Deep in the public pension weeds
Most discussion about public pensions revolves around the levels of funding that governments report in their Comprehensive Annual Financial Statements (CAFRs). Itâ€™s a means of taking the temperature on the health of the pension fund.
To get these numbers, actuaries do some complicated math that projects the lifetime earnings of the public employees in the plan. They also calculate how much funding the sponsor government must contribute, how much payout retirees will receive and they make projections on how the investments owned by the pension funds will perform over time.
Like most financial modeling, the math is based on numerous assumptions — some which are accurate over time and some of which vary from actual results.
Muniland research firm Diver Analytics created a heat map (above) that illustrates pension-funded levels in 2012 (the most recent complete official data). We can see some severe problems.
Puerto Rico, for example, has less than 7 percent of the assets needed to make its required pension payments over the next 30 years. Illinois had less than 45 percent (both Puerto Rico and Illinois have done pension reform that will help). In contrast, New York made hard choices and funded its state pension system (which covers local employees) at almost 100 percent.
These numbers matter for taxpayers who are on the hook to fund public pensions and also to municipal bondholders who want to know that a state or local government wonâ€™t be drowned by its future unfunded liabilities.
There are numerous forces fighting these pension battles. Groups including credit rating agencies are pushing to use stricter methodologies to measure future pension liabilities. This push would require that governments dedicate even more funding to pension funds or pursue pension reform to lower future liabilities.
Indiana embraced substantially tougher standards to determine the future liabilities of its pension fund. The Indiana Public Retirement System (INPRS) adopted what may be the most conservative public pension investment return assumption in the nation. In June 2012, the systemâ€™s board reduced the investment return rate to 6.75 percent from 7 percent. INPRS, the only public system under 7 percent, is now the lowest among the 126 public systems monitored by the annual Public Fund Survey. The national median for funds in the Public Fund Survey is 7.9 percent.
The municipal bond market is supportive of pension reform. The Head of the Municipal Bonds Group at Blackrock, Peter Hayes, blogged this week:
In my last post, I shared my views on why pension reform is gaining traction in states throughout the country, and why this is generally good news for muni investors. While we do not believe pension problems threaten to harm state and local finances to the point of breaking the municipal bond market (a view shared by the Center for Retirement Research at Boston College), they are a source of financial pain in some locales. And in rare cases, overly burdensome pension liabilities, when combined with a generally weak credit profile, may be reason to avoid investing in the municipal debt of certain issuers.
So how do we spot pension tension? To identify the potential trouble spots, we ask ourselves three questions:
- Does the state or city in question have a pension funded ratio of below 60 percent?
- Has that state/municipality issued pension bonds to fund that gap? (Incidentally, those bonds are taxable, not your traditional tax-exempt municipal debt).
- Does that state/municipality also have municipal debt outstanding?
Hayesâ€™ focus, like most in the municipal market, is on liabilities that will weigh on future revenues and limit what resources governments have to pay for services and repay bondholders.
Another force involved in the pension battle is public unions. Are public unions to blame when a state has a poorly-funded pension system? Do unions push so hard for enormous retirement benefits that state and local governments donâ€™t have the resources to pay for promises in the future?
Recent data published by Diver Analytics shows mixed evidence. In the chart below I put a red star next to the states that have the lowest-funded pensions. Some states with low-funded pensions have high concentrations of public unions and some do not. There doesnâ€™t appear to be a consistent pattern. Mississippi has less than 5 percent of unionized public employees, but its pension system is less than 60 percent funded. Meanwhile, about 70 percent of New Yorkâ€™s public employees are unionized, but the stateâ€™s pension fund is funded at nearly 100 percent:
Other mythologies have arisen in the public pension debate, including criticism by writer David Sirota that the rich are using a â€śpension crisisâ€ť to attack public workers and protect corporate subsidies.
Many of us in muniland had raised concerns about pension funding long before any billionaires piped up. To understand how real the pension crisis is, just look at Puerto Rico, which is now on a pay-go system for public pensions because it exhausted its pension assets. Itâ€™s not pretty.
Sirota may have a legitimate issue in criticizing the subsidies that state and local governments give to corporations to keep them in their state. But it is not as black and white as he describes. From Sirotaâ€™s work â€śThe Plot Against Pensionsâ€ť (page 7):
The goals of the plot against pensions are both straightforward and deceptive. On the surface, the primary objective is to convert traditional defined-benefit pension funds that guarantee retirement income into riskier, costlier schemes that reduce benefits and income guarantees, and subject taxpayers and millions of workersâ€™ retirement funds to Enronâ€™s casino-style economics.
At the same time, waging a high-profile fight for such an objective also simultaneously helps achieve the conservative movementâ€™s larger goal of protecting profligate corporate subsidies. The bait-and-switch at work is simple: The plot forwards the illusion that state budget problems are driven by pension benefits rather than by the far more expensive and wasteful corporate subsidies that states have been doling out for years. That ends up 1) focusing state budget debates on benefit-slashing proposals and therefore 2) downplaying proposals that would raise revenue to shore up existing retirement systems.
Sirotaâ€™s methodology to determine the â€śfar more expensive and wasteful corporate subsidiesâ€ť appears to rely on the groundbreaking work done by Louise Story at the New York Times two years ago. Story and her team estimated that corporate subsidies across the country totaled about $80 billion a year. State governments admit that they donâ€™t consistently track or do cost benefit analysis on corporate subsidies, but have begun an effort to do so.
In contrast, the largest 126 public pension plans in the country had employee and employer contributions of over $100 billion in 2012 and investment earnings of $100 billion, following $350 billion of investment earnings in 2011.
To bring more parties to the table, states could make an effort to jointly reform pensions and corporate subsidies. This would focus the statesâ€™ efforts on reducing expenses and prevent them from singling out workers or businesses for unfair treatment.
Pew recently wrote about statesâ€™ efforts to tax corporate profits that have been sheltered offshore. I think most state officials would admit that they have been too generous with those who showed up at the state house for financial preferences. Down in the weeds of pension reform, a corporate subsidy or two may need to be reformed as well.