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Ponies For Everyone

Is it wrong to promise a child a pony to get her to calm down before surgery? An anesthesiologist posed this question to The New York Times’ Randy Cohen in a recent installment of Cohen’s column “The Ethicist.”

Cohen responded that, unless the anesthesiologist had a stable full of ponies he was ready to part with, it was indeed wrong to make such empty promises.

The same lesson applies to states and municipalities. They entice public employees with post-retirement health benefits and pension plans rather than ponies, but their stalls are about as vacant as the anesthesiologist’s.

My colleague Jonathan Bergman and I have both written in this column about the enormous unfunded liabilities that states and cities have accumulated. Governments continue to promise generous post-retirement benefits that become more costly as life spans increase and health care costs skyrocket. Meanwhile, these governments have fallen short on contributions to their plans. The result is an ever-widening gap. Rather than face this gap, many jurisdictions have turned to questionable accounting to try to make the situation appear better than it really is.

Two recent studies illustrate the magnitude of the problem.

The first is a report from Northwestern University's Kellogg School of Management on municipal pension obligations. By performing their own calculations on governments’ raw numbers, the authors concluded that the unfunded obligations of the localities they considered were more than double the officially reported figures. By the municipalities’ accounting, they had a total of $190 billion in unfunded obligations. The study’s authors, Robert Novy-Marx and Joshua Rauh, put the actual amount at $383 billion.

The main difference between the municipalities’ calculations and the study’s calculations is the selection of an appropriate discount rate. When actuaries calculate how much money must be set aside now to meet obligations in the future, they consider the rate of return a plan’s investments can generate. If a town promises to pay someone $108 in a year, and it knows it can get an 8 percent return on its money, it only needs to set aside $100 today to consider that $108 commitment fully funded. Most states and municipalities assume around an 8 percent rate of return.

The problem, however, is that investments come with risk, whereas promises, ideally, do not. Achieving an 8 percent rate of return requires investing fairly aggressively, with significant short-term fluctuations. Such a high return may not be attainable if there is a long-term market downturn, or if pension trustees dump stocks near a market bottom, or if current fears of deflation — which I believe are overblown — turn out to be well-founded.

Therefore, Novy-Marx and Rauh suggest that funding levels should be determined using a lower discount rate. They use the rate for U.S. Treasury bonds, whose returns currently are at much lower levels than those assumed by the governments.

Computed using these much more conservative assumptions, states’ and municipalities’ current reserves are far from adequate. In an earlier study, Novy-Mark and Rauh applied their approach to state pension plans and found a funding gap of $3.2 trillion. The $383 billion they say municipalities are missing is in addition to that $3.2 trillion racked up by the states.

The other recent study illustrating the problem’s scope, by the Empire Center for New York State Policy, considers post-retirement health benefits promised to public employees in New York. According to the study, the cities, counties and authorities of New York have promised more than $200 billion of health benefits, and they have set aside close to nothing. In New York City, each resident would have to chip in $7,343 to provide the health benefits the city has promised its workers. On top of that, every city resident would have to pay $3,082 to meet commitments to state employees.

The costs of post-retirement health benefits in New York were largely hidden until recently. But a new rule now requires public entities in the state to disclose these obligations.

An article in The New York Times drew attention to the conflicting commitments made to public workers and to investors. In addition to promising money and benefits to employees, states and municipalities also issue bonds, promising money to investors. New York State and its localities owe their bondholders about $264 billion, just a bit more than they owe for retirees’ health benefits.

So far bondholders have assumed the commitments to them will be honored, even if that means other commitments must be neglected. New York State has managed to keep a AA rating on its general obligation bonds, even as its debt to public employees has grown. E. J. McMahon, director of the Empire Center, told The Times, “So far, the market doesn’t care. The market seems to assume, on the basis of nothing, that at some point all of these places are simply going to stop paying retiree health benefits.” But retirees and public employee unions are not likely to cede their promised benefits without a fight.

Retirees who have been promised health benefits, investors and pensioners are all going to fight to get what they are owed. There is not going to be enough cash for everyone, and future taxpayers may not be able to make up the difference. There will be court battles and legislative squabbles. It is impossible to predict which promises will be broken, but it’s almost certain that many promises will not be kept.

The anesthesiologist who wrote to Cohen said he began to sense there might be a problem with his pony promises after nurses from the recovery room told him that children often wept uncontrollably when they woke up after surgery and discovered they had been deceived.

We are all going to wake up eventually, and there won’t be any pony.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

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