One More Thing to Worry About: Underfunded Public Pensions

If there is one thing that politicians love to do it’s to promise people things now and not worry about how we will pay for those promises until sometime far into the future, when some other politician is on the hook to balance the budget. 

We see this all the time in the form of budget deficits in the federal government, and also with the accounting tricks used on the Social Security Trust Fund.

These sorts of shenanigans get less press at the state and local level because many state and local governments are required to have balanced budgets (this paper by my thesis adviser Jim Poterba lays out some of the details).  There are, of course, ways for states to get around the balanced-budget provisions.  The method that currently casts the greatest shadow over the future is underfunded pensions.  State governments promise generous retirement packages to state employees, but use accounting tricks to avoid recognizing the full value of what taxpayers will owe in the future to cover those debts.

So how big is this hidden burden?  In a new paper, economists Robert Novy-Marx and Josh Rauh try to figure it out.  Their conclusion: Covering the shortfall due to underfunded state and local pensions would require an average increase in taxes of $1,365 per year for every taxpayer.

This is not the biggest number ever – I actually would have guessed the number would be larger – but it is definitely something to complain about.  If you’ve never thought about unfunded public pensions, then what you’ve discovered is that if you are the average taxpayer, you should think of yourself as being $1,365 per year poorer than you thought you were just a few minutes ago.

That is one expensive blog post.


Rick

Speaking of shenanigans and state pensions, school districts and municipalities in which I live and live near would bribe teachers and city employees near the minimum retirement age with 20% - 30% raises in their final two years of service.

The logic behind this action is to gain an early retirement at a higher annual pension payout that an early retiree would receive, thereby getting a teacher / city employee with 30 - 35 years of service and commensurate salary off the books and hire a replacement for 1/3 the cost.

I can confidently say that there are gym teachers, retired at age 55, who have $100,000 annual pension payouts.

Joe Dokes

As a teacher in California I can tell you that the state teacher retirement system STRS as it is called is not nearly as generous as you assume, and thus not nearly as underfunded as the public employee retirement system, or PERS.

The reason is simple, retiring at 55 is possible but the payout is still quite low. Calculating your retirement under STRS is relatively simple. Multiply your number of years of service by 2.2% or by 2.4% if the retiree is over the age of 61 1/2 years old, this becomes the percentage of your highest salaried year for your retirement. With top salaries for public school teachers in California right around 100K and assuming a teacher started teaching at 23 1/2 years old and retired at the age of 61 1/2 a teacher would have taught 38 years.

There 38 X 2.4% = 91.2% of their top year salary. To get to the magical 100% a teacher would have to teach to the age of 66.

Keep in mind that thanks to a change in Social Security, teachers are not entitled to collect their full Social Security benefit. Thus, if a teacher were to work during the summers at non-teaching job and pay into Social Security, they are not entitled to the same benefit as other workers.

The above calculation also assumes that a person does not include a death benefit for a spouse, including a spouse would substantially lower the percentage guarantee.

I don't teach PE, never have, but people often throw PE teachers under the bus as though the job is essentially glorified baby sitting. Nothing could be further from the truth. In my district PE has a class size of 54 yes 54, you try getting 54 adolescents to do anything. On top of that you are giving students sticks and balls with which they can easily pummel one another. Like all teaching, teaching PE well is difficult. You try standing in the sun for 40+ years straight trying to teach adolescents the concept of sportsmanship, resilience, and athleticism.

Finally, it is clear that an expected return of 8% is unrealistic in TODAYS economy, but it wasn't unrealistic a few years ago. Small changes to contributions by both taxpayers AND public employees would result in saving the system. Conservatives use these huge projected unfunded liabilities in an attempt to do away with a defined benefit program to a 401K style retirement. The original selling point of a 401K style retirement plan was that it would allow employees to retire wealthier AND have control over their retirement. The reality is that the move to 401K style retirement is impoverishing a generation of retirees who will come to rely solely on Social Security. The only group that has benefited from the switch to 401K style retirement plans has been investment groups that charge exorbitant fees which only serve to enrich mutual fund managers at the expense of retirees.

Regards,

Joe Dokes

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Steve

So a teacher can retire with 100% of their salary at age 66 and I don't get my $2,200 a month social security until I am 67 (and you are effectively making that a worse case scenario.) The problem with public sector unions... their main goal is all about getting paid to NOT to provide a service. The politicians have given them more sick time, more vacation and earlier retirement. They are truely bankrupting our future.

joe

Since the unfunded liability varies by state, you can expect (and we've already seen) retirees to leave the high obligation states and move to low obligation states. It helps that the weather is warmer too.

The end result is an over-promise death spiral. Obligation goes up, taxpayers move, obligation goes up again, taxpayers move. The last worker left in the state is holding the bag.

Warren Buffet wrote about the ridiculous return assumptions for pension funds in his annual shareholder letters 10-15 years ago. Entirely predictable, and likely to get worse.

Enter your name...

All we need is a change in laws that will demand full funding (ideally phased in over a number of years, because catch-up is difficult). That should simultaneously put a stop to the disproportionate pension schemes and solve the problems.

Perhaps California should plan an initiative statute: All local government agencies must be at least 75% funded by 2020, 85% by 2030, and 95% by 2040.

tom obrien

This is even worse that the typical "I'll gladly pay you Tuesday for a hamburger today" approach to funding political promises and ambitions. In Illinois we have had years and years of corrupt politicians sitting across from their public sector union benefactors "negotiating" over the pile of (taxpayer) money belonging to neither.

I'm not against collective bargaining - just the kind that is paid for by someone not at the table.

Not exactly an arms length transaction.

@tomob

JAM

As Steve noted in his post, most of these hidden tax payer burdens occur with some sort of accounting tricks or gimmicks.

Thus, the real problem here is the lack of transparency such that these tricks and gimmicks can flourish. Transparency in government must be the goal.

Transparency in government is only truly be achieved by simplifying and refining government’s mission. Keep government simple by only applying it to basic public goods (police, fire, defense, some infrastructure, etc.) and difficult market externalities (pollution). Then it will be much easier for the public to detect the tricks and gimmicks behind these free lunches.

With simple and transparent government, the public will find it much easier for the price signal to help make choices, whether at the ballot box or in the market place. With this paradigm, we will all be more free and prosperous.

Steve Nations

"An average increase in taxes of $1,365 per year for every taxpayer."

I'm curious over what range this average is taken. Is this nation wide? I'm sure it's quite a bit worse in Illinois, where the cost to taxpayers just for keeping our former governors in jail is running awfully high.

the Gooch

Someone correct me if I have it wrong here.

State pension plans assume 8% annual returns.
Ben Bernanke stacks the deck so that risk-free investments return less than 1% annually.
Where are these pension plans investing their money to make roughly 10x the risk-free return when I know they are not allowed to invest in "risky" assets?

It seems to me like this is more of the public sector cannibalism death spiral. When California municipalities go bankrupt because they cannot afford the pension/health obligations to their public employees, who is often the biggest creditor? CalPERS. Since CalPERS has to invest in "safe" assets, it has a huge demand for municipal bonds. This demand pushes down borrowing costs for municipalities, so they borrow more than they would otherwise...and the leverage eventually brings down the house when reality sets in. Am I wrong?

Enter your name...

"Low-risk" and "risk-free" are not the same. They aren't limited to risk-free investments.

MarkB

401(k)'s for everyone! Drop pensions for all new public employees! (And existing ones too, if you can push it through the system...)

KB

Or think about all the public employees who weren't really a party to this underfunding, but who will be dependent upon these promised pensions for their retirement -- since many of these pensions come in lieu of social security. When the state manages to wiggle out of its responsibility to THEM, thanks to its own fiscal irresponsibility and trickery, they (and their families, and the rest of us) once again get to deal with the fallout.

Underfunding should not be allowed, and the rates of return should be long-term realistic. But there seems to be little political will for this, just to blame the employees who've worked to earn the pensions they were promised.

Elliot

Assume the legislature miraculously passes a federal balanced budget amendment; who is going to force the federal government to oblige? Not even 100% of states succeed in balancing budgets.

Current accounting practices allow for manipulation and opaqueness: This is very accurate. It's an inevitable response to propose reforming the FASB and GAAP. Similarly, it would be difficult to force the government to pass a balanced budget. Just my opinion: Balanced budgets are not a vaunted priority.

Brent

I have two ideas that I think could make significant inroads to problems such as this. The first is the use of sortition rather than elections for one of the chambers in bicameral legislative bodies. This will introduce a statistically representative citizen panel similar to jury duty (which we trust enough to sentence people to death) as a check and balance on elected lawmakers. It also eliminates campaign financing and gerrymandering issues for this group and, with dimished ability to "buy" one of the chambers whose votes are needed, these benefits will likely also spill over to the elected chamber. This would hopefully be coupled with a significant increase in the number of lawmakers to make it more difficult to "buy" votes and provide a better citizen-to-representative ratio.

The second idea is to actuarially derive tax rates based on the previous budget year's actual expenditures and revenues. You could then use those figures to set the tax rates to set for the current year as a % increase or decrease from the previous year's rate. This would effectively balance the budget automatically and leave lawmakers to only be concerned with where spending should occur and how revenue sources should be weighted. Lawmakers will have a much greater motivation to limit wasteful spending in order to avoid rates skyrocketing quickly, in turn causing voter outrage. For funding sources, ideally they would be consolidated to just a net worth tax (with an exemption equal to median income times the number of years remaining in your life expectancy) and a sales tax (with a flat rate and a flat dollar refund in order to be fair and progressive). Finally, lawmakers should be restricted from obligating future lawmakers and taxpayers to expenditures via long term bonds, pensions, or other mechanisms.

no future commitments, sales tax only

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mannyv

Before doing anything, let's get some of the value-neutral terminology out of the way. Using obfuscating language just confuses the issue.

"State governments promise generous retirement packages to state employees" makes it sound like these agreements fall out of the sky. Maybe a more accurate statement would be:

"Governors and legislatures promise generous packages to public employee unions during collective bargaining sessions."

OK - given that, why would the various actors want to hide the true cost off the books? Here's a quote from today's Oregonian, on the PERS mess here:

"[...]PERS is political kryptonite in Salem, an issue most ambitious Democrats avoid for fear of reprisal by the party's political patrons, the public employee unions. "

http://www.oregonlive.com/politics/index.ssf/2012/10/oregon_treasurer_race_turns_in.html

So...now that we understand the context. Nobody wants to anger the public employee unions, because they won't get re-elected. Nobody wants to challenge the public employee unions, because they won't get elected. So what incentive is there for any politician to be honest about any kind of PERS system?

This is one of the reasons that WI is trying to remove the power of collective bargaining from the public employees. They have too much leverage, and to a large extent have become an untouchable class. In Oregon payments to PERS tier 1 retirees are projected to overwhelm all other state expenses in the coming years. I'm sure the issue is even greater in other, larger states.

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Howard Brazee

Most state pensions give payouts based upon your income at the end of your career. This is because those who end up with high salaries make the rules.

They would be better served by using the same investments measured in shares. Every paycheck buys shares in the total fund (PERA shares). The payout is based upon the investment income from month to month.

Make sure early investments pay off in the long run more than late investments.

Dan

I am currently a paramedic and hope to soon work for a city as a firefighter. Having a degree in finance has made me a opponent of pensions despite the benefits i would undoubtedly receive from one. I do agree with Joe that teachers work extremely hard and should be able to retire at a reasonable age with a reasonable income. I also agree that taxpayers will have to pay for this and they should. What I disagree with is that taxpayers should insure teachers, firefighters, etc. Investment risk. Everyone else takes on their own risk and its time that public employees do the same. Honor the contracts the cities have made but grandfather all newcomers out. 401ks are the reality.

Charles L.

The solution is simply to cut teacher benefits and pay teachers more, so that their value isn't hidden by clever accounting. Truth is, we need more teachers, we need good teachers, and above all we need more good teachers. Unstable pension systems don't provide too much incentive to debt-laden graduates, but higher salaries do. Some politician would do well to simply cut pensions and give teachers a raise from the money; two things most voters would support. But knowing politics someone will call foul or turn it into a tax cut or something else bogus.
I wish it was done better. But it won't be. It's a stiff price to pay, but I don't think giving teachers less money is going to fix our broken education system.