Last week, Larry Elkin commented here about the report by the Pew Center on the States that revealed a $1 trillion funding gap between what states have promised in retirement benefits to public employees and what they have actually set aside to meet those obligations.
The report made it clear that the situation is bad, but I believe this situation is actually even worse.
When states calculate the portion of their pension promises that are funded, they do not simply compare the amount they have at present with the anticipated costs of the future payments. Instead, they make an investment return assumption, so that a dollar saved today can cover more than a dollar’s worth of payments in the future.
Since states invest in stocks and bonds, instead of stuffing their billions under the mattress, it is reasonable for them to assume that they will earn some level of return. But the rates of return that states project for themselves are often unrealistic.
In an act of hypocrisy, governments, which regulate pension plans of private industries so that they cannot deceive pension stakeholders with overly optimistic benefits projections, are not opposed to using a little creative accounting of their own.
A recent article by Andrew G. Biggs, a resident scholar at the American Enterprise Institute in Washington, D.C, reported that, if New Jersey used assumptions similar to what private companies use, its pension funds would be considered to be only 38 percent funded. New Jersey, assuming an 8.25 percent annual rate of return, reports that its pension promises are 73 percent funded. With the revised projections, New Jersey’s unfunded liability for its pension plans increases from $32 billion to $145 billion.
New Jersey is not the only government to manipulate its finances to make the future look rosier. European countries such as Greece, Portugal, and France have skillfully massaged their numbers to meet European Monetary Union fiscal requirements. The Wall Street Journal reported that European countries “have a rich history of exotic maneuvers aimed at meeting the euro zone’s fiscal ceilings.”
This “aggressive bookkeeping,” as the Wall Street Journal termed it, makes budgets look better in the short term, but it does nothing to address long-term problems. In fact, by masking economic realities, the massaged numbers may prevent policy makers from taking the actions necessary to make real improvements, rather than merely aesthetic ones.
One public pension system is beginning to address this funding fallacy. According to the WSJ, California Public Employees’ Retirement System (Calpers), which manages over $200 billion making it the largest public pension in the U.S., recently discussed reducing its assumed rate of return from 7.75 percent to 6.0 percent. A rate reduction of that magnitude for a $200 billion pension fund would reduce expected portfolio growth by $64 billion over 10 years, assuming all gains are reinvested during that period.
While California’s annualized return over the past 20 fiscal years is slightly higher than the 7.75 percent target, analysts are doubtful about whether the pension fund can continue to count on such impressive earnings. Laurence Fink, chairman and chief executive of BlackRock Inc. and an advisor to Calpers, told pension board members last July, “You’ll be lucky to get 6 percent on your portfolios, maybe 5 percent.”
The rate reduction would mean that contributions from the state, from employees, or from both would have to go up to compensate for the decline in projected investment gains. Gov. Arnold Schwarzenegger has proposed requiring state employees to contribute an additional 5 percent for their retirement costs. Under the governor’s plan, the state would also increase its contribution, to at least $4.5 billion in the next fiscal year.
New Jersey is taking a baby step in the right direction. At the end of February the Senate unanimously approved three bills to cap the amount that retiring employees can receive from unused sick days, bar part-time workers from enrolling in the state pension system, and require local and county employees to contribute to their health plans. Republican Gov. Chris Christie called the bills “a good start.” But, unless New Jersey faces up to the true extent of its problems, the reform measures are unlikely to go far enough.
The longer that action is delayed by false assurances of security, the worse problems will become. It’s time to pull back the curtain on public employees’ pension plans so that employees expecting pensions, investors purchasing municipal bonds, taxpayers, voters, and policymakers can make realistic predictions about the future and take appropriate action.