Pensions: The Biggest Story of the Week - Or the Year

By James Kwak

This is the biggest story of the week. Or the year. Frightening.

I’ve been wondering why the impact of the financial crisis on the overall retirement “system” hasn’t gotten more attention in the media. We already knew the system was in bad shape before September 2008. According to the Fed’s Survey of Consumer Finances, in 2007, only 60.9% of households where the head of household was age 55-64 had retirement accounts . . . and their median retirement balance was $98,000. Given that the stock market has fallen by over 50% from its October 2007 peak - and that, for decades, the standard investment advice has been that stocks do better than any other asset class in the long term - we would be lucky if that median balance were more than $70,000 today.

The Bloomberg article linked to above describes the fragile state of state and local pension systems. These systems suffer from two major problems today. One is that even if they had been managed in a reasonable way, the fall in asset prices over the last year would have blown a huge hole in their long-term solvency.

The second, and the focus of the article, is the perverse behavior that is caused by accounting rules governing pension funds. The key question for a pension fund is whether the assets it has today will be enough to pay off its future liabilities. The assets are relatively easy to value, at least most of the time; the future liabilities are relatively easy to predict actuarially (although unanticipated developments, such as a sudden change in life expectancy, could mess up that calculation); but the hard part is estimating the rate of return on the assets. So . . . public pension funds are allowed to assess their long-term solvency using assumed annual rates of return, generally around 8% per year. Of course, as we know, things don’t always work out that way: the Vanguard Balanced Index Fund (which indexes virtually all U.S. stocks and bonds) has an average annual rate of return of 0.9% over the last 10 years, and even since its inception in 1992 its annual return is only 6.0%.

These optimistic assumptions are bad enough, because they allow underfunding of pensions. But what’s even more bizarre is the behavior this causes. As the Bloomberg article explains, local governments issue pension obligation bonds to raise cash for their pension funds. These bonds usually pay fixed interest rates, say 6%, and the proceeds are then invested in risky assets. But the magical thing is that because you are allowed to assume an 8% return, for pension accounting purposes, the difference between 8% and 6% is free money! Well, it’s free money as far as this year’s assessment of the pension is concerned. In the long term, of course, it’s a crazy investment strategy (and a mistake many people make - comparing a risk-free interest rate you borrow money at with a risky expected rate you hope to earn). And the results in the future are predictable: either higher taxes, or yet more value-destroying pension obligation bonds. Sometimes people get caught saying stupid things, like Christine Whitman saying, “You’d be crazy not to have done this. It’s not a gimmick. This is an ongoing benefit to taxpayers,” but it’s really a systemic problem.

Our retirement “system” has four main legs: Medicare, Social Security, corporate or government defined-benefit pensions, and private saving (IRAs, 401(k)s, etc.). Right now it looks like Medicare and Social Security are the stronger legs.

Note: The Bloomberg article refers disapprovingly to Jon Corzine’s proposal to reduce state pension contributions during the recession. I actually agree with Corzine, at least on principle. When the pension fund’s assets fall because of a recession, you don’t want to force the state to make up the difference immediately, because that would be extremely procyclical - it would cripple the state budget right when you want to be spending more, not less. The converse, of course, is that when the economy is good and tax revenues are high you should over-contribute to the pension fund - not just make up for the recession years, but also build up a surplus. We’ll see if that happens.

Comments

[Tricky:]

No worries, I have full faith that American taxpayers will pick up the bill

Mar 03 02:44 PM

[morph366:]

Exactly as Tricky said - just stick it on the tab. After all the taxpayer's got a lot of money.

Mar 03 03:00 PM

[Matthew Rafat:]

Excellent, excellent article--I've been trying to warn the public about the danger of underfunded public pensions. The government's actuarial projections border on being deceitful. Links to my articles are below:

willworkforjustice.blo...

willworkforjustice.blo...

willworkforjustice.blo...

Mar 03 03:01 PM

[doofkcans:]

I've always felt confident that somewhere in the future medical technology would at least halt aging, which would then later bootstrap into a further actual reversal of aging - I now wonder if, hypothetically, the haltability occurs around 2020 and the reversal is available 2035 what that would do to Social Security and if maybe we should be thinking of a future scenario just in case...

Mar 03 03:03 PM

[spope33:]

It will be impossible for taxpayers to make up the shortfall for PBGC, Calpers, and all the rest without onerous levels of taxation that would tank the economy and/or create social unrest and taxpayer revolt. The only avenue is to wind down these pension systems, to quit offering defined benefit pension products and to try to make a fair buyout to people already in the system. The alternative, if nothing is done, is a string of defaults across California and elsewhere.

Mar 03 03:06 PM

[Reggie:]

New Jersey, as the country as a whole, has had some very good years with tax returns higher than expected. NEVER, I repeat, NEVER has the state over-funded the pension fund.

So, now they want to skip some contributions till better times. That's a joke that will hit those ready to retire and the state's taxpayers.

Taxes will go up and frankly, I don't believe they can go up high enough (without a real revolution) to meet the needs of the pension fund.
So, get ready for hell to break out.

Mar 03 03:14 PM

[nw:]

"Our retirement “system” has four main legs: Medicare, Social Security, corporate or government defined-benefit pensions, and private saving (IRAs, 401(k)s, etc.)."

Perhaps children should become a main leg. I recall reading that Singapore has a law requiring children to support their parents if needed.

Mar 03 03:26 PM

[hernje:]

Why is it that state and federal government employees aren't made to live in the real world they helped create? That world being one where pensions are, for the most part, a thing of the past. Private sector employees have been forced to fund their own retirement by way of 401/k plans and a social security pittance. It's time for government employees to do the same, as we the people!

Mar 03 03:40 PM

[Chris B:]

Warren Buffet warned us about this years ago.

There aren't any pension plans earning 8%. There should be a law requiring that anticipated future returns must be tied to risk-free yields available at the time, such as treasury rates, instead of being made up out of thin air.

The end game of all of this is that the government will end up bailing out the pension plans of GM, AIG, GE, F, Chrysler, and others because all those old folks vote. As "nw" says above, that's when children become the fifth leg. Whether through taxes or inflation, they will pay.

And just think, we could have avoided all this with sensible regulations applied to pension plans. Of course, then we'd have the usual suspects claiming this was wasteful government intervention and so on, just like with bank regulation.

Mar 03 03:45 PM

[JohnL:]

-- Right now it looks like Medicare and Social Security are the stronger legs. --

Wow! That says it all right there!

Mar 03 03:59 PM

[orangutan:]

"Private sector employees have been forced to fund their own retirement by way of 401/k plans and a social security pittance. It's time for government employees to do the same, as we the people!"

Let's race to see who can create the worst system!

Mar 03 06:23 PM

[mwfall:]

one of the biggest criminal rings in the u.s. is government worker pensions. my cousin worked for 20 years as a social worker. she retired after only 20 years with a pension equal to her last years pay plus benefits every year for the rest of her life. if she lives to 85 thats about $3 million dollars !

that means for her job as a counselor she will be compensated the equivalent of about $111.00 per hour.

are children are shouldered with the burden from the government criminals that vote themselves these pensions.
pid=20601109&sid=a...

Mar 03 07:49 PM

[Speedspirit:]

No worries at the rate we are going the govt will lift the mandatory retirement age to help the working class.

Mar 03 08:09 PM

[@TexasER:]

We already have this law. It is just called social security.

On Mar 03 03:26 PM nw wrote:

> Perhaps children should become a main leg. I recall reading that
> Singapore has a law requiring children to support their parents if
> needed.

Mar 03 10:43 PM

[RalphTR:]

The premise that elected officials at all levels of government just might serve as good fiscal stewards of taxpayer funds at any point in the economic cycle is seriously flawed. It was during the "good" times that they contributed to our current fiscal mess by feathering the pay, benefits, and pensions of government employees, particularly police, fire, and corrections unions, in return for political support. It's a self perpetuating quid pro quo situation.

Only a few politicians have stood their ground against the public employee unions -- Guliani, Bloomberg, and Schwarzenegger to name the few. At the other end of the spectrum we have Nancy Pelosi, Harry Reid, Obama, and Barney "Elmer Fudd" Frank.

The only possible reconciliation of this problem is a full "blood in the streets" depression that will scatter the pigs from the taxpayer funded government trough. .

Mar 04 12:23 AM

[John Lounsbury:]

Just read a news article this morning from New York State. Gov. Patterson is proposing changing New York State employee retirement changes:

1. Raise minimum retirement elegiblity age from 55 to 62.

2. Increase minimum service to be eligible for pension from 5 years to 10 years.

3. Institute employee contributions to pensions. (I blieve this used to be the case, but was eliminated a number of years ago.)

The news article said unions have issued statements against the proposed statements.

Mar 04 10:55 AM

[Fred Voetsch:]

I agree that this wwill be one of the next big stories but I imagine it will end up being one of the BIG stories that stays with us over the course of the next DECADE and gets retold over the decades.

Mar 04 01:57 PM

[Simon Smelt:]

>Right now it looks like Medicare and Social Security are the >stronger legs.

According to U.S. national accounts these, plus veterans' entitlements, have a future unfunded liability of $60 trillion - over 400% of the U.S. annual GDP. Never mind, maybe the Chinese will lend the money.

Mar 04 02:04 PM

[Kinabalu:]

"When the pension fund’s assets fall because of a recession, you don’t want to force the state to make up the difference immediately, because that would be extremely procyclical - it would cripple the state budget right when you want to be spending more, not less. The converse, of course, is that when the economy is good and tax revenues are high you should over-contribute to the pension fund - not just make up for the recession years, but also build up a surplus."

While this would, theoretically, be stimulative fiscal policy, its terrible investment policy and would result in even worse investment returns and more poorly funded plans as money is thrown in at the market tops.

Government's historical record for crafting truly stimulative spending is poor. The latest bailout bill and the proposed federal budget prove that they just can't do it.

Mar 04 03:40 PM

[pockyclips ...:]

Sounds a little like class envy, but you are right. If I had it to do over again, I should of put up with the incompetent bureaucrats, and I could have retired 11 years ago at the market peak, with full benefits!


On Mar 03 07:49 PM mwfall wrote:

> one of the biggest criminal rings in the u.s. is government worker
> pensions. my cousin worked for 20 years as a social worker. she retired
> after only 20 years with a pension equal to her last years pay plus
> benefits every year for the rest of her life. if she lives to 85
> thats about $3 million dollars !
>
> that means for her job as a counselor she will be compensated the
> equivalent of about $111.00 per hour.
>
> are children are shouldered with the burden from the government criminals
> that vote themselves these pensions.
> pid=20601109&s...

Mar 05 09:25 AM