Public Money

BY: Girard Miller | January 5, 2012

One of my pet peeves in the ongoing debates over public pension reform is the way partisans on each side try to pitch half-truths and myths to support their arguments. The other side seldom believes any of these, but they help rally the allies on the speaker’s side. Sometimes the press naively re-circulates these fallacies, which leaves the general public even more confused about what to believe. There’s an old saying in politics that if you tell the same lie long enough, the public will eventually believe it — and that apparently is the mentality of lobbyists on both sides. In an effort to start the new year with a clean slate for public debate, I’d like to set the record straight on a dozen of the most glaring fallacies and silly slogans.

This is a lengthy column, so readers can click on to any one of these topics to jump to that subject

1. “The pension mess was caused by greedy people (from the other side), not us.”

2. “There’s no crisis. The stock market will recover and then there is no problem.”

3. “The solution is to replace pensions with 401(k) plans, like the private sector.”

4. “Experts consider 80 percent to be a healthy pension funding ratio.”

5. “Only 15 percent of pension costs is paid by employers. Investment income pays the lion’s share.”

6. “My pension contract is protected by the Constitution and can’t be violated.”

7. “States are already fixing the problem with reasonable pension reforms.”

8. “The solution is collective bargaining. There is no need for drastic legislation.”

9. “This is a $3 trillion problem when you measure it using honest (risk-free) math.”

10. “We earned more than 8 percent in the last 25 years, and will do so again.”

11. “The average public pension is $23,000.”

12. The $100,000 pension club.



So let’s look at each of these myths, misrepresentations and slogans, one-by-one

Half-truth #1: (Multiple-choice) “The pension mess was caused by greedy …
(a) Employees
(b) Unions
(c) Politicians
(d) Wall Street investors and bankers
… and they are the ones who should pay to fix it.”

There is a target for every finger-pointer. The truth is that the pension community has plenty of blame to go around. About half of the underfunding in most public pension plans is attributable to the six-sigma market plunge that nobody saw coming in 2008. When stocks declined by 55 percent in the last recession, more than double the average decline in the 13 previous recessions, that knocked a gaping hole in funding ratios and doubled the average plan’s unfunded liabilities. I guess you could try to blame the big banks and the homebuilders and the money managers and the mortgage brokers and the speculators and hedge funds and the real estate industry and the CEOs of the Fortune 500 with their short-sighted stock options and Fannie Mae and Freddie Mac and the Congress that goaded them to lend to unworthy borrowers in the name of universal homeownership, for causing pension deficits. But I’m at a loss to see how that will ever help us fix the public pension problem.

Yet that is only half of the story. Long before the Great Recession, the seeds of today’s mess were carelessly sown by politicians who declared pension holidays, unions that bargained for retroactive pension increases, trustees who assumed that investment returns would continue to grow to the moon, employers that granted early retirement incentives and gave away benefits to pass the buck to future taxpayers, pension administrators who were too timid to stand up to self-interested trustees or stakeholders and insist on more conservative practices, accountants who allowed unfunded liabilities to be amortized over two generations, and actuaries abetted by investment advisors who jiggered the investment portfolios toward ever-riskier allocations to enable disingenuous trustees to justify discount rates that would avoid the inevitably heftier contribution rates needed to assure intergenerational equity. Those who point fingers of blame should first look in the mirror.

Half-truth #2: “There is no crisis. Once the stock market recovers, there is no problem.”

Some of today’s pension Pollyannas claim that when stock-market trends return to their historical averages, everything works out. That is simply ignorance and puffery from people who don’t even bother to understand pension math. The actuarial projections used by most public pension plans are already assuming that 85-year historical returns will continue indefinitely, even though many of the major investment consultants have already dialed down their projections for the next decade. Perpetual stock-market increases of 10 percent annually are already baked into the funding ratios that now hover just above 70 percent on average nationwide. Even if stocks return next year to their previous peak levels (DJIA 14,100), that wouldn’t restore pre-recession funding ratios. That’s because there have been no capital gains from equities for the five intervening years while the underlying liabilities have grown about 50 percent. Stocks may have good and bad growing seasons, but there is never a crop failure on the liabilities farm. As I explained last year, stock indexes would have to double in the next two years to restore most pension funds to their 2007 funding ratios. To return the average pension fund to full funding, stock markets would have to produce 14 percent compounded returns the rest of this decade, with no intervening recession. That would put the Dow Industrials at 30,000 in January 2020. I’ll gladly give even odds against that scenario to anyone who wants to buy into that long-shot.

Half-truth #3: “The solution is to replace pensions with 401(k) plans, like the private sector.”

First of all, new 401(k) plans cannot be instituted for state and local government employees under the 1986 tax act. Pre-existing “k” plans are allowed, but there is no ongoing federal tax authority to install these corporate-style, defined contribution (DC) plans for public employees. But there are 401(a) defined contribution plans that can be offered, so a DC option is still available by law. However, the creation of a new DC plan does nothing to eliminate or even reduce the unfunded liability of a pension system. In fact, it probably makes matters worse, as described in my earlier column on this topic.

Freezing an existing pension plan will compel prudent trustees to adopt a more conservative investment portfolio to manage its risks as retirees age (just like individuals must de-risk their own investments as they age), and that will reduce the discount rate which in turn increases the employer’s contribution rates. This doesn’t mean that DC plans should not be part of the solution, but a wiser approach is a hybrid structure with a smaller pension (using a 1 percent multiplier) with a companion DC plan — like the federal employees’ system or the Washington state model. Rhode Island has officially figured this out, as did California Gov. Jerry Brown in his proposed reforms.

Half-truth #4: “Experts consider 80 percent to be a healthy funding level for a public pension fund.”

This urban legend has now invaded the popular press, so it’s about time somebody set the record straight. No panel of experts ever made such a pronouncement. No reputable and objective expert that I can find has ever been quoted as saying this. What we have here is a classic myth. People refer to one report or another to substantiate their claim that some presumed experts actually made this assertion (including a GAO report and a Pew Center report that both cite unidentified experts), but nobody actually names these alleged “sources.” Like UFOs, these “experts” are always unidentified. That’s because they don’t actually exist. They can’t exist, because the pension math and 80 years of data from capital markets history just don’t support these unsubstantiated claims.

With only one rare and fleeting exception (which occurs at the very bottom of a business cycle, similar to the green flash in a tropical sunset), 80 percent funding is not a sufficient, sound or healthy funding level for a pension fund. The only authoritative references to 80 percent funding ratios are the federal ERISA and pension protection act provisions which require private-sector pension plans below 80 percent funding to take immediate remedial action! (Remember that public plans are not even governed by these laws.) These statutes do not make funding ratios at 80 percent “healthy” or “good” or “sound” or “well-funded.” Pensions funded at 80 percent are no different than a $400,000 house in a distressed neighborhood with a $500,000 mortgage — you can keep living there if you keep making the payments, but it’s underwater and your balance sheet is now upside down no matter how much you try to double-talk it. The only difference is that state and local governments can’t mail in the keys to the bank.

Until the last recession, respectable and world-wise actuaries would tell you privately that when a pension system gets its funding ratio above 100 percent, there is a political problem. Employees, unions and politicians suddenly become grave-robbers who invariably break into the tomb to steal enhanced benefits and pension contribution holidays. So these savvy advisors historically have tolerated modest underfunding, based on their recurring past experience with the forces of evil in this business. They figured the ideal public plan would drift between 80 to 100 percent funding over a market cycle, and nobody would be hurt if the plans were a “little bit underfunded” in normal times. Obviously that didn’t work out so well in the Great Recession, which has forced us all to take a harder look at the math and this conventional wisdom.

As I have explained in one of my very first Governing columns in late 2007 (when the last business cycle was peaking), a fully funded pension plan must today have market-value assets of 125 percent of current accrued actuarial liabilities near the peak of an average business cycle — in order to offset the near-certain loss of stock market values in the following recession. Historically, that is because the 14 recessions since 1926 (including the most recent) have shrunk equity values by 30 percent on average, and equity investments represent about two-thirds of the average public pension funds’ portfolio. Real-time pension funding ratios will therefore likely decline by about 20 percent in the average recession, depending on how much the bond portfolio offsets the stock losses and mounting liabilities. So there is not a major public pension plan in the United States today that can be described as “overfunded.”

A pension plan that is 100 percent funded at the end of a business expansion will likely lose 20 percent of its value in an average recession, so 80 percent is the bare-minimum “healthy” funding level at the bottom of a recession — and only then. Once the economy begins to recover, it is mathematically necessary for a reasonable funding ratio to be higher than 80 percent and rising on a clear path to full funding. Otherwise, the plan is doomed to be chronically underfunded with current taxpayers supporting retirees who didn’t ever work for them. A plan funded at 80 percent going into a recession will likely find itself funded at 65 percent at the cyclical trough — and that’s a toxic recipe calling for huge increases in employer contributions to thereafter pay off the unfunded liabilities. That’s why today’s 70 percent funding ratios are a legitimate concern and a financial burden on younger generations who will inherit this problem that their elders keep sidestepping.

Just think for one minute about what would happen if Europe unravels or China lands hard and we suffer another average recession from today’s levels. That would take most pension funding ratios well below 60 percent percent and trigger a more horrendous multi-year budgetary catastrophe for public employers nationwide. Pension trustees and plan administrators with funding ratios at or below today’s national average should be asking that question on the record in formal board sessions — if they understand how fiduciaries are expected to perform their duties.

One can argue that a pension plan with 80 percent funding today can be deemed prudently funded if it adopts a more aggressive amortization schedule that defrays its unfunded liabilities over the average remaining service period of incumbent employees. That’s essentially what the GASB’s proposed service-life amortization guidelines would ultimately imply. Anything less should invite suspicion and deserves serious reconsideration of the plan’s funding policies and benefits levels. And if employees put skin in the game by agreeing to hereafter bear one-half the cost of paying down the plan’s unfunded liabilities during their working years, we can then talk about 80 percent funding as a logically “healthy” or “sustainable” number.

Half-truth #5: “Public employers and thus taxpayers only pay about 15 percent of the cost of public pensions. The rest comes from employee contributions and the investment income.”

The idea that investment income comes out of thin air to pay the bills is disingenuous and deceptive. I’m all for actuarial pre-funding and using the power of compounding investment earnings to achieve intergenerational equity, but “interest follows principal.” If employers/taxpayers hadn’t made their contributions, there would be no investment income in the pension fund. Instead, the employers/taxpayers could have invested the money themselves and pocketed the earnings. Especially for police and fire funds and the majority of pension plans with serious underfunding, most public employers today continue to make the lion’s share of total contributions — even though we are beginning to see worthwhile incremental increases in employee contributions toward normal costs in some states. But when you count employer contributions to pay for unfunded liabilities that are required (because investments didn’t earn what these same pension advocates expect them to earn as part of this myth), the employers’ share dwarfs most employees’.

If interest does not follow principal, then why do plans pay interest on refunds on unvested participants’ contributions, and retirees’ deferred retirement “DROP” accounts?

Half-truth #6: “This is a contract, protected by the federal Constitution’s contracts clause. You can’t reduce my pension.”

The federal Constitution also authorizes Congress to create bankruptcy courts, which routinely overturn contracts, although I doubt that municipal bankruptcy proceedings will be the solution to pension problems, as explained in an earlier column on bankruptcy and benefits reform.

There is no question that some state constitutions declare the pension promise to be inviolable, and some state courts have held that the pension promise is a contract. In “normal” economic times when the pension plan is properly funded, almost everybody would agree that contractual pension obligations should be fulfilled. But these are not ordinary times, and dozens of major public pension plans are facing the potential for depletion of their assets during the lifetimes of current employees if nothing is changed. Ultimately, some municipal employers will face a genuine financial emergency if they don’t significantly revise their plans’ benefits structures. We have already seen such actions upheld in Colorado and Minnesota, where courts held that benefits changes could be made, in order to preserve a reasonable benefit for everybody in the plan. Rhode Island just enacted a law to change benefits including the retirement age for incumbent employees. The city of Cincinnati took similar actions. In some states, these “breaches of contract” will go to court, but what the plaintiffs often do not understand when they file suit is that several courts have supported the police power of the state to make plan modifications if they are necessary — provided that the remaining benefits are reasonable, and if the plan change is the minimum change required to fix the plan. The simple economics of pension plans inform us that the sooner you fix them, the less pain the beneficiaries will suffer later on. This does not mean that every underwater pension plan should stiff its retirees; the plan must clearly be at risk and alternative remedies should be explored. In fact, the courts typically require such efforts before they impair contracts and reduce vested benefits.

Half-truth #7: “Many states have already adopted pension reforms. We can manage through this problem with some moderate consensus-based changes.”

As this editorial cartoon from California illustrates, the magnitude of the pension problem dwarfs the scope of reforms enacted in most state legislatures and proposed in others. Not that I would belittle the work done so far and the ongoing efforts of pension reformers nationwide. But the simple math is that, when you include both the pension and the retiree medical benefits (OPEB) obligations, we are facing a $2.5 trillion problem with state and local government retirement deficits. Most of the state reforms made to date focus on prospective benefits changes, often with increased employee contributions and sometimes with higher retirement ages for new hires. But they seldom address the massive unfunded liabilities of the plans. Very few states have seriously attacked the unfunded liabilities, which leaves the bills for these debts to the next generation — what President Obama rightfully calls “kicking the can.”

What’s worse mathematically, not even one state has adopted laws to require public employers to begin funding their OPEB plans on an actuarial basis. Not one. What are we waiting for? It’s been 28 years since Massachusetts belatedly joined the other 49 states to require actuarial funding for pensions instead of pay-as-you-go. It’s been 7 years since GASB issued Statement 45 to put OPEB liabilities on the books. The DNA tests are all positive: How much longer will it take the legislatures to admit paternity of this orphaned child?

Half-truth #8: “The necessary changes can be achieved through collective bargaining.”

I’m quite impressed by dozens of public-sector unions that have stepped up and agreed to increase employee contributions to support their current benefits. Their leadership is directionally correct, and although their critics may quibble with the magnitude of their concessions, these specific unions deserve genuine praise for becoming part of the solution. They genuinely understand the value of the benefits, and their members are willing to pay a fair personal price to preserve them. I’ve even seen a few cases where unions have agreed to share some of the cost of contributions to their OPEB (retiree medical benefits) That was unheard-of in most localities before GASB shed light on the size of those liabilities seven years ago. So my hat’s off to you folks: your hearts are in the right place, and your payroll deductions are too.

That said, most unions must still be dragged to the table to address retirement plan reform. When confronted with harsh reality, most will begrudgingly agree to plan changes for new hires. But in 2012, real change must begin with incumbent employees. At the very least, we must see more multi-year increases in employee contributions for both pensions and OPEB. Where state law permits prospective benefits reforms for future service of current workers, those must be included in the package as well.

To read entire column, click here.