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

Will America’s Private Sector Continue to Shrink? A Look at Government Compensation

In my previous blog looking at America’s Private Sector for October, 2010, I stated that I thought over the long-term the private sector share of personal income would continue to fall.  This post will begin to explore why I think that is the case.  Be warned that this journey involves delving into the intricacies of national accounting (which is why it took me awhile to amass this blog) so I’m going to try to keep it a high level.  Links to mind-numbing details will be provided.

So, let’s refresh our memory on how the private sector is measured.  The equation is: Private Sector = Total personal income – (government transfer receipts [Social Security, Medicare, Medicaid, etc.] + government compensation [Federal Civilian and Military, State and Local]).  Today we will look at government compensation.

Government compensation consists of wages and salaries and benefits and are accounted for on a cash-basis.  This is no big deal for wages and salaries since they are paid in cash in the current period; however, benefits are another story.  A large part of benefits for government workers is their defined-benefit (DB) retirement plans–this is where it gets tricky becomes the timing of payments makes a big difference.

Under cash accounting, only the payments being made into the DB plans are counted in compensation.  However, the final value of the DB plan to the employee is worth more than the actual contributions because the return earned on the trust fund will also be used to pay their benefits.  So, ideally, an accrual-based accounting would be better a better system because it would make estimates of the total value of DB plan including the future returns on the trust fund.  However, due to a lack of data and disagreement on the assumptions needed to make it work, accrual accounting is not yet possible.

As such, cash accounting is the de facto measure of government compensation.  This is a serious problem for two reasons:  First, payments to state DB plans rarely equal the annual required contribution (ARC) based on requirements from the Government Accounting Standards Board (GASB) and, second, as economist Novy-Marx and Rauh point out the GASB mandates dramatically underestimate the ARC payments.  In the future, this means ARC payments will dramatically increase dragging government compensation with it.  In Maine, for example, where stronger Constitutional constraints trump GASB; official pension payments are expected to more than double in just four short years from $300 million to over $700 million.

To illustrate how cash accounting affects the timing of DB payments consider the effects of Pension Obligation Bonds (POBs).  States have resorted to risky schemes such as POBs to try and undo the damage of short-changing their DB plans.  Let’s look at the case of Illinois which in 2003 issued one of the largest POBs ever worth approximately $10 billion.  Chart 1 below shows how the POB issuance in 2003 caused state compensation to significantly jump in 2003 under cash accounting .  This one-time infusion created an overestimate of compensation in that one year, but an underestimate in the years (most years) that Illinois neglected to pay its ARC.

Illinois State Compensation 2000 to 2009

More disturbing, states that issue POB’s not only face the escalating cost of their ARC payments due to year’s of underpayment, but they also saddle their taxpayers with the payback schedule of the POB.  Chart 2 below shows the payback schedule of Illinois’s 2003 POB which more than doubles over the 30 year schedule.  Adding insult to injury, note that the first few  years were interest-only payments!  But wait, there’s more, a new study by the Center for Retirement Research at Boston College (pdf), found that:

“while POBs may seem like a way to alleviate fiscal distress or reduce pension costs, they pose considerable risks.  After the recent financial crisis, most POBs issued since 1992 are in the red.”

Illinois Pension Obligation Bond Payment Schedule Issued in 2003

To wrap this up, the point of this is that under the current cash accounting system contributions to state DB plans will soar in the future because of past underfunding, unsustainable assumptions about the future and the use of risky schemes such as POBs.  This means that government compensation will be growing at rates that the private sector will find hard to keep up with, especially if taxes on capital are raised to pay for the growing DB costs.  As a result, government compensation will continue to crowd-out the private sector.

The only way this doesn’t come to pass is if the DB pension burden becomes too much to bear and they are dramatically reformed.  In the case of California or Illinois, that decision may be forced on them because their DB system has effectively bankrupted the state government.  If these DB systems are reformed, willingly or not, then perhaps we will one day see the private sector grow again.  I’m still not optimistic, because we still need to look at the other part of the equation, government transfer receipts, which is also an ugly picture . . . stay tuned.

For mind-number details on how the Bureau of Economic Analysis treats DB plans in their statistics, see:

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.