Taxpayers on the Hook for Unfunded Public Pensions Liabilities

Joshua D. Rauh just announced on his blog about a new study that he just released, with Robert Novy-Marx, that estimates state and local pension contributions need to increase by a factor of 2.5 to reach solvency in 30 years.  That amounts to a tax increase of $1,398 per household, per year!

The study is titled “The Revenue Demands of Public Employee Pension Promises.” (pdf)  Here is the abstract:

We calculate the increases in state and local revenues required to achieve full funding of state and local pension systems in the U.S. over the next 30 years. Without policy changes, contributions to these systems 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. In thirteen states the necessary increases are more than $1,500 per household per year, and in five states they are more than $2,000 per household per year. Shifting all new employees onto defined contribution plans and Social Security still leaves required increases at an average of $1,223 per household. Even with a hard freeze of all benefits at today’s levels, contributions still have to rise by more than $800 per U.S. household to achieve full funding in 30 years. Accounting for endogenous shifts in the tax base in response to tax increases or spending cuts increases the dispersion in required incremental contributions among states.

The chart below is taken from Table 5 of their study on page 40 which ranks the states (from highest to lowest) in terms of the size of the necessary tax hike, per year, to achieve solvency of the state’s public pension system.  As you can see, New Jersey ranks top in the country at $2,475 while Indiana comes in last at $329.

Estimated Annual Tax Increase Required to Bring State and Local Pensions into Solvency by State_Wealth Alchemy

Explaining How Pension Assumptions are Bogus

Josh Rauh and Robert Novy-Marx have an excellent blog explaining the wrong-headed logic behind how state and local pensions are valued.

Under current standards, state and local governments value pension liabilities using the expected return on pension fund assets. Arguing that diversified investment portfolios have an 8% expected return, governments typically use a discount rate of around 8%. Under these procedures the 50 states report unfunded liabilities of around $1 trillion.

But this practice misrepresents the cost of the government promises. The value of a financial obligation has nothing to do with the allocation of the debtor’s assets. If a state wanted to pay an investor to take over the pension liability, the amount the investor would accept would not depend on the state’s asset allocation. If a state tells its employees that their pensions are secure — not risky like the stock market — then it should use the yields on safe government securities such as Treasury bonds to discount the benefits.

Do the GASB rules make sense? Let’s consider an underwater homeowner’s financial situation under common-sense financial logic, and then under GASB rules.

Do read the rest of the analogy as it makes crystal clear that the “official” pension obligations are the work of a true Master Wealth Alchemist.

Public Pensions–A Case Study in Wealth Alchemy

Josh Rauh has an excellent post on Everything Finance about the state of public pensions.  If you are not familiar with his work, along with Robert Novy-Marx, you should check out here, here and here.

Rauh states that:

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 . . . 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) . . . In sum, systems that use 7% are being more responsible than those using 8% — but even 7% is a flagrant violation of the principal that states should run balanced budgets. Already this system has led to state pension debt that when properly measured amounts to $3 trillion across the 50 states, since unfunded pensions were the way that politicians could borrow money out of the view of taxpayers and outside of budgetary requirements.

If going forward we want to actually return to the principal that states should run balanced budgets, there are only two routes for future retirement benefits: 1.) defined benefit (DB) pensions funded at risk-free rates and invested in bonds that match the profile of benefit payouts; or 2.) 401(k)-type defined contribution (DC) pensions like the private sector. Anything else is simply borrowing in disguise.