Fun with Unfunded Pension Fund Liabilities

By Paul Springer

While the more spectacular financial catastrophes tend to originate in the private sector, public pension plans may well provide the fiscal plutonium for the next money meltdown.

Public pensions offer defined benefits, which put the fund on the hook for clearly defined payouts that are paradoxically difficult to estimate in advance for various reasons, including the vagaries of retirement decisions, investment performance, and inflation.

The ultimate success of a pension fund depends on the accuracy of its assumptions, and some of those assumptions are increasingly coming into question.

One recent critique comes from Business Insider, which draws on a Northwestern University study to predict the first 11 state pensions to go belly up.

See the post for a run-down on the 11 front runners. The study itself provides the bigger picture:

In recent work, Novy-Marx and Rauh (2009a, 2010) have shown that the difference between state public pension liabilities and the assets set aside to fund them is substantially greater than the municipal debt recognized on state balance sheets. Discounting the benefit cash flows at Treasury rates, for example, the gap between assets and already-promised liabilities in state pension funds alone was over $3 trillion at the end of 2008.

The study says that with average returns of 8% annually, state funds on average will go bust by 2028. Returns of 10% would allow funds to meet their obligations, as long as that 10% rate remains through 2045.

So what kind of rate can pensions be reasonably expected to produce? In, say, 1999, or maybe last year, 10% didn’t look like that big of a number. Over time, it looks huge. Last year saw huge returns for equity and debt investors who capitalized on the credit crisis and equity plunges in 2008, but on average the last decade is a smoldering crater.

When it comes to riskless investments, forget about it.

Pension funding problems can afflict entire states or specific counties within them. California’s affluent Marin County has its own problems according to information from Stanford public policy professor Joe Nation, a former state assemblyman who says Marin’s pension is $2 billion in debt, twice the official amount. From The Marin Independent Journal:

The new study by Stanford public policy professor Joe Nation, a former Marin assemblyman, noted that an analysis by his graduate students at Stanford’s Institute for Economic Policy Research estimated last spring that the state’s three major public employee pension funds were underfunded by $425 billion as of June 2008, compared with fund estimates of only $55 billion. That study included CalPERS, the program to which most Marin cities belong, and estimated that the likelihood of meeting obligations to public employees over the next 16 years was just 16 percent.

CalPERS Chief Investment Officer Joseph Dear took issue with the study’s 4% riskless rate for Treasurys. Investment behemoth CalPERS has a strong track record of good results, and Dear said the 4% figure did not reflect the fund’s sophisticated investing choices.

Still, the I.J. points out, both assumptions and results can differ when viewed in different time frames:

CalPERS pension investments have yielded 7.9 percent a year over the past 20 years. But over the past 11 years, they have earned just 2.5 percent.

What happens when the assumptions don’t pan out? Taxpayers foot the bill:

When higher rates are used and investments fall short, the burden of paying for pensions is pushed onto future generations of taxpayers. At the same time, higher investment return rates enable agencies to contribute less to pension funds while claiming the books are balanced, but a tidal wave of red ink swells when investments falter.

And some of those future taxpayers might not like it. At the same time, the federal government isn’t sitting on a pot of gold. It can always print up more money, but that solution seems to have had less than a 100% success rate.

The Economist reports that a panel of experts recently engaged in some role playing in a scenario based on what would happen if “ new Jefferson,” a proxy for Alabama’s financially ailing Jefferson County, went to the federal government for help.

It was very interesting to see the back and forth on this issue, especially with the Fed governor . . . regarding this as a political issue. And it was also interesting to see that some participants felt that New Jefferson should be left to swing.

In such a situation, both the county and its workers would end up big losers. Is there a winner? It won’t be JPMorgan Chase, which made millions from municipal finance in Jefferson County but ended up in court. Per The Financial Times:

Behind the toxic sewer debt was a web of bribes, captured in taped phonecalls, including alleged payoffs by JPMorgan officials to local bankers and county commissioners to get the bond underwriting business and the county’s blessing on high-fee swap deals, with the cost of the graft added to the bill. There have been high-profile convictions. Larry Langford, a former Birmingham mayor, is in jail. JPMorgan settled a civil suit with the Securities and Exchange Commission related to alleged payments associated with the deals, but did not admit or deny guilt.

The real winner? Maybe the lawyers who have so far collected $20 million in fees in the Jefferson mess, according to The Birmingham News.

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