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- Pension Report for March 2011
Pension Report for March 2011
- By Ray Sanderson
- Published 02/21/2011
- Pension Watch
In a revised special supplement to the February 1, 2011 newsletter from Cypen and Cypen comes the following:
On January 20, 2011, Center on Budget and Policy Priorities issued “Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm – Misconceptions Also Divert Attention from Needed Structural Reforms.”
The paper deals with bond indebtedness, pension/ pension obligations, retiree health benefits/insurance, structural deficits, projected operating deficits and state/local debt.
A spate of recent articles regarding the fiscal situation of states and localities has lumped together their current fiscal problems, stemming largely from the recession, with longer-term issues relating to debt, pension obligations and retiree health costs, to create the mistaken impression that drastic and immediate measures are needed to avoid an imminent fiscal meltdown.
The large operating deficits that most states are projecting for the 2012 fiscal year, which they have to close before the fiscal year begins (on July 1 in most states), are caused largely by the weak economy. State revenues have stabilized after record losses but remain 12 percent below pre-recession levels, and localities also are experiencing diminishing revenues. At the same time that revenues have declined, the need for public services has increased due to the rise in poverty and unemployment.
Over the past three years, states and localities have used a combination of reserve funds and federal stimulus funds, along with budget cuts and tax increases, to close these recession-induced deficits. While these deficits have caused severe problems, and states and localities are struggling to maintain needed services, the problem is a cyclical one that eventually will ease as the economy recovers. Unlike the projected operating deficits for fiscal year 2012, which require nearterm solutions to meet states’ and localities’ balanced-budget requirements, longer-term issues related to bond indebtedness, pension obligations and retiree health insurance can be addressed over the next several decades.
It is not appropriate to add these longer-term costs to projected operating deficits. Further, the size and implications of these longer-term costs should not be exaggerated, as some recent discussions have done. Such mistakes can lead to inappropriate policy prescriptions.
Some argue that states and localities are in a crisis because pension funds have large amounts of “hidden” debt in form of underfunded pension funds. A figure of $3 Trillion in pension underfunding is sometimes cited; other estimates place the underfunding at levels as low as $700 Billion, or less than a quarter of the $3 Trillion figure. While some pension funds are indeed underfunded, there are a number of misconceptions about the extent and depth of the problem and about states’ ability to resolve pension funding issues over time without disrupting their ability to continue public services.
States and localities currently make annual contributions to their pension trust funds equating an average of 3.8% of their general (operating) budgets. They began to make deposits to pre-fund their pension costs in the 1970s. Each year, they are supposed to deposit in a trust fund an amount that equals the present value of the future pensions their employees earned that year. (The present value is the amount that has to be invested today to grow to the desired amount in the year the employees are expected to retire.)
As of 2000, state and local pension obligations were fully funded on average, if obligations are discounted at 8 percent per year, which was the return on pension fund investments over the previous two decades. Since then, however, the nation has experienced two recessions, during which some states and localities have reduced or skipped pension trust fund deposits to help balance their budgets. In addition, the recessions have caused significant investment losses. By 2008, state and local pensions in aggregate were funded at 85 percent of their future liabilities; the other 15 percent is considered to be the “unfunded liability.” The Center for Retirement Research at Boston College projects that, in the aggregate, state and local pensions were funded in 2010 at 77 percent of their future liabilities, a ratio projected to decline to 73 percent by 2013.
A drop to funding in the 70 percent range is a significant problem, although not an imminent crisis. Many experts argue that 80 percent funding is sufficient for public pensions because states and localities, as ongoing entities, can use tax revenues to make up a shortfall if necessary. A private company, in contrast, can go out of business, at which point the federal Pension Benefit Guaranty Corporation pays the company’s employees their accrued benefits out of a combination of assets the company accumulated before it went out of business and the insurance premiums PBGC collects from private-sector employers with pension plans. (Federal law generally requires private companies to be
100 percent funded so the federal government does not have to make up any shortfall.)
The issue whether states’ discount-rate assumptions are reasonable is more complicated. The “discount rate” is the interest rate used to translate future benefit obligations into today’s dollars. Discount rates are important, since 60 percent of pension trust fund revenues come from trust fund earnings, and discount rates help determine how much money a state should put into the fund each year.
One school of thought argues that that it is appropriate to continue to use the actuarial method recommended by the Governmental Accounting Standards Board, which is to use as a discount the historical return on funds’ assets—about 8 percent. (State pension trust funds invest their assets in a diverse mix of stocks, bonds and other instruments until they are needed to pay for benefits.) Others argue that a much lower assumption is warranted: because pension obligations are guaranteed, they argue, the assumed growth of assets (the discount rate) should be similarly “riskless” and based on returns from the safest investments such as Treasury bonds—around 4 percent or 5 percent.
While it may make sense to reconsider whether the typical 8 percent discount rate is the right one going forward, simply basing annual state contribution amounts to pension funds on return on riskless investments appears to go much farther than is necessary, for a number of reasons.
Pension funds invest for the long term, so a few years of below-average returns can be averaged out with years of higher returns.
As noted, the 8 percent discount rate that most states assume reflects experience of the trust funds over the last 20 years (including the 2008 stock market decline); median returns for the last 25 years were even higher, at 9.3 percent. While rates of return on investments were much lower in the recent recession, it is generally assumed that they will rise in the future, even if they do not return to the very high rates of the late 1980s.
In addition, if the pension fund assumes a 4-or 5-percent discount rate and actually gets higher returns on its investments, funds will build up in the trust fund. When pension trusts have been overfunded in the past, it has led to problems such as employee demands for increases in pension benefits that later proved unsustainable. Overfunding also has led jurisdictions to skip payments that they subsequently found difficult to resume because programs were funded or taxes were cut permanently by the amount of the skipped pension contribution. A 2008 Government Accountability Office report said “... it can be politically unwise for a plan to be overfunded; that is, to have a funded ratio over100 percent. The contributions made to funds with excess assets can become a target for lawmakers with other priorities or for those wishing to increase retiree benefits.” If states and localities continue to use an 8 percent discount rate for calculating required contributions, a funding increase to 5 percent of their budgets would be required on average fully to fund their pensions. This level is not likely to be unduly burdensome after the economy recovers, and states could reduce it somewhat by adopting various pension reforms.
States that have significantly underfunded their pensions, such as California, Illinois and New Jersey, would require higher contributions (7.3 percent, 8.7 percent and 7.9 percent of their respective budgets), even using the standard 8 percent discount rate. These states will have to consider more significant changes in their pension plans to bring their required contributions down to a more reasonable level.
It is a very interesting study and can be accessed in PDF format.
On January 20, 2011, Center on Budget and Policy Priorities issued “Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm – Misconceptions Also Divert Attention from Needed Structural Reforms.”
The paper deals with bond indebtedness, pension/ pension obligations, retiree health benefits/insurance, structural deficits, projected operating deficits and state/local debt.
A spate of recent articles regarding the fiscal situation of states and localities has lumped together their current fiscal problems, stemming largely from the recession, with longer-term issues relating to debt, pension obligations and retiree health costs, to create the mistaken impression that drastic and immediate measures are needed to avoid an imminent fiscal meltdown.
The large operating deficits that most states are projecting for the 2012 fiscal year, which they have to close before the fiscal year begins (on July 1 in most states), are caused largely by the weak economy. State revenues have stabilized after record losses but remain 12 percent below pre-recession levels, and localities also are experiencing diminishing revenues. At the same time that revenues have declined, the need for public services has increased due to the rise in poverty and unemployment.
Over the past three years, states and localities have used a combination of reserve funds and federal stimulus funds, along with budget cuts and tax increases, to close these recession-induced deficits. While these deficits have caused severe problems, and states and localities are struggling to maintain needed services, the problem is a cyclical one that eventually will ease as the economy recovers. Unlike the projected operating deficits for fiscal year 2012, which require nearterm solutions to meet states’ and localities’ balanced-budget requirements, longer-term issues related to bond indebtedness, pension obligations and retiree health insurance can be addressed over the next several decades.
It is not appropriate to add these longer-term costs to projected operating deficits. Further, the size and implications of these longer-term costs should not be exaggerated, as some recent discussions have done. Such mistakes can lead to inappropriate policy prescriptions.
Some argue that states and localities are in a crisis because pension funds have large amounts of “hidden” debt in form of underfunded pension funds. A figure of $3 Trillion in pension underfunding is sometimes cited; other estimates place the underfunding at levels as low as $700 Billion, or less than a quarter of the $3 Trillion figure. While some pension funds are indeed underfunded, there are a number of misconceptions about the extent and depth of the problem and about states’ ability to resolve pension funding issues over time without disrupting their ability to continue public services.
States and localities currently make annual contributions to their pension trust funds equating an average of 3.8% of their general (operating) budgets. They began to make deposits to pre-fund their pension costs in the 1970s. Each year, they are supposed to deposit in a trust fund an amount that equals the present value of the future pensions their employees earned that year. (The present value is the amount that has to be invested today to grow to the desired amount in the year the employees are expected to retire.)
As of 2000, state and local pension obligations were fully funded on average, if obligations are discounted at 8 percent per year, which was the return on pension fund investments over the previous two decades. Since then, however, the nation has experienced two recessions, during which some states and localities have reduced or skipped pension trust fund deposits to help balance their budgets. In addition, the recessions have caused significant investment losses. By 2008, state and local pensions in aggregate were funded at 85 percent of their future liabilities; the other 15 percent is considered to be the “unfunded liability.” The Center for Retirement Research at Boston College projects that, in the aggregate, state and local pensions were funded in 2010 at 77 percent of their future liabilities, a ratio projected to decline to 73 percent by 2013.
A drop to funding in the 70 percent range is a significant problem, although not an imminent crisis. Many experts argue that 80 percent funding is sufficient for public pensions because states and localities, as ongoing entities, can use tax revenues to make up a shortfall if necessary. A private company, in contrast, can go out of business, at which point the federal Pension Benefit Guaranty Corporation pays the company’s employees their accrued benefits out of a combination of assets the company accumulated before it went out of business and the insurance premiums PBGC collects from private-sector employers with pension plans. (Federal law generally requires private companies to be
100 percent funded so the federal government does not have to make up any shortfall.)
The issue whether states’ discount-rate assumptions are reasonable is more complicated. The “discount rate” is the interest rate used to translate future benefit obligations into today’s dollars. Discount rates are important, since 60 percent of pension trust fund revenues come from trust fund earnings, and discount rates help determine how much money a state should put into the fund each year.
One school of thought argues that that it is appropriate to continue to use the actuarial method recommended by the Governmental Accounting Standards Board, which is to use as a discount the historical return on funds’ assets—about 8 percent. (State pension trust funds invest their assets in a diverse mix of stocks, bonds and other instruments until they are needed to pay for benefits.) Others argue that a much lower assumption is warranted: because pension obligations are guaranteed, they argue, the assumed growth of assets (the discount rate) should be similarly “riskless” and based on returns from the safest investments such as Treasury bonds—around 4 percent or 5 percent.
While it may make sense to reconsider whether the typical 8 percent discount rate is the right one going forward, simply basing annual state contribution amounts to pension funds on return on riskless investments appears to go much farther than is necessary, for a number of reasons.
Pension funds invest for the long term, so a few years of below-average returns can be averaged out with years of higher returns.
As noted, the 8 percent discount rate that most states assume reflects experience of the trust funds over the last 20 years (including the 2008 stock market decline); median returns for the last 25 years were even higher, at 9.3 percent. While rates of return on investments were much lower in the recent recession, it is generally assumed that they will rise in the future, even if they do not return to the very high rates of the late 1980s.
In addition, if the pension fund assumes a 4-or 5-percent discount rate and actually gets higher returns on its investments, funds will build up in the trust fund. When pension trusts have been overfunded in the past, it has led to problems such as employee demands for increases in pension benefits that later proved unsustainable. Overfunding also has led jurisdictions to skip payments that they subsequently found difficult to resume because programs were funded or taxes were cut permanently by the amount of the skipped pension contribution. A 2008 Government Accountability Office report said “... it can be politically unwise for a plan to be overfunded; that is, to have a funded ratio over100 percent. The contributions made to funds with excess assets can become a target for lawmakers with other priorities or for those wishing to increase retiree benefits.” If states and localities continue to use an 8 percent discount rate for calculating required contributions, a funding increase to 5 percent of their budgets would be required on average fully to fund their pensions. This level is not likely to be unduly burdensome after the economy recovers, and states could reduce it somewhat by adopting various pension reforms.
States that have significantly underfunded their pensions, such as California, Illinois and New Jersey, would require higher contributions (7.3 percent, 8.7 percent and 7.9 percent of their respective budgets), even using the standard 8 percent discount rate. These states will have to consider more significant changes in their pension plans to bring their required contributions down to a more reasonable level.
It is a very interesting study and can be accessed in PDF format.
