Cate Long, the MuniLand blogger from Reuters, wrote a blog post yesterday that misses the entire point about pensions and spreads gross misunderstanding about the cost of pension promises to taxpayers. The risky assets that pension funds invest in and the returns they have achieved historically have nothing to do with the cost of making these promises. The reason pension promises should be discounted at a default-free rate such as the Treasury rate is that governments are telling public employees that they will get their pensions no matter what happens to the pension funds’ risky investments in stocks and alternative assets.
Certainly if Ms. Long wants to credit state and local governments for their option to default on these promises in the event that asset returns are poor, then a higher discount rate than a default-free rate could be used. But then the contracts with public employees should specify that in fact they may only be paid a fraction of what they are owed and the discount rates should be motivated accordingly, not with historical asset returns.
For deeper analysis, I would refer readers to my paper The Liabilities and Risks of State-Sponsored Pension Plans with Robert Novy-Marx and my Congressional testimony of February 2011.
Finally, the piece by Ms. Long also refers to a statistic that approximately three percent of state and local government spending is used to fund pension benefits for employees of state and local governments. As I have blogged about before, this is very misleading. First, many governments are not making contributions they ought to be even under their own accounting. Under correct default-free measures essentially no government is contributing enough to claim they are truly paying pension costs. Second, the figure cited as a fraction of spending, not revenues. Since states are running deficits, as a share of revenues, pension contributions are higher. Finally, the denominator includes the hundreds of billions of state and local revenues that are direct transfers from the federal government. The right question is not how much is being paid now, but how much would have to be paid in order to claim that states are balancing their budgets. That figure is substantially higher, and amounts to 14% of total revenue excluding federal transfers and 23% of tax revenues.
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Thank you! And cost of pensions does not include payments on any bonds issued over the years to “fully fund” pension plans. Nor does it include false promises of retirement health benefits. Anyone who believes any current pension “reform” efforts will do much to decrease pension costs is ignoring the fact that none of the reform efforts have significant impact on existing unfunded liabilities. In fact, reform efforts may actually end up doing more harm in the long run.
http://www.statebudgetsolutions.org/blog/detail/tale-of-2-states-exposes-danger-of-false-reform-in-public-pension-crisis
Frank’s statement that “[anyone who believes any current pension “reform” efforts will do much to decrease pension costs is ignoring the fact that none of the reform efforts have significant impact on existing unfunded liabilities,” is patently and demonstrably false. Reforms made since 2010 in Colorado, Maine, Minnesota, New Jersey, Oklahoma, and South Dakota all have significantly reduced unfunded pension liabilities and costs.
Assumptions and projections about what will happen in the future are fair debate, but you can’t make up your own facts.
Let’s talk about spreading “gross misunderstanding.” In Joshua Rauh’s paper, “Are State Public Pensions Sustainable?,” in which he predicts widespread, near-term pension fund insolvencies, he assumes future contributions “will be sufficient to fully fund newly accrued or recognized benefits … but no more.” This assumption is key to his dramatic projections, but ignores the fact that plans in many states are constitutionally or statutorily required to pay down unfunded liabilities (the portion of accrued benefits that have not yet been advance-funded).
Mr. Rauh’s assumption about future contributions is also unsupported by past and current practice. Most public plans have been receiving contributions that not only are enough to cover newly accrued benefits, but also help pay off the cost of benefits accrued in the past. In fact, from FY 01 to FY 10, on average, pension plan sponsors paid around 90 percent of their required contributions.
Mr. Rauh’s analysis also does not account for the manifold changes that have been made and undoubtedly will continue to be made to improve the long-term sustainability of state and local government pension plans. More than 40 states have made meaningful changes to their pension plans since 2009, a fact ignored by Mr. Rauh in making his dramatic projections.
Likewise, to arrive at his similarly dramatic findings in his paper, “The Revenue Demands of Public Employee Pension Promises,” that every household in the nation will face significantly higher taxes to pay for the cost of public employee pensions, Mr. Rauh relies on series of specious assumptions. For example, he assumes a real rate of pension fund investment returns of 1.71 percent, well below both historic norms and what is projected by credible investment experts. His assumed level of future economic growth is also well below consensus projections. Also, his analysis limits the options available to states and local governments and ignores a range of other options, options that are being employed by states and cities, such as reduced hiring, higher employee pension contributions, reduced pension benefits, employee furloughs, etc.
By all means, let’s discuss the spreading of “gross misunderstanding.”
Keith, I could repeat my responses to all of these points which I’ve made elsewhere on the blog, but I won’t. Your organization is blocking the truth on this issue from coming to light.
Mr. Rauh, please update your studies based on the FY ’10 data on 222 state plans just released by Census. I consolidated the data and found that from FY 2007 through 2010 plans lost and paid out $158 billion more than total contributions and earnings. Is that correct? Under what miracle projection of economic growth can they ever make up for that? The question, Mr. Brainard, is not when or whether public pension plans go broke. The question is how much more money state and local governments must extort from the declining number of private sector workers and how long those workers will stand for it. For almost a decade politicians and pension fund managers have been telling us things will get better, yet things just keep getting worse even using the official assumptions and calculations.
[…] As any individual who receives a passing grade in my finance courses should be able to explain, the appropriate discount rate to use when computing the present value of a stream of cash flows depends on the riskiness (generally defined as the correlation of those cash flows with the market) of those cash flows. In the context of pensions, the discount rate depends on the risk of the pension payments to beneficiaries. In many states – such as Illinois and California – there are strong constitutional protections in place that make already-accrued benefits risk free. Thus, what Novy-Marx and Rauh do in their research is to apply basic finance principles to come up with a more accurate measure of pension liabilities than what one gets from using official government statistics. Cate Long fell into the same trap that so many others have – including the Government Accounting Standards Board (about which I have previously blogged here and here) – of thinking that the right discount rate is a function of the risk fo the assets, instead of the risk of the liabilities. As a result, she – like GASB – completely ignores an enormous implicit put option that is being dumped onto taxpayers. Her piece also contained other problems that are discussed Josh Rauh’s response. […]
Jeffrey Brown has a very nice piece on this topic as well
http://www.forbes.com/sites/jeffreybrown/2012/02/29/the-risk-of-ignoring-risk-the-case-of-pensions/
I hope you are right, Keith. But in the instances you cite, the bulk of pension benefits already earned must be paid, and absent an economic miracle unprecedented in history, there will not be enough money to pay those pensions without additional tax burden and service cuts. I tell you what, why not pool all public pensions and liabilities, and let everybody agree to take only whatever benefits can be paid through earnings, investment gains and ARCs determined by the current discount rates and other assumptions? If you are right, no problem. If you are wrong, beneficiaries take the hit instead of taxpayers. Fair?
Ms. Long is currently misquoting me in her response comment. She writes:
“Can you please direct me to any data/research that shows that states are spending ‘14% of total revenue excluding federal transfers and 23% of tax revenues.’ as you claim in your rebuttal.”
Of course, that is not what I claim. I wrote:
“The right question is not how much is being paid now, but how much WOULD HAVE TO BE PAID in order to claim that states are balancing their budgets. That figure is substantially higher, and amounts to 14% of total revenue excluding federal transfers and 23% of tax revenues.”
I have asked her to correct this but have not heard back.
It is self-evident that the reason the expense percentage appears so low now is that governments are not paying the full cost of pensions, but deferring that cost — at more than 8% compound interest — as a tax burden on citizens in the future. Mr. Rauh, your estimate of real percentage of own revenues probably is low. Again, if those who advocate the status quo truly believe what they say, then let workers covered by these plans take on the risk by accepting benefits reduced in proportion to plan performance. Simple solution. Nothing prohibits them from voluntarily doing so. I am just a simple citizen who tries to apply common sense to these things, and common sense says that solution is fair.
Well, everyone knows that if you don’t fully fund a liability that the liability goes away!
[…] As any individual who receives a passing grade in my finance courses should be able to explain, the appropriate discount rate to use when computing the present value of a stream of cash flows depends on the riskiness (generally defined as the correlation of those cash flows with the market) of those cash flows. In the context of pensions, the discount rate depends on the risk of the pension payments to beneficiaries. In many states – such as Illinois and California – there are strong constitutional protections in place that make already-accrued benefits risk free. Thus, what Novy-Marx and Rauh do in their research is to apply basic finance principles to come up with a more accurate measure of pension liabilities than what one gets from using official government statistics. Cate Long fell into the same trap that so many others have – including the Government Accounting Standards Board (about which I have previously blogged here and here) – of thinking that the right discount rate is a function of the risk fo the assets, instead of the risk of the liabilities. As a result, she – like GASB – completely ignores an enormous implicit put option that is being dumped onto taxpayers. Her piece also contained other problems that are discussed Josh Rauh’s response. […]
As an academic exercise, I ran a scenario of the pension liabilities and payments over the past 10 years based on the CalPERS published investment returns. For a retiree who received their last payment in 2011 after receiving their inflation-indexed pensions over the past 10 years, the equivalent annual discount rate for 2001 was below 3%. The govt actuaries were still using 8%.
An alternative analysis would be to look at the valuations over the past 10 years using the risk-free rates, and then show the excess returns as a “dividend-accumulation” used to offset annual costs. That would give us a meaningful measure of the risk premium and its accumulated value. Essentially, it would be a measure of the value of that implicit put option over time.
Robert, if an average pension scheme member joins at age 35, retires at 65 and dies aged 80 I would suggest that examining a ten year period where equities have not moved and interest rates are historically low doesn’t really provide a useful insight into the issue except to highlight how easy it is to shoot holes in the current methodology. Clearly if we had returns like the 90’s this debate would not be taking place.
That said, low interest rates and low equity returns in the past decade have raised an important debate regarding pension scheme funding. Valuation techniques will change but a knee-jerk reaction to mark-to-market accounting would appear not to be the solution.
We raised the issue of valuation in an NBER working paper when the stock market was at its peak, and in fact the debate has a longer history than our work. The question is why state and local governments should be using methods so far from mark-to-market when the private sector uses pension valuation techniques that are much closer to it. And it is a question of measurement. It seems to me that how the liability should be funded is a question that can be addressed only when the liability has been correctly measured.
[…] on historic market returns. At the other end is Josh Rauh, who argues a risk-free rate should be used as long as pension promises are ironclad. Governing’s Girard Miller recently weighed in […]