The Feds and the Pension Pit

By | 2017-06-02T18:30:05+00:00 December 12, 2016|
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Over the last several years, the public has become increasingly aware of a fiscal Sword of Damocles hanging over it—state and local public pensions that have promised far more than they will ever likely be able to deliver.

Often under the political influence of public employee unions, state and local governments, including school boards, have been saddling future citizens with substantial debts. Unlike defined-contribution plans, such as 401(k)s, defined-benefit pensions promise a payout to future retirees, based on certain investment returns.

When those returns fail to materialize, however, future generations are left to pick up the tab, at the cost of saving for their own retirements. These promises have been held by the courts to be contractual obligations, alterable only by agreement of both parties.

Right now, by some estimates, the country has up to $5 trillion in promises that it likely won’t have the money to meet. That’s trillion, with a T.

Public pension managers dispute these numbers, and claim that the actual unfunded liability is far lower. To reach that conclusion, however, they make use of an accounting loophole that isn’t available to private pensions, and isn’t available even to public pensions in most parts of the world.

When they calculate how much their promises are worth in today’s dollars, they discount their liabilities—the promises they’ve made—using the expected rate of return. Instead, they should use the interest rates that their state would borrow at, a far better measure of how risky people believe their contractual promises to be. That’s almost always a lower interest rate, which means that in reality, people judge those promises to be worth far more, to be far more reliable, than an investment in the stock market.

There’s another, more insidious effect of using the expected rate of return: it encourages funds to take on more risk, making the promises look smaller, but increasing the likelihood that those promises will go unfulfilled.

Nevertheless, the costs of public pension promises are real, and quite destructive. Money that could be going to rebuild roads and teach kids and keep neighborhoods safe instead is diverted to honor promises made by long-departed politicians to long-retired employees. As taxes rise, businesses and many citizens move on, but the debt remains. They have driven several major cities to bankruptcy, and have wrapped the finances of several states around an axle, most notably Illinois.

While cities can declare bankruptcy, states cannot. Sooner or later, some state is going to come, hat-in-hand, to the federal government asking for a bailout. Citizens of more fiscally responsible states will be asked to pay for the reckless, politically driven promises of politicians such as Mike Madigan, the long-serving Democratic Speaker of the House in Illinois.

This can’t be allowed to happen.

The federal government’s direct power here is limited. It can’t directly order state and local pensions to cut benefits, or close out these oversold promises and convert to defined contribution or cash balance plans. It can’t order them to lower their expected rates of return. But if it has the guts to stand up to the public employee unions and their pensions, the federal government could do a couple of things that would force states to confront the problems squarely.

First, it can have them use the proper discount rate.

In Colorado, the Public Employees Retirement Association (PERA) currently admits to an unfunded liability of roughly $26 billion. Properly discounted, that unfunded liability rises to more than $60 billion. When I present this figure to groups, I point out that this comes to roughly $30,000 in long-term debt per Colorado household, roughly equivalent to adding the cost of a nice kitchen remodel to a mortgage—without getting the new kitchen.

When properly accounted for, the liabilities will be much bigger than the pensions admit to now. The funding ratios will be lower, the admitted unfunded liabilities higher. And the political pressure to do something about the problem will grow overnight.

As valuable as a proper funding ratio is, the question that matters most is this: How likely is it that the pension fund will run out of money, or become dangerously underfunded, at some point in the future?

In 2014, the Colorado state legislature passed a bill requiring PERA to do exactly such an analysis. It found that PERA’s state and school funds—by far its largest—each have a better than 1-in-10 chance of running out of money in the next 30 years, and a 1-in-4 chance of dipping below 25 percent funding, based purely on variations in investment returns.

Pension funds over a certain size should be required to run exactly that same analysis every year.

Finally, Congress should pass and the president should sign legislation explicitly rejecting any federal responsibility for state and local pension debt. Eliminate the temptation to create a moral hazard now, and leave no room for misinterpretation.

Unfortunately, the politics of this last move may end up being the hardest to bring together. The federal government has been slowly extending its leverage over the states for decades, largely through threats to withhold funding for roads or schools unless states take certain actions.

By unilaterally washing its hands of the problem, Washington would also be renouncing both carrots and sticks, diminishing its own power.

That would be, to put it mildly, an exception.

About the Author:

Joshua Sharf has headed the Independence Institute’s PERA Project for three years. In that time he has authored a number of Backgrounders and Issue papers on Colorado’s Public Pensions, contributed to the Institute’s weekly newspaper column, and spoken to political and civic groups across the state on the subject. He routinely testifies before the state legislature on proposed pension reform bills. He has also done original reporting on PERA for Watchdog.org and I2I’s Complete Colorado news site and is a regular guest on local talk radio, discussing this and other state and national political issues. He has an MBA and an MS in Finance from the University of Denver’s Daniels School of Business, and has also worked as a sell-side equities research analyst.