Archive for the ‘pensions’ Category

Yesterday I posted about my new paper, “The Revenue Demands of Public Employee Pension Promise,” which finds that state and local pension contributions would need to rise on average by $1,398 per household per year to be on path to full funding. Keith Brainard of the National Association of State Retirement Administrators, has submitted more comments in addition to the ones I already responded to under the original post. Here are his further comments in quotes and my responses.


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My colleague (and fellow high school alum), Josh Rauh testified on the new systemic risk posed by underfunded state and local pensions.  Why is this a systemic problem?  Because, if cities and states start defaulting and/or massively raising taxes, will you let these elderly retirees go hungry and/or without healthcare?  Remember, they are not eligible for Medicare and Social Security – their pension is their safety net.  They took jobs and worked for the public sector at  given wage and pension promise.  Maybe some of them got good deals, maybe some of them got overworked for too little money.  But they all taught our children, protected our lives, administered the services which we take for granted, and so on with pay and a promise of a pension and healthcare.  But the politicians gave us lower taxes or higher benefits instead of setting aside the money to pay for the pensions and healthcare that they were promising to public employees while they worked. Now the workers are old and the bills are coming due.  And some states are woefully underfunded (see here). 

We in these states and localities have four options: pay more taxes, drastically cut spending, default on debt, or default on our promises to these elderly. In Illinois, up until the latest tax increase, we have such a big hole that if we cut all spending – 100% of schools, cops, everything – our projected taxes would just about cover our pension and benefit obligations.  The recent tax increase is a small and temporary fix to a major problem.  (Is it just a coincidence that so many of our governors end up in prison?)

Now the question is, what of these scenario’s is not systemic?  Default on debt looks pretty systemic. If states and localities default on debt, these defaults will reduce the assets of other local governments’ pension funds and presumably some private defined benefits plans and whatever foreign institutions hold the debt also, oh, and probably banks.  A large increase in state and local taxes sure sounds systemic.  As does massive cuts in spending – poor law enforcement, public education, public health etc are national problems.  And in the case of defaulting on pensions and healthcare, won’t we through the Federal government step in to stop elderly from dying of minor infections and starving, especially after these people worked their lives for these benefits?

Josh’s testimony is here.  Very troubling but worthwhile reading.

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by Josh Rauh and Robert Novy-Marx

If you are a homeowner, you have probably estimated your net worth. You know the balance left on your mortgage, and you have a sense of the market value of your home. Perhaps you also have some financial assets. If you are very cautious, most of these are in cash or bonds. If you prefer more risk, you own stocks. But whether your savings is in cash, bonds or stocks does not affect your net worth today, or the reported balance on your debts.

Unless, that is, you are a public pension system following Government Accounting Standards Board (GASB) rules. GASB has recently held hearings on proposed changes to their public pension accounting standards. Unfortunately, the changes under discussion maintain the flawed framework. State and local governments will still be able to hide trillions of dollars of borrowing in the form of improperly valued pension promises.


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Saturday’s Wall Street Journal featured an article by David Reily highlighting that most state and local pension systems were sticking to “unrealistic” return assumptions. Most public pension systems assume their assets will return around 8% annually, and the lowest assumption among major public pension systems is 7%. According to the article, only a handful of funds have reduced their return assumptions, despite an environment where such returns seem unlikely. Lowering the assumption would require that more money be set aside today to fund legacy liabilities as well as ongoing pension promises — and in these times the governments don’t have the dollars to spare.

While lower return assumptions would be a step in the right direction, it is important to keep the big picture in mind. This entire system effectively treats the expected return on the pension fund assets as achievable without any risk. When a state assumes, say, 7% instead of 8%, it sets a little more money aside and does a little less gambling on behalf of future taxpayers (our kids and our elderly selves). But the scheme still amounts to making future taxpayers come up with money exactly in those conditions (or “states of the world” as finance academics like to say) when it is most painful — namely when the stock market and other risk-bearing investments have performed poorly. That’s a situation when the other financial resources of future taxpayers — our retirement and college savings accounts — are also diminished.


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Noticing renewed interest in my March 2010 blog post, I should point out that I made some (relatively minor) updates to the calculations during the process of revising the paper and preparing it for publication. The paper is available here:

Are State Public Pensions Sustainable? Why the Federal Government Should Worry About State Pension Liabilities, National Tax Journal 63(3), 2010.

The main update was to use asset values as of September 2009, which reflect a recovery in asset values after the crash, and to implement some refinements to the model for benefit flows.

Table 1 of the paper shows the updated state-by-state table. The median runout year is 2026, and 20 states only have assets to pay for benefits through 2025. Illinois goes to 2018 and New Jersey to 2019.


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The financial soundness of pension systems for state and local government workers has been a topic of much debate. In recent work, Robert Novy-Marx and I have argued that the use of GASB rules to discount future benefit payments results in present value measures of liabilities that are too low to reflect the true economic liability faced by state taxpayers. At the same time, a number of states have enacted changes designed to reduce the liabilities associated with their pension systems. Most of these changes affect new employees only, and hence have no impact on standard liability measures, which do not consider future employees. However, some changes, such as the reductions in the cost of living adjustments (COLAs) passed by Colorado and Minnesota this year, do affect existing plan members and hence do affect the economic present value of current state pension liabilities.

Today, Novy-Marx and I have released a draft of a new paper, “Policy Options for State Pension Systems and Their Impact on Plan Liabilities.” In this paper, we examine the present value of state pension liabilities under existing policies and separately under several sets of hypothetical policy steps. In particular, we consider changes to COLAs, full retirement ages, early retirement ages, and buyout rates for early retirement.

We find that even relatively dramatic policy changes, such as the elimination of COLAs or the implementation of Social Security retirement age parameters, would leave liabilities around $1.5 trillion more than plan assets under Treasury discounting. This suggests that taxpayers will bear the lion’s share of the costs associated with the legacy liabilities of state DB pension plans.

Click on the image below to access the complete study:

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Today I am speaking at a conference in Washington hosted by the University of California Retirement Security Institute. I am unveiling a plan called “What the Federal Government Should Do About State Pension Liabilities,” jointly authored with Robert Novy-Marx. As I have blogged previously, states are making financial promises that they cannot possibly keep, and the bills are coming due much sooner than you think. Unless action is taken soon, the federal government will face intense pressure to bail out the affected states, at a price tag of $1 trillion or more.

Plan to save state pension funds by Rauh and Novy-Marx

Full text of Rauh & Novy-Marx plan (PDF)

The outline of the plan is that the federal government should cut a deal with states. (more…)

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