Responses on Revenue Demands of Public Employee Pension Promises

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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Wipe Away Your Debts with State Government Accounting

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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Return Assumptions: It’s All Just Borrowing in Disguise

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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Day of Reckoning for State Pension Plans, Continued

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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Policy Options for State Pension Systems

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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Pension Security Bonds: A New Plan to Address the Pension Crisis

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.

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

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

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Illinois’ Irrelevant Pension Reform

When the Wall Street Journal praised Illinois for its pension reform (“In Praise of Illinois”, April 8), it was like praising a doctor who has been watching a patient bleed to death and then orders a band-aid. As shown in my previous blog post, the major Illinois pension funds run out of money in 2018, even under some pretty generous assumptions about investment returns and contributions. The bill signed yesterday by Governor Quinn will slow the growth of liabilities, but only for newly hired workers. Newly hired workers are generally decades away from retiring with a large pension. By the time this bill is likely to make any real difference in actual benefit cash flows, I predict an Illinois pension crisis will have forced more drastic measures.

On April 13, Bloomberg called Illinois a “poster child of debt crisis draining state services.” I agree with the assessment in that article, but even the  figures stated therein are far too optimistic. In particular, the figures cited in the piece follow a simple procedure that has been employed in many studies and press reports, including the much-cited March 2010 study by the Pew Center: they simply subtract reported state pension assets from reported state pension liabilities and portray the difference as the unfunded liability.

In this post, I take an updated look at the three largest Illinois state pension funds: the Illinois Teachers Retirement System (IL TRS), the Illinois State University Retirement System  (IL SURS) and the Illinois State Employees Retirement System (IL SERS). I show how discounting at economically more sensible rates changes the most recent figures.

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The Day of Reckoning For State Pension Plans

The pension plans sponsored by states and municipalities will place a substantial burden on state and local public finances in the near future. My recent work has estimated that the present value of already-promised state pension benefits is over $5 trillion when the benefit payments are discounted using Treasury yields, compared to a little over $2 trillion in pension fund assets. Most state constitutions offer special protections to pension benefits that state workers have already earned.

This analysis raises the question of how soon such a situation might lead to an all-out state and municipal fiscal crisis. One important day of reckoning is the day that the state pension funds run out of money. At that point, pension payments to retirees will have to come out of general revenues. This day of reckoning is in fact not as far away as some might imagine. For Illinois, it could be as soon as 2018.

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The US debt deluge

The warning tremors that might presage a major US fiscal crisis began today.  A major credit rating agency, Moody’s, wrote of the current US fiscal projections: “If such a trajectory were to materialize, there would at some point be downward pressure on the triple A rating of the federal government.”

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Where do we go from here?

Last week I had the opportunity to opine on this question at a lively conference on the financial crisis sponsored by the Federal Reserve Bank of Chicago and the World Bank.  Since I spoke about things I’ve been meaning to blog about for some time, I decided to post the transcript here.  Apologies that the tone is more Fed-esque than the usual posting, but here goes…

Where do we go from here?

“You never want a serious crisis to go to waste.  And what I mean by that is an opportunity to do things you think you could not do before.”  Rahm Emanuel, Feb. 2009

I would like to touch briefly on two issues in answer to the question posed for this session:  first, the integration of housing finance into the financial and regulatory mainstream; and second, the need to modernize budgetary and regulatory accounting.   I chose these topics for several reasons: they are important; they get less attention than is deserved; and I have thought quite a bit about them from both an academic and policy perspective.

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