The Real Problem with Public Employee Pensions

October 11, 2009, 3:52 pm The Washington Post reports today (”Steep Losses Pose Crisis for Pensions”) on the sorry state of funding in state and local employee pensions, focusing on the impact of recent poor stock returns. While a poor investment climate certainly hasn’t helped, it’s not the biggest reason public employee funds are in bad shape. A bigger reason the plans are underfunded is that, in effect, we told them they can be. State and local pension plans use different and far less demanding accounting rules than do corporate pensions, even though public employee benefits are guaranteed by law while corporate pension benefits are not.

The key issue is how to “discount” future benefit obligations to the present, which tells us how much plans must have on hand today to fund their future liabilities. A high discount rate lowers the present value of a future obligation, while a low discount rate implies a higher present value.

Corporate pension plans must discount their future benefit liabilities at the low interest rates earned by high-quality corporate bonds, while public pension plans are allowed to use the much higher expected return on their assets, which include a high proportion of stocks and, more recently, hedge funds and private equity. The effects can be startling.

For simplicity, imagine a pension plan that owed a lump sum of $1 million 15 years from now. Discounting at a 6.25 percent interest rate—which is typical for corporate bonds today, although higher than several years ago—the present value of that obligation would be approximately $403,000. That is, the pension would require current assets worth at least $403,000 to consider itself “fully funded.”

Using an 8 percent return, which is not uncommon for public pension funds, the present value of that $1 million future obligation would be only $315,000. Plans that have investments worth at least $315,000 would consider themselves fully funded and, in some cases, use this status to justify increasing benefits.

Defenders of current actuarial practice argue that public pension funds are different, since governments can’t go bankrupt—a proposition that may well be tested soon—and because they can always raise taxes to fund deficits. The latter may be true, but surely the point of pension accounting is to give taxpayers some idea of the contingent liabilities hanging over them—which current methods do not.

Moreover, there is a good case that public pension funds should use lower discount rates than corporate pensions because public pension benefits are a safer asset for the beneficiary and thus a more binding obligation on the pension plan. Corporate pension benefits are not fully guaranteed if the sponsor goes bankrupt, while in most states accrued public pension benefits are treated as a binding obligation. In many states these benefits are guaranteed in state constitutions.

If these pension obligations are as binding as state government bonds, it makes sense to discount them at the same rates. Nationally, the yield on a state government bond with a maturity of 15 years averages around 3 percent. Discounted at that rate, a $1 million future obligation requires $642,000 in assets today—over twice as much as the funds themselves would consider necessary.

Moreover, while public pensions discount their future obligations at the “expected return” on their investments, this doesn’t mean we can actually expect those assets to meet their goals. The reason is that funds take as the expected return the average return on the asset classes they hold, and the average return is always higher than the median or typical return. Imagine that a public pension fund invested $315,000 in assets with an expected return of 8 percent and a standard deviation of returns of 13 percent. Using a Monte Carlo simulation we can check how often this portfolio is likely to exceed $1,000,000 in 15 years time. The answer is a little over 40 percent, meaning that there’s an almost 60 percent likelihood that even a “fully funded” public pension plan won’t be able to meet its obligations.

Allowing public pension funds to discount their benefit obligations at the expected return on their investments doesn’t just lower the amount of funding they must undertake, it also encourages them to take more risk with their investments. Were a fund to hold only safe investments like Treasury bonds it could discount its benefits only at a low interest rate. But the riskier the investments they make the higher discount rate they can use. It’s easy to see where this leads. For instance, the expected return on the Profunds “Ultrabull,” which doubles the returns on the S&P 500 would be, well, double the expected return on the S&P 500—or around 20 percent per year. This would solve plans’ funding problems on paper, but it’s hard to believe this is the most sensible investment strategy to take.

Accounting is a boring subject and so it’s not surprising that it doesn’t get much attention in the press or by lawmakers. But it’s hugely important.

Article by Andrew Biggs

Welcome to "Life Cycle Planning" 101

Financial planning means something different to everyone. For some, it's about getting by month to month on their paycheck, for others it's about watching how their stock portfolio performs each day.

Unfortunately, few of us feel completely prepared to meet our ongoing financial obligations and objectives. Worries about money have become one of the greatest anxieties of our day - witness the dramatic rise in financial-related publications, radio and television shows, and websites.

Because each person's situation, lifestyle, and goals are so different, there is no single turnkey solution for successful money management. However, we can identify several steps that successful people take in pursuing their financial goals. We call these steps "Life Cycle Planning" because each step can be tied to the attainment of certain life-defining events that almost everyone goes through.

Development of Human Capital

Human capital refers a person's ability to turn their skills and abilities into a livelihood. The development of these skills and abilities helps us maximize our income potential in a competitive marketplace.

In our early years, usually between age 18 and 25, we set ourselves on a course that largely defines our human capital potential. Each of us makes an investment in human capital, whether we realize it or not. For some this is an investment of time, gaining experience and skills on the job. For others it is an investment in trade school or college.

It should also be noted that, although our greatest focus on human capital development generally takes place in our early years, this is an investment we should continue to make and assess throughout our working careers. Your ability to earn income, now and in the future, is the most valuable asset you own.

Expense Management and Budgeting

Once your "human capital" investment begins to pay dividends in the way of regular income, you must begin to develop and apply management skills to your newfound earnings.

Without managing your expenses, your wants and needs will invariably outpace your ability to earn. By implementing some form of budgeting, you can begin to set your sights on saving and meeting your longer-term financial objectives.

A beginning budget can be as simple as setting aside a predetermined percentage of your earnings each month for saving, spending what is left until it is gone, then spending nothing more until next month. A more sophisticated budget takes into account irregular and flexible expenses, emergency expenditures, establishment of a "rainy day" fund, as well as saving and investing.

Ensuring Adequate Liquidity

As your budget begins to pay off in a healthy savings account, you might begin to wonder how best to apply your limited savings to your unlimited needs and wants.

Without exception, the first financial need you should meet is to have an emergency fund. An emergency fund allows us to cover unexpected short-term needs using cash instead of leveraging your future earnings through costly loans. As a general rule of thumb, your emergency fund should be adequate to maintain your standard of living for six months.

Ample Insurance Protection

A major disability, the loss of a family breadwinner, a fire in your home, a family member's major medical problem or need for skilled nursing care ... the most dramatic emergencies can seldom be paid for completely using personal savings.

Although such tragedies can create devastating individual financial hardship, the financial risk of such events can be shared by very large groups of families and individuals through insurance.

Life insurance, disability income insurance, property and casualty (P&C) insurance, long-term-care insurance, and major medical insurance all have a place in your "Life Cycle Planning."

Long-Term Funding Objectives

Once you've accumulated sufficient funds to cover your emergency needs and purchased protection against financial risks, you can begin saving for your long-term goals in earnest. We can help you design a plan to pursue your retirement objectives that fits with your personal financial goals, risk tolerance, and time horizon.

For information on how PFS helps their clients achieve their objectives-Dana Schulz can be reached at 1-888-640-4770.