past several more technical objections from Sgouros (whose paper is really worth reading). But the fundamental point here is fairly simple. Accounting conventions are supposed to help people think clearly about their financial health. But in the case of public pensions, they have warned of partly imaginary danger, pushing governments to stockpile vast asset hoards that are much larger than is necessary, and created a goal which is itself rather dangerous. The next time you see someone complaining about a pension funding shortfall, check the details carefully.
Let me begin by directing your attention to Tom Sgouros's paper, Funding Public Pensions, where he examines whether full pension funding is a misguided goal (click here to read it).

I too think this paper is well written and well worth reading as it raises many excellent points. First, public pensions are not private corporations and the solvency rules shouldn't be as onerous on them as they should be for companies which can go bankrupt.

In my last comment, I went over Boeing's huge pension gaffe, funding its pension with its company shares. Boeing has a funding ratio of 74 percent, which according to this study is no big deal if you're a public pension plan, but it's more concerning if you're a private corporation.

In June, I covered how GE botched its pension math and last month, I covered America's corporate pension disaster where I stated the following:
A few observations from me:
  • Pensions are all about matching assets and liabilities and since the duration of assets is much lower than the duration of liabilities, the decline in rates has disproportionately hurt private and public pensions because liabilities have grown a lot faster than assets.
  • Unlike public pensions which use an assumed rate-of-return of 7% or 8% to discount future liabilities, corporate pensions use a market rate based on corporate bond yields (see below). This effectively means that the way American corporations determine their future liabilities is a lot stricter and more realistic than the way US public pensions determine their liabilities.
  • Companies hate pensions. Instead of using money from corporate bonds to top up their pensions, they prefer using these proceeds to buy back shares, rewarding their investors and propping up executive compensation of their senior managers.
  • The pension crisis is deflationary and will only ensure low rates for a lot longer. Shifting out of defined-benefit plans into defined-contribution plans will only exacerbate pension poverty.
Now, let me thank Mathieu St-Jean, Absolute Return Manager at CN Investment Division, for bringing the top article to my attention. I commented on his LinkedIn post but lost it and there was a very nice actuary who corrected me, stating the discount rate corporate pensions use is A or AA, not AAA bond yields.

The point is that corporate pensions use a market rate, not some assumed rate-of-return based on rosy investment assumptions. Some argue this is way too stringent while others argue it is far more realistic and if US public pensions used this methodology, their pension deficits would be far worse than they already are.
In a more recent comment on how new math hit Minnesota's pensions and drastically impacted their funded status from just a year ago (from 80 percent to 53 percent), Bernard Dussault,  Canada's former Chief Actuary, shared this with me after reading that comment:
As you may already well know, my proposed financing policy for defined benefit (DB) pension plans holds that solvency valuations (i.e. assuming a rate of return based on interest only bearing investment vehicles as opposed to the return realistically expected on the concerned actual pension fund) are not appropriate because they unduly increase any emerging actuarial surplus or debt of a DB pension plan.

Nevertheless, while assuming a realistic rate of return as opposed to a solvency rate would decrease the concerned USA DB pension plans' released debts, any resulting surplus would not appear realistic to me if the assumed long-term real rate of return were higher than 4% for a plan providing indexed pensions.
I think Bernard is on the same page as Tom Sgouros, but he too raises concerns over the use of an inappropriate long-term real rate of return higher than 4%.

This week, I discussed US pension storms from nowhere, going over John Mauldin's dire warning on public pensions where I stated the following:
I have been covering America's public and private pension crisis for a long time. It's a disaster and John is right, it's only going to get worse and a lot of innocent public-sector workers and retirees and private-sector businesses are going to get hurt in the process.

But it's even worse than even John can imagine. With global deflation headed to the US, when the pension storm cometh, it will wreak havoc on public and private pensions for a decade or longer. At that point, it won't just be companies breaking the pension promise, everyone will be at risk.

Importantly, if my worst fears materialize, this isn't going to be like the 2008 crisis where you follow Warren Buffett who bought preferred shares of Goldman Sachs and Bank of America at the bottom, and everything comes roaring back to new highs in subsequent years.

When the next crisis hits, it will be Chinese water torture for years, a bear market even worse than 1973-74, one that will potentially drag on a lot longer than we can imagine.

This will be the death knell for many chronically underfunded US public and private pensions for two reasons:
  1. First, and most importantly, rates will plunge to new secular lows and remain ultra-low for years. Because the duration of pension liabilities is much bigger than the duration of assets, any decline in rates will disproportionately hurt pensions, especially chronically underfunded pensions.
  2. Second, a prolonged bear market will strike public and private assets too. Not only are pensions going to see pension deficits soar as rates plunge to new secular lows, they will see their assets shrink, a perfect double-whammy storm for pensions. 
No doubt, some pensions will be hit much harder than others, but all pensions will be hit.

This brings me to another point, how will policymakers address this crisis when it really hits them hard and they can't ignore it because pension costs overwhelm public budgets?

Well, Kentucky's public pensions may be finished but I am truly disheartened by the moronic, knee-jerk response. Tom Loftus of courier-journal reports, Kentucky pension crisis: Are 401(k) plans the solution?. I note the following passage:
Keith Brainard, research director for the National Association of State Retirement Administrators, said risk doesn't disappear under a 401(k) plan.

"These proposals shift that risk from the state and its public employers and taxpayers and put it all on the workers. In fact, there’s going to be more risk because they are no longer in a group that can manage the risk much better," he said.

Whether the moves actually will save the state money is a question being hotly debated.

Jason Bailey, executive director of the Kentucky Center for Economic Policy, of Berea, said, “Moving employees into 401(k)-type plans are actually more expensive … and harms retirees while making it much more difficult to attract and retain a skilled workforce.”
I will keep hammering the point that moving public sector employees to a 401(k) plan shifts retirement risk entirely onto employees, leaves them exposed to the vagaries of public markets, and ultimately many of them will succumb to pension poverty just like private sector employees with DC plans. Moreover, the long-term effects for the state of Kentucky are not good, they will raise social welfare costs and cut economic growth as more people retire with little to no savings.

Another point I need to make to the John Mauldins of this world, the pension crisis is deflationary. Period. I don't care if it's DB or DC pensions, a retirement crisis putting millions at risk for pension poverty will exacerbate rising inequality and necessarily impact aggregate demand and government revenues (collect fewer sales taxes).

Don't get me wrong, the US has a whole host of problems with their large public DB plans, and chief among them is lack of proper governance. Sure, states aren't topping them up, pensions still use rosy investment assumptions to discount future liabilities, but the biggest problem is government interference and their inability to attract and retain qualified investment staff to manage public and private assets internally.

On top of these issues, some decently-funded US pensions are getting hit with brutal changes to accounting rules. I recently discussed how this new math hit Minnesota's pensions but as other states adopt similar rules to discount future liabilities, get ready, they will get hit hard too.

This is why on top of good governance which separates public pensions from the government, I believe we need to introduce some form of risk-sharing in public pensions so when the plans do experience a deficit, contribution rates increase and/ or benefits are cut until the plan regains fully-funded status again.

In my recent conversation with Jim Leech on pensions and Canada's Infrastructure Bank, the former President and CEO of Ontario Teachers' shared this with me on how OTPP regained its fully-funded status:
Basically, there are two levers Ontario Teachers' Pension Plan uses when the plan goes into deficit to restore fully-funded status:
  • It partially or fully removes cost-of-living adjustments (conditional inflation protection) and
  • It raises the contribution rate from the base of 9% to an agreed upon rate (a special levy)
After the plan ran into deficits after the 2008 crisis, the contribution rate was increased to 13% and since it is a jointly sponsored plan, both teachers and the government needed to contribute this rate.

However, unlike 1997 where benefits were increased, now that the plan is fully-funded,  the new agreement is simply to restore full inflation protection and reduce the contribution rate back to the base case of 9% (can never go lower).

The key here is there are no increases in benefits, it's simply restoring full inflation protection and reducing the contribution rate going forward to the base rate of 9%.
Lastly, a dire warning to John Mauldin and residents of Dallas. All roads lead to Dallas. The great state of Texas will survive and rebuild after Hurricane Harvey but get ready for major increases in property taxes when the pension storm cometh and deflation hits the US.

And there will be no escape (to where? Illinois, New Jersey or Kentucky?!?). The pension storm will strike us when we least expect it and it will wreak havoc on the US and global economy for a very long time.
Now, I want to be careful here, the United States isn't Greece, it can print its reserve currency and in theory inflate its way out of debt or keep servicing its debt in perpetuity as long as long-term growth is decent.

But there are limits to debt and there are a lot of reasons to believe growth will be very subdued over the next decade, which means interest rates will remain at ultra-low levels for a very long time, especially if my worst fears of deflation hitting the US come true.

It's also worth noting that public pension liabilities are long-dated and unlike corporate pensions, there is no solvency threat to treat them the exact same way as their corporate counterparts.

Equally important to keep in mind that in the past when US public pensions reached fully-funded status, state and local governments stopped topping them out, took contribution holidays and increased benefits to buy votes just (like they did in Greece!!). This too exacerbated pension deficits which is why I would make contribution holidays illegal and enshrine it in the constitution.

There is plenty of pension blame to go around: governments not topping out pensions, unions who want to stick to rosy investment assumptions and refuse to share the risk of their plan, and huge myths on just how widespread the US public pension crisis truly is.

John Mauldin's warning on the pension storm is informative but he too perpetuates myths because he has a right-wing agenda in all his comments just like those union members above have a left-wing agenda in writing their comment.

Ironically, I'm probably more of an economic conservative than John Mauldin. I hate Prime Minister Justin Trudeau's new tax plan because it's dumb policy and hypocritical on his part but when it comes to health, education and pensions, I believe the federal government must offer the best solution in all three because it makes for good economic policy over the long run.

I've said this before and I will say this again, expanding and bolstering large, well-governed public pensions in Canada and elsewhere is good pension and economic policy over the long run.

Period. I don't care what John Mauldin or Joe and Jane Smith think, I know I'm right and the proof is in our Canadian pudding!

Now, let me get back to Tom Sgouros and the articles above because I'm not going to give them a free pass either. They're right, US public pensions can be 70 or 80 percent underfunded in perpetuity but funded status matters a lot and things can degenerate very quickly.

Importantly, when the funded status declines, governments and workers need to contribute more to shore up public pensions, and this will necessarily mean less money for other services.

Also worth noting rating agencies are increasingly targeting US public pensions, and as their credit rating declines, state borrowing costs go up.

There is something else that bothers me, apart from the fact that a lot of US public pensions would be chronically underfunded if they were using the discount rate Canada's large public pensions use to discount future liabilities, there are no stress tests performed on US public pensions to see just how solid they really are.

For example, the Federal Reserve stress tests banks but nobody is looking at the health of large US public pensions and what they can absorb in the form of a severe deflationary shock (to be fair, nobody is doing this in Canada or elsewhere either).

Now, let's say your US public pension is 70 percent funded, and a huge deflationary shock that lasts a very long time sends long bond yields to zero or even negative territory. I don't need to perform a stress test, I know all pensions will get clobbered but chronically underfunded and even "decently" funded pensions will be at risk of a death spiral they simply will never recover without huge increases in contributions along with huge haircuts in benefits.

"Come on Leo, over the very long run, pensions can withstand whatever the market throws at them, they have a very long investment horizon." True but some pensions are in much better shape than others to withstand financial shocks.

Last February, Hugh O'Reilly, CEO of OPSEU Pension Trust (OPTrust) and Jim Keohane, CEO of Healthcare of Ontario Pension Plan (HOOPP), wrote an op-ed, Looking for a better measure of a pension fund’s success, where they underscored the importance of a pension plan's funded status as the ultimate measure of success.

I can tell you without a doubt that HOOPP, OPTrust, Ontario Teachers' Pension Plan, OMERS and other large Canadian pensions will get hit too if another financial crisis hits us but they're in a much better position to absorb this shock because of their fully-funded status. Also, some of them (HOOPP and OTPP) have adopted a shared-risk model which means they can increase contributions and/or decrease benefits if their plan runs into trouble in the future.

I keep stating pensions are all about matching assets and liabilities but more importantly, they are about fulfilling a pension promise to allow plan beneficiaries to retire in dignity and security.

So, if you ask me, there is no doubt that the funded status of a public pension matters a lot. Maybe US public pensions can't attain the fully-funded status of their Canadian counterparts but there is a lot of room for improvement, especially on the governance front and adopting a shared-risk model.

Demographic pressures are hitting all pensions, we simply cannot afford to be complacent about the funded status of large public pensions or else we risk seeing Kentucky's pension problems all over the US.

No doubt, we need to be careful when looking at the US public pension crisis, not to overstate it, but it's equally irresponsible and dangerous if we understate it and think they're on the right path and their funded status is much ado about nothing.

In my last comment on Boeing's huge pension gaffe, I stated flat out:
It's high time the United States of America adopts a single payer healthcare system like Canada and the rest of the civilized world has done and privatize and enhance Social Security for all workers, adopting the Canadian governance model to make sure it's done well.
There will be tremendous opposition to these much-needed reforms from healthcare insurers, insurance companies, and mutual fund companies but it makes good economic sense to go through with them whether you're a Democrat, Republican or independent.

Below, an older clip where Tom Sgouros discusses the wealth flight myth (2011). He's obviously very bright and I agree with him on the wealth flight myth and think you should all take the time to read his paper, Funding Public Pensions, keeping my comments above in mind.

If you have anything to add, feel free to email me at and I will gladly post them in an update to this comment.

Update: Tom Sgouros was kind enough to share this with me after reading my comment:
"Thanks for the note and the kind words. I'm with you on the discipline question, by the way. I just think the current system of discipline -- which is mostly just about people yelling at the mayor if he makes a bad pension decision -- isn't working very well. Discipline isn't consequences a decade down the line. Discipline is having your checks to retirees bounce or your budget not balance in the very near term. The closer we can get to a system like that, the better off systems will be in the long term, in my opinion."
I thank him for sharing his feedback on this post.

Also, Jim Leech, the former President and CEO of Ontario Teachers' Pension Plan shared his thoughts on the second article at the top of this post:
This article has two fundamentally flawed assumptions:

1. It assumes that the public employer sponsor will never become insolvent/bankrupt ie taxpayers will always pay higher and higher taxes to fund pension promises - NOT. There is a practical limit to how much property, income and other taxes can be levied, public services cut and public infrastructure deteriorates before the economic viability of a municipality/state is destroyed and everyone leaves town.

2. As important, there is a serious intergenerational equity issue that is ignored. When a fund is in:
  • A. Balance - there is enough $ (comprising existing assets, future contributions and future earnings on the funds) to pay for past earned benefits and future benefits yet to be earned
  • B. Surplus - the current generation of retirees/employees/taxpayers have overpaid for the benefits (earned and to be earned)
  • C. Deficit - the current generation of retirees/employees/taxpayers have underpaid for the benefits; future generations of taxpayers/employees will have to pay more than the value of the benefits. ie the next generation is saddled with a debt for nothing. This is particularly troublesome as longevity increases, ratio of retirees to employees increases and workforces (plan members) shrink.

But the biggest "false news" is the example used (mortgage debt). Of course the bank does not require the borrower to have 100% of the principal and future interest payments in cash upfront. But the bank sure as heck wants some proof that the borrower can realistically meet the future payment stream (proof they ask for is: net worth statement, insurance, income verification, etc)

That is the same for the pension fund valuation. You need to show that net worth (assets on hand) plus future inflows (contributions and earnings on fund) are sufficient to meet the future payment stream.
I thank Jim for sharing his wise insights with my readers and highly recommend you read our recent discussion on pensions and the Canada Infrastructure Bank.

Suzanne Bishopric, the former CIO of the UN Pension Fund, echoed some of Jim's concerns in her comments which she shared with me:
The pay as you go system is likely to create intergenerational inequities because:
  1.  Demographic changes in recent years have meant the next generation is likely to be smaller (think of China and Finland), so a higher proportion of the tax revenue is required from one generation to the next, to cover the retirement benefits of retirees. Do we want to exploit our children this way?
  2.  Income generating opportunities are not uniformly distributed across time. One generation (think of Southern Europe today) may have higher unemployment rates and less stable working opportunities than did their parents' generation. If each generation sets aside money as they earn it, for example, via payroll deductions, they will support themselves without placing further burdens on the next generation. Our children should not have to be responsible for our generation, which has not left better opportunities for them.
  3. Market volatility being what it is, one generation could have the misfortune of needing funds to support their retirement right when the market has reached a nadir. This is an especially severe problem in the USA, where most retirement funds are segregated into small personally managed individual accounts. When combined with low interest rates, amateur expertise, lack of access to higher returning asset classes and limited scope for competitive pricing contribute to the underfunding of retirement assets.
I thank Suzanne for sharing her thoughts with my readers.