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America’s Urban Distress: Why the Public Pension Problem Is Worse than You Think

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Submitted by F.F. Wiley via Cyniconomics blog,

In January, the Pew Charitable Trusts published a study showing that 61 U.S. cities have an aggregate pension funding gap of $99 billion and an additional shortfall of $118 billion for retiree health benefits. These figures were widely cited by the media in the aftermath of Detroit’s bankruptcy filing. They refer to fiscal year 2009, which was the latest year with a full data set.

Unfortunately, Pew’s analysis is ridiculously optimistic. Or, to be fair to the authors – who simply tabulated figures found in official reports – the ridiculousness is in the public data they used.

The problem is that the present value of future pension obligations can be just about anything you want it to be, based on your actuarial assumptions. And the most important assumption is the future investment return on the assets in the pension fund.

Ideally, the return assumption should be, well, achievable. You should be able to look at market yields and find investments that can deliver the assumed return.

Is this the case today?

Have a look at this chart comparing actual market yields to the median return assumption in a database of over a hundred state and local government pension plans:

pension assumption chart

The chart suggests that the median return assumption is nonsensical, as the authors of the Pew report may be gently hinting when they write that “[t]he two recessions of the past 12 years have raised major questions about the ability of governments at all levels to achieve the investment returns that pension plans assume they will get.”

Why the return assumption matters

The most important question raised by the gap between market yields and the return assumption is: How big is the effect on reported funding shortfalls?

And the answer is that it’s a huge effect.

Let’s take a simple example. Imagine a city with a single employee who’s been promised a lump sum pension of $1,000,000, which is due to be paid in 2025. And let’s say the city set aside $300,000 to fund that pension. If the pension fund earns an annual return of 8%, it’ll have $755,451 in 2025, leaving a funding gap of $244,549 – roughly 24%. This is close to the Pew estimate of a 26% funding gap for the cities in its study.

And if the fund doesn’t deliver triple today’s long-term Treasury yields? If its managers outperform Treasuries by only a moderate amount after fees and earn, say, 4%?

With a 4% annual return, the city would have $480,310 in 2025 – a shortfall of 52% against its $1,000,000 obligation.

In other words, a small dose of realism more than doubles the funding gap, which climbs from 24% to 52%.

But don’t just take my word for it.

Last year, Boston College’s Center for Retirement Research examined a much more modest reduction in the return assumption, together with a change in the customary approach of “smoothing” asset values instead of marking to market. Here’s an excerpt from my April article on these issues:

Boston College’s retirement specialists recently tested such a reduction [in the investment return assumption], based on a methodological change recommended in the Government Accounting Standards Board’s (GASB) Statement No. 68, approved in June of last year. Although the new methodology only changes the assumed investment return for a small portion of the pension liability, Boston College estimates that unfunded liabilities would increase by about 30%. And together with another new GASB standard with a similar-sized effect, the aggregate 2010 funded ratio of 76% would be 57% under the new accounting guidelines. Put differently (subtracting both figures from 100%), the funding gap would rise from 24% to 43% – a near doubling in unfunded liabilities.

In other words, Boston College found that unfunded liabilities may be almost double the official estimates despite applying a lower return assumption to just a piece of the overall calculation (in addition to eliminating asset smoothing).

Like so much of the information that governments produce about their finances, you can’t believe what you read without digging under the surface, as I discussed at length in a “word match challenge” published earlier this year.

For local and state government pensions and other post-retirement benefits, I suggest a rough rule of thumb of doubling the shortfalls found in official reports. Reality may prove worse than that, but let’s be optimistic.

 

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