No Pension? You May Still Owe $30,000 On One

State and local retirement shortfalls are everyone's problem, writes Jack Hough.

Wednesday, November 09, 2011

Pension accounts for state and local government workers are underfunded by $4 trillion, according to one recent analysis. If America's households were to split that tab today, each would have to kick in $34,000.

Don't have that kind of cash on hand? Another option is to chip away at the shortfall over 30 years starting now. That would cost households $1,400 a year beyond what they pay in taxes today.

A pension, for those who aren't familiar with one, is like a 401(k) plan in reverse. With a 401(k), or defined contribution plan, a worker knows how much he socks away, but not how much he will have at retirement. That part depends upon investment returns. With a pension, or defined benefit plan, a worker is told how much he will receive in retirement. It's up to the pension to put aside enough today. To do that, pensions guess about future returns. The higher the returns they assume, they less money they must save today. And therein lies the problem.

Most states assume a yearly return of around 8%, says Kil Huh, who manages fiscal research for the Pew Center On the States, a think tank. "In past decades when investment markets boomed they were able to achieve those returns," he says. "Now they're not even coming close."

Indeed, whether states and local governments have a funding problem under current rules depends on what markets do in coming years. Pensions have two-thirds of their money invested in risky assets like stocks, real estate and hedge fund positions. If the next 20 years could be counted on to resemble the 1980s and 1990s, when stocks returned double their historic yearly average, then states would be flush today.

But plenty of market forecasters expect just the opposite -- for America's burdensome debt, aging population and slowing economic growth to reduce stock returns to a crawl. If they're right, states and cities are vastly understating what they owe.

Future stock returns shouldn't enter into the math, says Joshua Rauh, a finance professor at Northwestern University. He and Robert Novy-Marx of the University of Rochester have proposed a new treatment for pension benefits. "You'd never say to your bank, 'I'm not going to make my credit card payments because my stock returns will take care of that,'" says Mr. Rauh. "That's what state and local pensions do."

What they should do, say the professors, is to treat pensions like debts that don't allow for default. That would call for math that uses a default-free investment rate, like the rate on U.S. Treasury bonds. Even the longest-maturity Treasury bond pays barely 3% at the moment, or less than half what pensions are assuming for their returns. "The only reason to use a higher rate is if you allow room for future defaults," says Mr. Rauh.

Pension abuses by workers might have have helped create the problem. "Nearly every fire house in the country saves the overtime pay for the guy who's about to retire," says Mr. Novy-Marx. That's because pensions often base retiree benefits on the highest year's pay workers achieve.

Some municipalities have adopted so-called anti-spiking rules to prevent such abuse. "But those only affect new workers," says Mr. Novy-Marx. "It's going to make things cheaper 40 years from now but it's not going to do anything now."

A bigger problem than pension-gaming, however, is "ignoring your bill, and that's what pensions have done," says Mr. Huh.

Not everyone agrees that there's a pension funding crisis. In June, the National Conference of Public Employee Retirement Systems (NCPERS), a trade group for pensions, published survey findings showing that plans were "solidly funded." Among more than 200 funds that participated in the survey, the average had achieved average returns of 8.2% a year over the past 20 years and was now assuming a 7.7% yearly return in its funding math.

Over the past five years, however, the Standard & Poor's 500-stock index, a benchmark for U.S. stocks, has returned 0.25% a year. NCPERS did not respond to requests for comment.

"At the end, what you have is a distributional problem," says Mr. Novy-Marx. State and local governments say they're $1 trillion underfunded, but the truth is closer to $4 trillion. All of the discussion should be about how to distribute that pain."

Possible recipients of that pain, he says, include taxpayers, who could pay more or get less in services; workers, including future hires and retirees, who could have benefits cut; and municipal bondholders, who could suffer defaults if local governments can't pay what they owe.

States are already working on changes. Illinois has raised its retirement age and capped the salaries used in calculating benefits. New York has proposed similar changes. California's governor proposed a shift toward a defined contribution plan. But most of the changes don't apply to current workers.

"Right now everyone is trying to foist the problem on new workers," says Mr. Novy-Marx. "That's politically painless but it has little effect on shortfalls." Retirees account for about half of pension obligations.

The "day of reckoning" won't come for 10 to 15 years, says Mr. Rauh. By then pension accounts will be low on assets and municipal bond markets will react, he says. "As we know from the European debt crisis it's hard to predict when bond investors will panic," he says. "We've known about Greece for a long time, but its bonds imploded only recently."

To prevent such a fate, pensions will have to decide soon how to distribute the pain. "Most of it is going to go to the taxpayers," says Mr. Novy-Marx, "because they're the only ones who can afford to pay."