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

Moody’s Penalizes States with Unfunded Pension Liabilities

Here is a news items that you can file under: “what the heck took them so long?”  According to the New York Times, Moody’s finally recognizes that unfunded pension liabilities are a threat to the financial well-being of states:

Moody’s Investors Service has begun to recalculate the states’ debt burdens in a way that includes unfunded pensions, something states and others have ardently resisted until now.

States do not now show their pension obligations — funded or not — on their audited financial statements. The board that issues accounting rules does not require them to. And while it has been working on possible changes to the pension accounting rules, investors have grown increasingly nervous about municipal bonds.

Moody’s new approach may now turn the tide in favor of more disclosure. The ratings agency said that in the future, it will add states’ unfunded pension obligations together with the value of their bonds, and consider the totals when rating their credit. The new approach will be more comparable to how the agency rates corporate debt and sovereign debt. Moody’s did not indicate whether states’ credit ratings may rise or fall.

However, while this change is an important step forward, Moody’s does not go far enough as the pension burden is significantly higher than official estimates as I’ve pointed out in other blog such as “Public Pensions-A Case Study in Wealth Alchemy,” “When Will Pension Systems Go Broke,” and “Explaining How Pension Assumptions are Bogus.” The NYT article goes on:

In making the change, Moody’s sidestepped a bitter, continuing debate about whether states and cities were accurately measuring their total pension obligations in the first place. In adding together the value of the states’ bonds and their unfunded pensions, Moody’s is using the pension values reported by the states. The shortfalls reported by the states greatly understate the scale of the problem, according to a number of independent researchers.

“Analysts and investors have to work with the information we have and draw their own conclusions about what the information shows,” Mr. Kurtter said.

In a report that is being made available to clients on Thursday, Moody’s acknowledges the controversy, pointing out that governments and corporations use very different methods to measure their total pension obligations. The government method allows public pension funds to credit themselves for the investment income, and the contributions, that they expect to receive in the future. It has come under intense criticism since 2008 because the expected investment returns have not materialized. Some states have not made the required contributions either.

Moody’s noted in its report that it was going to keep using the states’ own numbers, but said that if they were calculated differently, it “would likely lead to higher underfunded liabilities than are currently disclosed.”

So, they’re only partially lifting their heads out of the sand.  See chart below from the NYT on how the debt burden picture changes for select states.

New York Times New Moodys Debt Rankings

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.