The American Interest
Analysis by Walter Russell Mead & Staff
The Pension Crisis is Worse Than We Thought

Stockup

America’s pension crisis may be much worse than we thought. A new report from State Budget Solutions looks at each state’s pension liabilities using a lower estimate of the rate of return than the states use themselves, and found that the country’s plans are underfunded by $4.1 trillion, and only 39 percent funded overall. The state-by-state breakdown looks even worse, with Illinois, Connecticut, Kentucky and Kansas holding plans that are less than 30 percent funded, and another 27 states below 40 percent. Other states have it bad as well: Reuters notes that in five states, pension liabilities more than 40 percent as large as the state’s economy as a whole, and in Ohio and New Mexico, they’re more than half as large. Considering that many people consider plans to be “safe” only when their funded level is over 80 percent, this is troubling news indeed.

These numbers are significantly higher than those we’ve seen before, which is due to the extremely conservative estimates of the rate of return. Rather than assuming a rate of return in the 7-9 percent range, as most plans do, State Budget Solutions is using the “risk free” rate of 3.225 percent, which is tied to the yield on treasury bonds. The SBS explains its reasoning:

Current public sector practices involve discounting a liability according to the assumed investment returns of plan assets, typically around 8 percent. Yet with discount rates tied to expected investment performance, plan sponsors can easily take on greater risk in order to make liabilities appear smaller. This reduces the resources required today to pay for the promises of tomorrow.

Accurately accounting for a pension system’s liability requires incorporating the nearly certain nature of benefits. That is, once promised, the chances that benefits will not have to be paid are extremely low.

A fair-market valuation does away with optimistic investment return assumptions and instead uses a rate that reflects the risk of the liability itself. One common approach, taken here, is to discount liabilities according to the yield of a 15-year Treasury bond.

We’re not actuaries, and we’re not sure whether the the rate of return will be as low as the risk-free rate suggests. Nonetheless, it’s obvious that the rates of return used by cities and states are far too high, and given the problems we’ve seen with underfunded pensions, it’s probably prudent for states to err on the side of caution when it comes to calculating the rates of return on pension investments.

[Stock graph image courtesy of Shutterstock]

Published on September 7, 2013 12:05 pm
  • Hubbub

    “…crisis may be much worse than we thought…”

    Can this not be said of practically all crises we faced since the 1960s? More destructive policies were foisted on the American public than in any period since the Civil war – with the possible exception of Reconstruction.

  • Jane the Actuary

    I AM an actuary — working with private-sector plans. The original FASB approach for pension valuations was to use as a discount rate, the rate at which the liabilities could be settled, that is, by purchasing annuities. As time passed, this ultimately became standardized into “high quality corporate bond rate.” Some actuaries argue that a true risk-free rate should be used, but they’re in the minority. In any case, the concept of the annuity-settlement rate is becoming more relevant in the corporate world, as settling pension liabilities (by buying annuities or offering lump sums) is becoming increasingly popular. http://www.janetheactuary.blogspot.com/2013/09/lets-talk-pension-accounting.html

    • Me

      I deal in annuities, so I can comment from that side of things. We’re seeing an increasing number of people use an annuity as a “personal pension”, for exactly the reasons you see above. What most people don’t realize is that the next-day rate for an annuity is in the 5% range…and if you’re dealing with deferred obligations, can be closer to 10%

      • mike mace

        What do you mean by a next day rate? Thanks.

        • Me

          Lemme illustrate. So, you’re a retiree, heading out the door with a 401k. You’ve put built that up to $500K.

          Your goal is to turn that into an income stream (to replace the income from your job) without endangering your principle. Since you’re now out of the job, you need an income starting the next day – thus, the “next day rate”.

          Conventional solutions will do well to give you 4% on that, or $20K/year. Last week, when I had this discussion with a gentleman in _exactly_ this solution, his “next day” number was $27K/year.

          Alternately, you can wait a little, grow the money, THEN pull the income stream off the top. One great example we had on that a while back – his conventional “next day” number was $22K/year. We arranged things to wait one year, then pull income – and through various machinations, that income stream was $37K/year.

          • mike mace

            Thanks. I’m familiar with the concept, not the term.

  • charlesrwilliams

    8% is way too high but 3.2% is too low. T-bonds have features that are irrelevant to funding pensions that make them attractive at a low interest rate.

  • kurt9

    Do remember than public pensions are not covered by the Pension Benefit Guarantee Corporation (PBGC), which has assumed the pension liabilities of many bankruptcies (many of the airlines come to mind). In some cases, most notably CALPERS, many state employees were exempt from FICA withholding. They never paid into Social Security and, thus, are not eligible for Social Security when they reach retirement age.

    In short, the very deserving bureaucrats will actually suffer consequences. This will not be a pretty story.

    • CuriousKevmo

      I doubt very much that “the very deserving bureaucrats” will suffer consequences so much as we rubes paying the taxes.

      • kurt9

        Actually they will. The problem is that the truly, truly deserving people, the union officials and politicians who negotiated the deals back in the 70′s and 80′s will not have their personal assets seized to make up the shortfall, even though I think someone will try to do this through the courts.

  • Rick Caird

    The other problem is that Bernanke’s ZIRP is killing people who are trying to save themselves for additional pension income. Those of us who are retired are being forced to eat our savings because of very low yields or take on risk that could really be damaging.

    Add to that, IBM has announced the end of retiree health care benefits and it is clear retirement is becoming a pipe dream.

    • Jeff McCabe

      That’s not exactly what IBM announced.

      • Rick Caird

        You are right. I overstated it.

        But, I understand how this works and what will happen is the first year or two, it will work out pretty well, but as it goes on, the HSA will be less and less a percentage of the cost of the policy. IBM did say they expected that without this change, their retiree medical costs would triple by 2020. So, you can assume IBM will be reducing the effective contribution.

        Secondly, in 2003, IBM announced that no new hires will get retirement health care benefits.

        So, the direction is clear. It will just take a while.

  • sukietawdry

    Err on the side of caution? Oh, way too late for that. Caution left the building long ago.

  • iconoclast

    Well, we could always just cut their pensions in half. Or refuse to pay pensions to anyone who was a apparatchik in the school system.

    After all, they depend upon us to pay them. Not the other way around. Screw ‘em.

  • teapartydoc

    Wall Street, predatory lending, corporate greed. Why can’t we be more like Sweden? It’s all your fault. Waah.

  • Bruno_Behrend

    Public pension “contracts” can, and should, be attacked on various elements of contract law.

    First, many pensions are “impossible” contracts, in that there never was going too be a way to fulfill them financially or actuarily. These “void” on their face.

    For most of the rest, there never was an honest, arms-length agreement, given that both sides of the table were owned and operated by the unions, who purchased the elected officials.

    These contract are “voidable.”

    Dump all of them, and tell recipients they will receive what the systems can afford.