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Using June 2009 data, Robert Novy-Marx and I measured a $3.1 trillion gap in state and local pension systems, arising from $2.3 trillion in assets and $5.4 trillion in liabilities.

Since then, the situation has evolved in several ways. First of all, the stock market continued to recover from the financial crisis. Based on the correlation between broad equity market indices and the changes in state and local pension assets, a reasonable estimate is that pension fund assets today are higher by about 14.5% than they were in June 2009.

More importantly, the true financial value of the liabilities that have been promised have grown substantially due to much lower bond yields. Pension liabilities are greater when market interest rates on securities of comparable risk are lower. The basic economic rationale is clear: the appropriate discount rate for measuring liabilities depends on the risk of the cash flows being discounted. So while reports from state governments continue to discount pension liabilities at 8%, a financial valuation needs to take today’s market interest rates into account, and in particular interest rates on very safe assets such as government bonds. The only reason to use a discount rate higher than a default-free government bond yield is if one wants to reflect in the measurement the possibility that taxpayers might be able to default on these promises.

Assuming that accumulated pension promises will be paid, liabilities were $5.4 trillion in June 2009 using Treasury discounting. But at that time, the yield on the 30-year Treasury bond was 4.4%, the yield on the 10-year Treasury bond was 3.6%, and the yield on the 5-year Treasury bond was 2.6%. Today, in October 2011, these rates are all approximately 150bp lower, which assuming a duration of 15 years would imply that liabilities are 23% larger.

Together with the estimates of assets, these calculations imply an unfunded liability in October 2011 of $4.0 trillion.

This is a lower bound, however, as liabilities as reported by state and local governments seem to creep steadily up with each report due to “actuarial losses” or overly generous assumptions about mortality and worker behavior. In recent years, these have added growth of about 4-5% per year to total liabilities. It is reasonable to think that such increases will have continued, as most reforms to pension systems in recent years have affected only new hires, not the current workforce.

Assuming an additional 4% per year liability growth due to these factors, the total unfunded liability is $4.4 trillion.

These updates are still back-of-the-envelope calculations. It is interesting that financial reporting on corporations allows for accurate estimates of corporate pension liabilities to be kept current, and indeed there has been extensive financial reporting on the rapidly deteriorating funding of corporate pension systems in 2011. The same factors are also impacting public systems. They are simply hidden from plain view.

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This morning a colleague asked me what I thought of the argument that state pensions are not a big deal because contributions currently account for only 3.8% of state and local spending. Here is what I wrote.

How much is being contributed now has nothing to do with how much needs to be contributed to avoid a crisis. Consider a household with $50,000 per year of annual income. You observe the household paying only $100 per month in total payments to creditors. Does that tell you anything at all about whether their debts are a “big deal”? Obviously not. Household A might make $100 monthly payments having no mortgage and minimal credit card balances that are being paid off every month, that’s no big deal. Household B might have a $500,000 mortgage and $100,000 of credit card balances — that is definitely a big deal, especially if they are only paying $100 per month! So in fact, low payments may be as much a cause for concern as a cause for reassurance.

What about the numbers for state and local pension systems? In our paper Revenue Demands of Public Employee Pension Promises, we present the following. Contributions from state and local governments to pay for public employee retirement benefits, including the employer share of payments into Social Security, currently amount to 5.7% of the total own-revenue generated by these entities (all state and local taxes, fees, and charges). In aggregate, and assuming each state grows at its 10 year average with no Tiebout effects, these contributions must immediately rise to 14.2% of own-revenue to achieve fully funded systems in 30 years. Average contributions would have to rise to 40.7% of payroll to achieve these goals, corresponding to an increase of 24.3% of payroll. This analysis starts from our estimates of December 2010 asset and liability levels for state and local pension funds, and holds employee contributions as a percent of payroll at their current rates.” (page 1)

Note the goal of full funding in 30 years is a what many systems aspire to. If  they are aspiring to lower funding goals (e.g. zero funding!) then the number gets smaller. We also show that just to claim that state and local governments are paying the true cost of new benefit promises (not paying down any unfunded liabilities) would require an average 60-70% increase in contributions. Furthermore, these increases would have to be immediate. The more slowly contributions rise, the greater amount by which they will ultimately have to rise.

It’s worth noting that the inclusion of all own-revenue assumes that fees state and local governments charge for services (e.g. university tuition) are a fully available source that could be increased to pay pensions. If one restricts to just tax revenues, contributions need to be 23% and are currently only 9%. I would say that the need to contribute almost one-quarter of total state and local tax revenues across the US to pensions in order to claim that they are being funded does constitute a big deal.

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The debt ceiling negotiations broke down last weekend. Despite predictions of looming financial catastrophe, the stock market fell less than 1%  on Monday. Andrew Ross Sorkin in today’s New York Times writes:

Wall Street’s blasé response presents a serious challenge for the administration. The government has been ringing the alarm bells of an impending catastrophe to add urgency to its efforts to get Republicans to hash out a compromise.

While the sky indeed may fall if the sides cannot compromise, the fact that the market has been calm has served only to deepen the resistance to a deal. People who perhaps should be worried don’t seem to be, and worse, appear to have stopped listening to the warnings.

Uh oh. We do not want Washington basing its decisions on the behavior of the stock market.

The problem is that if investors are trying to figure out how the government will behave, and the government is looking to investors to learn how it should behave, then the market’s reactions may reveal nothing about the costs of default. To understand the issue, suppose two things: first, that Congress and the administration will reach agreement if and only if the stock market falls substantially prior to Aug 2; second, that the stock market will crash if the debt ceiling is breached. What happens? It’s not clear.

If investors believe that there will be a default, the stock market will fall, and Congress and the White House will then reach agreement. The stock market’s belief, however, will have been irrational: the fall of the stock market will induce an outcome where it should not have fallen.

On the other hand, if investors believe that there will not be a default, the stock market will not fall, Congress and the White House will not reach an agreement, and the stock market will fall. Again, the belief will have been irrational: the stock market will not have fallen when it should have.

So what happens? Clearly if the negotiators in D.C. are paying attention to the stock market, then investors must make a delicate calculation that requires thinking about, at a minimum: the objective costs and benefits of a default; the beliefs of other investors about the likelihood of a default; the private information of government officials (how disruptive to operations would a default be?); and the extent to which the negotiators are really paying attention to the stock market. Yikes! We can only guess what the market price is telling us.

It is of course possible that reaching the debt ceiling will be no big deal. Perhaps the government can muddle through without much damage and eventually there will be some agreement. But you cannot be sure that this is what the market believes. If Republican leaders are taking solace from the market’s apparent complacency, they may be on thin ice. Worse, we all may be on thin ice.

If you want to know more, this issue has been discussed in the academic literature. See in particular papers by Bond, Goldstein and Prescott (2010, Review of Financial Studies) and Bond and Goldstein (2011, working paper).

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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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An often-stated goal of public employee pension systems is to achieve fully funded pension systems in 30 years. In a newly released paper with Robert Novy-Marx, covered in a New York Times article, we calculate the increase in contributions that will need to be devoted to these funds on an annual basis to achieve this goal, starting with estimated December 2010 asset levels. Without changes to pension formulas, state and local pension contributions across the US would have to immediately increase by a factor of 2.5, reaching 14.2% of the total own-revenue generated by state and local governments (taxes, fees, and charges). This represents a tax increase of $1,398 per U.S. household per year, above and beyond revenue generated by expected economic growth.


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Crain’s Chicago Business has reported on a statement by Cook County Treasurer Maria Pappas that the average Chicago household now owes $63,525 to cover local government debt, based on figures collected under a debt disclosure law that was amended in February of this year to require pension disclosures. Suburban Cook County households owe $32,901. This was based on a figure of $25 billion of unfunded pension liabilities for the entire county (Chicago and the Cook County suburbs), contributing to total debt within Cook County of $108 billion.

But the truth is worse. By my calculations, there are around $60 billion in unfunded pension liabilities in Chicago and Cook County. Chicago households in fact each owe over $80,000 for all the pensions and other debt obligations when the pensions are properly measured.


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While pleased to be recognized in the Wall Street Journal (page A7) this morning under “People to Watch,” the feature also hammered home to me how entrenched the use of flawed official statistics still is.

The article includes a graphic, “How the States Measure Up,” including unfunded pension liabilities, sourcing Moody’s for the pension data. Moody’s covers itself by using official statistics provided in the annual financial reports of the systems — although according to another WSJ article from Tuesday Feb 22, Moody’s has “voiced support” for legislation that would require states to furnish annual reports to the Treasury using the correct methodology.

According to the graphic, unfunded liabilities to GDP maxes out at around 16% for the states Hawaii and Mississippi. The reality is that when proper financial discounting is applied to pension liabilities, the average unfunded liability across the 50 states represents 18% of GDP. For eight states it is over 25% of GDP. For three it is over 30% of GDP, and for one (Ohio) it is 35% of GDP. Here is a table. This includes only unfunded liabilities from systems sponsored at the state level, and only benefits promised based on service and salary up until today (legacy liabilities). Local liabilities increase the unfunded liability by about 20%.


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The Treasury Department has published the administration’s plan to reform the housing market. The report calls for ultimately “winding down” Fannie Mae and Freddie Mac, but with the recognition that their longtime dominance has effectively crippled the private market for housing loans so the winding down will take time. (I should add that it’s unclear to me whether “winding down” Fannie and Freddie means that the goal is to eliminate them or just to make them substantially smaller.)

The report touches on many other issues related to housing, including consumer protection, the structure of the servicing industry, risk retention requirements for banks (but aren’t we trying to make the banks less risky? See Jonathan Parker’s post on this), the provision of rental housing, etc. The ultimate reforms will probably differ in many respects from the proposal, which is often vague. But at least it is now possible to discuss the future of Fannie and Freddie in a serious way.

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The FASB this week backed off on a plan to expand mark-to-market accounting to loans and deposits.  To understand what the FASB actually did, you have to understand a bit about how financial institutions currently account for assets.

Currently, most loans are classified as “hold to maturity”. Such assets are carried at values based on historic cost, unless they experience an “other than temporary impairment” in value. In that case, the loan is supposed to be irreversibly marked down in value. (When a developer files for bankruptcy, his mortgage has probably suffered an other than temporary impairment.)

Accounting rules also identify “trading assets” and “available for sale” assets. These are currently marked to market, meaning that their value on the balance sheet varies with their value. (There is a separate question of how marking to market affects reported earnings. We can ignore that point for this discussion.)

If the rules seem Byzantine, well, they are. It’s true that it’s not always easy to value assets, and advocates of historic cost accounting will point to the potential for fraud and deception when assets are marked to market. It’s true that prices in a thin market may not be representative. Also, the FASB wanted to harmonize US and international accounting rules, an important goal. But why should the accounting system rely on the bank’s declaration of intent about its holding period to determine how the asset is to be valued? If it is hard to value, why not report it as such? If it is possible to mark it to market, why not do so?

In most cases the bankers have a reasonable idea of what their assets are worth. The regulators also know the truth. The hedge funds probably know the truth. But the FASB says that firms are not required to tell you what they know. You, as a member of the investing public, are being told that you can’t handle the truth. There are consequences when the accounting system does not respect economic reality: witness the crisis in state pension systems.

Historic cost accounting is like a stopped clock, which provides the correct value twice a day. With a stopped clock, you always know the reported time, and you know where the number came from. Mark-to-market accounting, on the other hand, is unquestionably messier, like a real clock. Is the clock running fast or is it slow? Was it adjusted for daylight savings time? Can it be manipulated? (Of course.) But which kind of clock helps you make better decisions?

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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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