Tag Archives: public pension

State finances going into 2012

In 2012, municipal bonds are unlikely to return at same levels as 2011

Investment analysts worry that without further fiscal action Illinois bonds will underperform the market in the coming year.

On January 1, many new laws go into effect in the states. The National Conference of State Legislatures has a rundown.

According to the U.S. Census the 100 largest public pension plans declined 8.5 percent in the third quarter of 2011.

The $237 billion drop in public pension plans is the biggest drop since the crash of 2008


Pension News From Around the Country

In California:

LOS ANGELES — Gov. Jerry Brown offered a far-reaching proposal on Thursday to reduce the cost to government of public pension programs, calling for an increase in the retirement age for new employees, higher contributions from workers to their own pensions and the elimination of what he termed abuses that have allowed retirees to inflate their pensions far beyond their annual salaries.

In Kansas:

TOPEKA — Kansas Gov. Sam Brownback and officials of the state’s public pension system aren’t saying publicly whether they favor issuing bonds to help close a close a long-term funding gap.

In Massachusetts:

The state House of Representatives today unanimously approved a plan to tighten the state’s pension provisions and raise the age that lawmakers and public employees are eligible for retirement. The move follows passage of a similar plan by the Senate earlier this fall. Both plans would only affect future hires, not current employees or retirees.

The House version passed today would boost the retirement age from 55 to 57 and could ultimately save $6.4 billion over 30 years, House lawmakers estimate. The Senate version went farther, raising the minimum age for retirement to 60.

In Mississippi:

JACKSON, Miss. (AP) — A group charged with studying the long-term viability of the state pension system is expected to release a formal report in two weeks.

During a meeting Monday, study commission chairman George Schloegel said he thinks several changes may be needed to shore up the Public Employees Retirement System.

The Clarion-Ledger reports…lawmakers alone can make changes, and it’s unclear whether they will make any radical alterations.

In North Carolina:

North Carolina is one state that’s planning to use a high-tech solution to look into the future and the present. The state’s Department of State Treasurer announced Thursday, Oct. 27, it will implement customized analytics software to better protect pensions for 850,000 state and local government employees….According to SAS, the customized software suite North Carolina will be using includes risk and performance measurement models for fixed-income equity, private markets and hedge funds.

And, in Rhode Island:

PROVIDENCE, R.I. — The General Assembly Joint Finance Committees will resume discussion of pension overhaul legislation Tuesday morning with a hearing on parts of the proposal that deal with municipal-run pension plans….Mayors have said they want the ability to make changes similar to what is proposed for state-run plans, such as suspending cost-of-living adjustments.

(here is Emily with more on RI)

Here, again, is Jeff Miron’s estimate of the date at which each state’s debt-to-GDP ratio will exceed 90 percent (the value at which economists believe debt tends to begin to hamper economic growth).


Unlike the calculations that the states themselves use, Miron’s calculations use the more-realistic discount rate assumptions of Novy-Marx and Rauh.

(HT to the National Association of State Budget Officers for their extremely helpful “state budget press clips”)

Fitch Downgrades Cook County’s Bond Rating Because of Pension Liabilities

Fitch Ratings downgraded the general obligation bond rating of Cook County, Illinois, from AA to AA- earlier this week. Moody’s similar downgrade last June makes this Cook County’s second downgrade of the year.

It is of no surprise that the county’s pension liabilities were cited as an important factor in the downgrade. Cook County’s local governments currently face more than $108 billion in outstanding debt, almost a quarter of which can be attributed to unfunded pension liabilities.

This problem is further compounded by the fact that the City of Chicago has its own unfunded pension liability of $48.8 billion or $42,000 per capita.

Illinois’s pension problems, however, run much deeper than Cook County. Illinois’s FY 2012 operating budget reports that the state’s pension system is 45 percent funded with total unfunded liabilities amounting to $75.7 billion.

Although, in recent research, Eileen Norcross and I find that when using discount rates that reflect the risk of public pension liabilities, Illinois’s unfunded pension liabilities amount to $173 billion and the funded ratio across systems drops to 36 percent in FY 2010.

By 2018, Illinois pension system will require a tripling of the state’s annual contributions from $6 billion to $17.5 billion. Therefore, without serious structural reform, it is likely that Illinois’s pension liabilities will lead to additional rating downgrades in the future.


Yes, the Government is Long-Lived

In the debate over how to value public sector pension liabilities an argument that seems to impress some people is this. Public sector pensions can guarantee their pensions with risky assets because the government never goes out of business. Andrew Biggs has written several responses to this notion. The latest piece to make this claim appeared in The Weekly Standard. Andrew and I offer a refutation.

The recurring theme that the government can value pension liabilities as though they were risky because it is long-lived is an oxymoron.  It is precisely because the government is unlikely to go out of business that public sector pensions are considered guaranteed. That is why economists suggest using a risk-free discount rate to value public pension obligations. It’s because of the government guarantee – the government is more likely, not less likely, to pay it. Current public pension accounting implies otherwise. The subtext in defense of this flawed accounting is, “If all else fails, raise taxes.”

“The risk is borne by the taxpayer” is the missing subtitle to the headline, “The government is long-lived.”

Veronique deRugy offers a fantastic analysis of this debate here. Followed by Yuval Levin here.

What Does An Artificially High Discount Rate Mean?

The appropriate discount rate to be used in valuing public pension liabilities might seem like an arcane and technical question. I suppose it is. But thanks in large part to the indefatigable work of Eileen, her coauthor Andrew Biggs, and professors such as Novy-Marx and Rauh, it is a technical debate that has actually been covered by mainstream media outlets. In short, the official actuaries who value these liabilities use what is known as a high discount rate while most economists—Eileen included—believe that it is more prudent to use a low discount rate. The choice makes a big difference: with the high rate, state public pension systems appear to be underfunded to the tune of about $1 trillion; while with a low rate, they are underfunded by about $3 trillion.

What, exactly, does a low discount rate mean? More importantly: what does a low rate say about the assumptions of those who prefer to use it?

To get at this question, we first need to talk about why anyone uses a discount rate in the first place. The rationale has to do with the fact that the big costs of public pension systems will not be felt for a number of years (interestingly, some have looked at the modest current costs of pensions and concluded that state finances are perfectly healthy; but that is like looking at my child’s current college tuition expenses—which are $0—and pretending that her education isn’t going to be expensive). In any case, the big costs will not be felt for a number of years, and so we need some way to make sense of future costs in today’s context.

The way economists (and accountants, and financial analysts) do this is with a discount rate. This is a number that helps us figure out what we need to put aside today in order to pay for a liability down the road. We call it a “discount” rate because it discounts future costs in order to make an apples-to-apples comparison with current costs. In other words, paying $50,000 in tuition 18 years from now is not as difficult as paying $50,000 in tuition today (because I have 18 years to save for it). So to make sense of that future cost, I discount it. And the larger the discount factor I use, the smaller that liability looks.

Now according to economic theory, the discount rate should take account of the likelihood that a future cost will actually occur. If it is unlikely that my daughter will go to college, then I should use a larger discount rate in valuing the expected costs. In other words, I should discount those costs more than I would if I thought it a certainty that she’ll go.

So, what does it mean when people argue for a high discount rate in valuing pension systems? It means that they don’t think it is very likely that we will actually honor our promises to public employees. Thus, they believe we should discount those costs accordingly. They won’t say this, but this is exactly what such an assumption means. Conversely, people like Eileen who feel it is more prudent to use a low discount rate are saying that we should count on actually having to pay these pensions; that we should plan to honor our commitments.

As if the mathematics weren’t confusing enough, the politics are enough to drive one to distraction. For some reason, those who favor a low discount rate (i.e., those who think we should actually plan to live up to our promises) are often painted as anti-worker. This is because these cold-hearted economists’ calculations come to the conclusion that public employees’ pensions are expensive. Meanwhile, some groups defend a high discount rate. They do this so that they can claim that public employee pension systems aren’t a big factor in states’ fiscal woes. And for this, they are often characterized as pro-worker. In reality, though, their accounting assumes that we should leave workers out to dry.

I’d be grateful to anyone who could help me make sense of that!

Pension accounting narratives

The controversy over just how expensive public pension plans are, and are likely to be, is growing more contentious. The reason is that some defenders of the current system cavalierly dispense with insights of financial economics in favor of a story that unravels on closer inspection.

Here is one current narrative. State budgets only require 3.8 percent of total spending to pay for pension obligations. This is taken from a report by the Center for Retirement Research at Boston College by Alicia Munnell, Jean-Pierre Aubry, and Laura Quinby.

Read the report more closely. This claim is based on what states contributed on average in 2008. First, it is an aggregate number. Second it is based on an 8 percent discount rate. That is, this is what states contributed, on average, based on the flawed notion that it is possible to lower the size of your debts by assuming high returns on your assets. Yes, they weren’t contributing very much. Their accounting is set up to ensure they underfund their pensions.

Secondly, some states have made a habit of deferring payments. So, what states contributed in 2008 tells us nothing about what they will need to contribute to make up for the shortfall. The next thing to keep in mind is that while some states are moderately funded, other states like Illinois and New Jersey are very badly underfunded. The aggregate “hides substantial variation” as the authors admit. The authors go on to calculate under more realistic discount-rate scenarios (Alicia Munnell adds one percentage point to the Treasury rate to get to 5 percent), Illinois and New Jersey will need to start contributing 12 to 13 percent of their budget. Now also consider a new report by Willshire Associates indicating no state will be able to meet its assumed investment returns over the next ten years.

The second claim being made by a few opinion makers is so deeply contradictory, I am not sure how it can be reconciled.

It is this. And, I quote two articles in full:

Nor are state and local government pension funds broke. They’re underfunded, in large measure because — like the investments held in 401(k) plans by American private-sector employees — they sunk along with the entire stock market during the Great Recession of 2007-2009. And like 401(k) plans, the investments made by public-sector pension plans are increasingly on firmer footing as the rising tide on Wall Street lifts all boats.

And, from today’s Washington Post:

“Public-employee unions say that although the occasional stories of workers who game the system make for good headlines, the real problem was reckless behavior on Wall Street, which caused the value of pension-fund assets to plummet. To force state and local employees to accept what now passes for retirement security in the private sector would amount to a race to the bottom for all workers, they contend.

AFSCME Secretary-Treasurer Lee A. Saunders said: “401(k)s have been around for a generation and the result is tens of millions of workers who lack retirement security. We need to figure out ways to expand effective retirement programs to more Americans. We gain nothing by destroying the defined benefit plans that public employees agreed to and funded over the course of their careers.”

Now, consider the primary critique of public sector defined benefit accounting. Current public sector pension accounting claims it’s possible to measure pension obligations according to what the assets are expected to return when invested in the market.  This has led plans to apply an 8 percent discount rate to value their liabilities. This in turn has led them to invest increasingly in higher-risk vehicles like hedge funds and real estate. The reason: they need to get 8 percent or better on average in order to have enough assets set aside to pay their obligations, which are already underestimated, because of this circular logic.

Economists have been stating consistently that  public plans should be valued using the yield on Treasury bonds (currently 4 percent) to reflect the safety and security of a government pension. What follows from this? An accurate calculation of the size of what is owed; and a more conservative investment strategy.

But defenders want to cling to the math that has led plans to embrace risk and underfund promises.  Remarkably, and without any sense of contradiction, the same defenders express dismay when the market doesn’t return what they anticipated.

What is so scary about 401(k)s? Investment risk must be borne by the individual worker and it cannot be made to disappear with actuarial alchemy.

Perhaps defenders of the accounting mess really think the numbers don’t matter and underfunding is nothing concerned about. After all, the government has a sure hedge against this risk: the taxpayer.

Tim Pawlenty on Public-Sector Unions

Minnesota’s Governor has an op-ed in today’s Wall Street Journal, arguing that the growth of public-sector unions presents a major problem for any small-government reformers.

Federal employees receive an average of $123,049 annually in pay and benefits, twice the average of the private sector. And across the country, at every level of government, the pattern is the same: Unionized public employees are making more money, receiving more generous benefits, and enjoying greater job security than the working families forced to pay for it with ever-higher taxes, deficits and debt.

Governor Pawlenty notes three principals he’d like reformers to consider. First, normalize pay between the private and public sectors.

Second, get the numbers right. Government should start using the same established accounting standards that private businesses are required to use, so we can accurately assess unfunded liabilities.

Third, we need to end defined-benefit retirement plans for government employees. Defined-benefit systems have created a financial albatross for taxpayers. The private sector dropped them years ago in favor of the clarity and predictability of defined-contribution models such as 401(k) plans. This change alone can save taxpayers trillions of dollars.

Our own Eileen Norcross champions both these policies. Her recent paper, The Crisis in Public Sector Pension Plans, co-authored with AEI’s Andrew Biggs, uses New Jersey’s public-sector unions as a case study for the growing government work-force. They also discuss the moral hazard inherent in defined benefit plans:

From the perspective of workers, defined benefit pensions in the public sector are risk-free; they are guaranteed benefits by the state, which has the power to tax. This means, of course, that from the perspective of the taxpayer, the liability is a near-certainty. The discount rate chosen to value future liabilities in the plan, therefore, should reflect the low-risk character of the benefits promised to workers.

From the government’s perspective, it is appealing to use a higher discount rate to estimate plan liabilities because it produces a lower annual contribution. By contrast, a low discount rate will result in a higher annual contribution required by the employer (in this case, the government) to fund pension obligations.

Eileen and Andrew were also part of a Mercatus panel discussion with Utah State Senator Dan Liljenquist, Scott Pattison of the National Association of State Budget Officers and Jim Musser of Mercatus. Today she also released another paper, Getting an Accurate Picture of State Pension Liabilities.

Last year I addressed the incentive for governments to gamble with public employees’ retirement savings in an op-ed. Giving public employees control of their own savings is essential for any kind of fair relationship between governments, their employees, and the taxpayers. An accurate accounting system is crucial to any fiscally responsible discussion.

Correction: In my AOL piece there is an error: I wrote “Then there was New Jersey Gov. Christie Todd Whitman, who from 1998 to 2003 held “pension holidays,” suspending employee payments into the pension system so workers could spend the money elsewhere. . . . Today, New Jersey’s public pensions lack billions of dollars in funding, and both public employees and taxpayers will suffer.” Instead, the piece should read “so employers“, i.e, the state of New Jersey, could spend the funds elsewhere. Thanks to reader John for bringing that misstatement to my attention.

Michigan’s Pension Reform Experience

In 1997 Michigan undertook a significant though incomplete reform of its public pension systems. The legislature closed Michigan State Employees’ Retirement System (MSERS) to new hires and established a defined contribution plan for public sector workers, shifting risk away from the taxpayer. Pre-1997 workers remain in the defined benefit plan and MSERS’ liability is scheduled to be paid off by 2037.

This pension reform was not comprehensive. The Michigan Public School Employees’ Retirement System (MPSERS) was left untouched and continues to operate as a defined benefit plan. A study by Richard C. Dreyfuss of the Mackinac Center estimates, based on the state’s assumptions, that the unfunded liabilities for pension and health care benefits for Michigan’s public school teachers range between $28 and $39 billion. This estimate is based on the state’s assumed rate of return on assets of 8 percent. In other words, the total is far higher than this study suggests.

In the meantime employee benefit costs are rising in school budgets. For every $1 the school district pays a teacher it must give $0.20 to MPSERS.

Mr. Dreyfus writes Michigan’s successful 1997 reform of MSERS is a “case study for the state” and although savings from moving teachers to a defined contribution plans will not be realized in the short-term the long-term policy outcome remains the same. Shift risk away from the taxpayer and establish a predictable and affordable retirement system for public sector workers.

U.K. Austerity Measures Unveiled

Chancellor of the Exchequer George Osbourne, detailed his four-year fiscal plan for the United Kingdom yesterday estimated to reduce spending by £81 billion ($127 billion). They are described as the biggest cuts to spending since World War II.  Welfare payments will be reduced, including the removal of a child tax credit for couples earning more than £44,000 ($64,449) per year. Government departments face budget cuts and the retirement age for public sector workers will rise to 66 by the year 2020. In addition, Mr. Osbourne is recommending a permanent bank levy. The full details are here.

The U.K. is also facing huge levels of sovereign debt described very memorably by MEP Daniel Hannan. According to Nick Record of the IEA, the U.K.’s public pension obligations are £1 trillion ($1.58 trillion).

Meanwhile as Britain tightens its belt, The Wall Street Journal reports French workers are protesting President Sarkozy’s proposal to raise the retirement age from 60 to 62.

Are such cuts possible here? Veronique de Rugy considers why The Washington Post’s David Wessel doesn’t think it can be done in America.