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A Good Primer on the Public Pension Crisis


Now that Detroit has officially declared bankruptcy, the next big battle in the Motor City will be fought over the future of city pensions. It’s generally agreed that massive pension liabilities are a major part of the city’s financial difficulties, but there is a significant argument over how big the problem is and, in some quarters, whether it is even a problem. If you ask the unions, some pensions are fine: The Detroit Police and Fire Retirement System claims that it is 96 percent funded. Emergency Manager Kevyn Orr sees things differently, claiming that the funding level is a much less healthy 77 percent. Given that a difference of this size could determine whether and how much the city cuts pensioners’ benefits, this is no small matter. Where do these discrepancies come from?

Quartz has an excellent new piece looking at this question, noting how seemingly minor differences in the calculation of the discount rate can lead to widely divergent estimations of the health of these plans:

The Detroit police and fireman retirement system assumed an 8% expected return for [its] assets and liabilities in 2011. An 8% return is very optimistic going forward.  That assumes the 21st century will experience the same growth as the 20th century did. If the investment returns turn out to be lower, the pension fund will run out of money. The whole point is that is uncertain. Even if that 8% return is realized, on average, using it as the discount rate doesn’t account for the risk that in some years returns will be lower. Financial economists believe that the discount rate shouldn’t be the rate of return; it should be the price that reflects the costs of providing the benefits each year. That might be the treasury rate, if the benefits will always be paid, or maybe the municipal bond rate, what the states pay to borrow money. Some actuaries claim the expected return is fine for state pensions because you only need to earn 8% on average, some years you earn more others less. The problem with that is it’s much more expensive to raise capital, if you don’t have enough assets, when markets are down. Jeremy Gold’s research shows that using the expected return as a discount rate effectively shifts the cost of providing the guaranteed benefits to future generations, even when the average return is realized.

Cate Long reckons the right discount rate is a matter of opinion. But using a risk-appropriate discount rate is standard in finance and has been for decades, otherwise states are pretending the guarantee is free. If the fund doesn’t get an 8% return and Detroit can’t rely on its taxpayers, people like Dennis will be vulnerable to even larger benefit cuts in the future.

As the struggle over pensions spreads, a solid understanding of pension financing will be crucial to following state and municipal government responses to the crisis. This piece is a good primer on the basics of pension funding.

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  • Jim__L

    Interesting idea — require pension projections (and therefore contributions) to be tied to the Fed’s Prime Rate. Lower rates, lower projections; lower rates, higher contributions.

    If the Fed keeps the rate at zero, pensions have to assume the returns on their money (money that competes with the Fed’s money) will be considerably reduced.

    It’s the only way for the system to reflect reality.

  • Kavanna

    Ultimately, the pensions crisis is a result of the explosion of municipal hiring and benefits in the 1990s and 2000s, and the delusional Greenspan-Bernanke era of bubble blowing: a false sense of high returns/low risk was created inside of what amounted to a glorified welfare system. The Fed is still trying to keep this going, while municipalities have to figure out how to return to the basics of local government without special interests controlling how money is spent and commitments are made. Discretionary and responsible control was abandoned to special interests and public employee unions decades ago.

  • Andrew Allison

    If the pensions being paid exceed the contributions to, and growth of, the
    fund assets, the assets must decline. What the unions are doing, in effect, is attempting to protect the pensions of those who have retired at the expense of those who have not in anticipation of a taxpayer bailout. I wouldn’t want to bet my retirement on that happening.

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