A new research note from Moody's found that State pension funds were underfunded by $1.3 trillion at the end of FY15 but was expected to grow to $1.8 trillion at the end of FY17 as pensions continue to struggle with low returns. We've discussed the unintended consequences of the Central Bank's low-rate polices on pension funds multiples times (see "Pension Duration Dilemma - Why Pension Funds Are Driving The Biggest Bond Bubble In History")...with the two most likely outcomes being benefits cuts for pensioners and/or crippling tax hikes for citizens.
Total US state aggregate adjusted net pension liabilities (ANPL) totaled $1.25 trillion, or 119% of revenue in fiscal 2015, Moody's Investors Service says in a new report. The results, based on compliance with new GASB 68 accounting rules, set a new ANPL baseline and are poised to rise for the next two fiscal years as market returns fall below annual targets.
"The median return for public pension plans in FY 2016 was 0.52% compared to an average assumed investment return of 7.5%," Moody's Vice President -- Senior Credit Officer Marcia Van Wagner says. "We project that aggregate state ANPL will grow to $1.75 trillion in FY 2017 audits."
The states with the highest pension burdens -- measured as the largest three-year average ANPL as a percent of state governmental revenue -- were consistent with previous years. Illinois topped the list with pension liabilities at 280% of total governmental revenue, followed by Connecticut (Aa3 negative) at 209%, Alaska (Aa2 negative) at 179%, Kentucky at 162%, and New Jersey at 157%.
Given that pretty much every state pension is now underfunded, Moody's introduced a new metric which they referred to as the "Tread Water" benchmark. The largest underfunded plans in Kentucky, Illinois and New Jersey would require an incremental 7 - 7.5% of annual state revenue for contributions in order to simply stop unfunded liabilities from growing further.
Moody's new report also introduces a new "Tread Water" benchmark, which measures whether states' annual contributions to their pensions are enough to keep the unfunded net liability from growing. For FY 2015, states were evenly divided between falling short and exceeding the benchmark.
The report "States -- US: Medians - Low Returns, Weak Contributions Drive Continued Growth of State Pension Liabilities," says there were several states whose pension contributions were notably below the Tread Water mark, including Kentucky (Aa2 stable), New Jersey (A2 negative), Illinois (Baa2 negative), and Texas (Aaa stable).
To tread water, Kentucky would have had to contribute an additional 7.5% of revenue to its pension plans; the figure for Illinois is 6.8% of revenue and 6.9% for New Jersey. A tread water contribution plus debt service and retiree health care costs would result in total fixed costs of 33.5% for fiscally stressed Illinois and almost 31% of revenues for Connecticut.
Meanwhile, the CATO Institute points out that wages and benefits for state employees totaled $1.4 trillion in 2015 or 53% of total state and local spending. Moreover, the report highlights that retirement benefits for state and local workers are substantially higher than the private sector at roughly $4.80 per hour compared to $1.23 per hour for private-sector workers.
The largest component of state and local government spending is compensation for 16 million employees. Total wages and benefits for state and local workers was $1.4 trillion in 2015, which accounted for 53 percent of all state and local spending.
State and local workers typically receive more generous benefit packages than do private-sector workers. On average, retirement benefits for state and local workers cost $4.80 per hour, compared to $1.23 per hour for private-sector workers. Insurance benefits (mainly health insurance) for state and local workers cost $5.43 per hour, compared to $2.59 per hour for the private sector. Most state and local workers receive retirement health benefits, whereas most private-sector workers do not.
The costs of government pension and retirement health benefits are expected to rise rapidly in coming years. Governments have promised their workers generous retirement benefits, but most states have not put enough money aside to pay for them. As a consequence, state and local governments will either have to cut benefits in coming years or impose higher taxes.
Per the following chart, many states have racked up over $20,000 of liabilities per capita, a level from which it will be very difficult to recover absent benefit cuts, massive tax hikes and/or a federal bailout.
Looking at pensions on a standalone basis, New Jersey, Illinois and Alaska remain the most at risk with underfunded liabilities equal to over $10,000 per person living in those states. Meanwhile, only Wisconsin and South Dakota have fully funded plans.
But, as the CATO Institute points out, the pension crisis is likely much worse than what most auditor reports would suggest because discount rates of 7.4% are unreasonably high. CATO estimates that reducing the discount rate from 7.4% to 2.7% would increase state pension underfunded liabilities from $1.2 trillion to $3.4 trillion.
Pension shortfalls are actually larger than these figures indicate. Those are the officially reported figures, but financial experts think that the discount rates used to report pension liabilities are too high. Higher discount rates reduce reported liabilities and create an overly optimistic picture of pension plan health.
In his study, Rauh recalculated pension plan funding using a 2.7 percent discount rate, rather than the official average rate of 7.4 percent. His recalculated unfunded liability jumps from $1.2 trillion to $3.4 trillion. Similarly, Munnell and Aubry found that their unfunded pension liabilities jumped to $4.1 trillion if plans are estimated using a 4 percent discount rate. Under that assumption, the funding level of state and local pension plans averages just 45 percent.
Unfortunately, the pension ponzi becomes more and more unsustainable each year with funds simply borrowing from future benefit payments, which are almost certainly impaired in many states, while paying current benefit recipients in full. While these types of "kick the can down the road" games can be played for a long time, eventually the massive underfundings will have to be addressed...and that will not be a pretty day.