Public Sector Pensions 101: The Hidden Taxpayer

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Public Sector Pensions 101The Hidden Taxpayer
Put
If a taxpayers personal portfolio
underperforms, he or she can cut back on their
expenditures. But if the governments pension
portfolio underperforms, the taxpayer will be
asked to pay to the government the difference
between what the government promised to public
employees and the resources that are left to meet
those obligations. Professor Joshua Rauh,
Northwestern University February 14th, 2011
statement to Subcommittee on Courts, Commercial,
and Administrative Law The Role of Public
Employee Pensions in Contributing to State
Insolvency and the Possibility of a State
Bankruptcy Chapter

• NEW JERSEY TEA PARTY COALITION

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Are We Against Pensions?
Of course not we just dont want to be lied to
about the true cost pensions to taxpayers
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Public Sector Pension UnderfundingReally,
Really Boring but Actually Quite Dangerous

• Pension liabilities for states and local
  governments are 40 understated nationally
  through near-fraudulent accounting
• Real unfunded accrued liabilities are many times
  higher than reported
• This means that total state and local government
  debt is much higher than bonded debt-- and a
  pension-muni bond collision is coming
• Pension reform efforts to date focus on current
  employees only and not the accrued liability
  (Battle of Madison just the beginning)
• The accrued pension liability is too large and
  cant be paid
• Municipal bond ratings are based on faulty data
  and willful misperception, and are wrong
• The municipal bond market is straining to
  downplay the problem and lull retail investors,
  and generally in deep denial that a problem
  exist
• The players--pension boards, legislators,
  financial managers, rating agencies, and state
  judges--are seriously conflicted

4
Public Sector Pension UnderfundingReally,
Really Boring but Actually Quite Dangerous

• Pension liabilities for states and local
  governments are 40 understated nationally
  through near-fraudulent accounting
• Real unfunded accrued liabilities are many times
  higher than reported
• This means that total state and local government
  debt is much higher than bonded debt-- and a
  pension-muni bond collision is coming
• Pension reform efforts to date focus on current
  employees only and not the accrued liability
  (Battle of Madison just the beginning)
• The accrued pension liability is too large and
  cant be paid
• Municipal government bond ratings are based on
  faulty data and willful misperception, and are
  wrong
• The municipal bond market is straining to
  downplay the problem and lull retail investors,
  and generally in deep denial that a problem
  exists
• The players--pension boards, legislators,
  financial managers, rating agencies, and state
  judges--are seriously conflicted

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Why Do We Care?

• I dont think of the long-term budget fight as
  being between Democrats and Republicans or
  between rich and poor. I look at it as a fight
  between people with funded retirements and
  unfunded retirements.
• If I have saved enough to support my lifestyle in
  retirement, then I have a funded retirement. If
  my neighbor who teaches in public school wants to
  support a similar lifestyle based on her pension,
  then she has a retirement that is somewhat
  unfunded. That is, as of now, her pension plan
  has only about 50 for every 1 of promised
  benefits. Social Security and Medicare also are
  unfunded. Their trust funds consist of government
  bonds. If I took care of my own retirement the
  same way, the drawer where I keep statements from
  mutual funds that I own would instead be filled
  with IOUs from myself. More important, the
  actuarial shortfall in Social Security and
  Medicare, like that in my neighbors pension
  plan, is very large.
• Down the road, someone is going to get the shaft.
  It could be my neighbor, it could be me, or it
  could be both of us. That is, people who are
  relying on the unfunded systems--public sector
  pensions, Social Security, and Medicare--might
  find their benefits cut. Or people who are
  relying on personal savings could wind up having
  those savings taxed away in order to address the
  shortfalls in the public systems. Or all of us
  could have our savings eroded by inflation, from
  which we may not be able to protect ourselves.
• Arnold Kling, April 2011

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Why Do We Care, Once Again?

• Entitlements political promises that be taken
  back
• Social Security 12 trillion?
• 1935 benefits began at age 65, vs life expectancy
  of 58-62 (now 78-81)
• Medicaid/Medicare 80 trillion?
• Death panels and rationing
• Debt the rules are decided by the lender
• Total US private wealth 49 trillion
• Federal debt 14.3 trillion as ofwhat time is
  it?
• Municipal Bonds 2.6 trillion
• Reported unfunded public sector pension
  liability 1.3 trillion
• Real unfunded liability 3 trillion or more
• Public pensions are not a distant future problem
• Pension costs now encroaching on essential
  services
• 20-30 of general budgets in some cases
• About ten state pensions are within a decade of
  going bust
• And we still havent dealt with OPEB entitlements

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Does This Look Like a Smoking Gun? (Hint lying
about the true liability)
Source Official Statement, State of Illinois
General Obligation Bonds, Taxable Series
February 2011
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How About This? (They also lie about the assets)
17. On June 29, 2001, the State legislature
approved legislation (P.L. 2001, c. 133) that,
effective November 1, 2001, increased retirement
benefits for employees and retirees enrolled in
TPAF and PERS by 9.09 percent. In order to fund
the enhanced benefits, without increased costs to
the State or taxpayers, the legislation revalued
TPAF and PERS assets to reflect their full market
value as of June 30, 1999, near the height of
the bull market.13 Bond offering documents did
not disclose the retroactive mark-to-market
revaluation of the pension assets under the 2001
legislation until March 2003 or the reason for
the reevaluation. More specifically, bond
offering documents did not disclose that the
State used the market value as of June 30, 1999
in order to make it appear that the State could
afford the benefit improvements.
13. In the actuarial valuations as of June 30,
1999 for TPAF and PERS, the actuarial value of
assets was replaced with the market value of
assets. Subsequent actuarial valuations,
including actuarial valuations as of June 30,
2000 and June 30, 2001, applied the five-year
smoothing method.
Source Securities and Exchange Commission
Administrative Proceeding re State of New
Jersey File No. 3-14009 Release No. 9135, August
18, 2010
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Some Points of Reference

• Defined Benefit Plans (vs. 401 k Defined
  Contribution)
• Contractual obligation is at least legally
  equivalent to bonded debt
• Even more protected under some state
  constitutions (IL, NY, HA)
• In past cases of muni bond default, pensions not
  affected
• Dollar-certain future annuity
• Obligation to pay much stronger than Social
  Security or Medicaid/Medicare
• OPEBs--health benefits--are a separate category
• State and local plans not governed by ERISA
  (1974)
• Same actuaries use different assumed-return
  standards
• Private plans in better shape, though ERISA put
  taxpayers on the hook via PBGC
• Not all public workers covered by Social Security
• Most public sector employees covered through 220
  state wide plans
• Range in size from 500 mm to over 150 bil
• About 19.8 million state and local government
  employees (2.7 m Fed civ, 153 m total US)
• Muni bond market very disaggregated compared to
  corporate bonds
• 50,000 issuers from states to local districts
  many security types (GO, revenue, etc)
• Illiquid, buy and hold market
• 30 institutional, but 70 held by individuals
  directly or through mutual funds
• Munis never default

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Some Major Conflicts of Interest

• Most statewide pensions were 100 funded in 2000
• Same poor accounting but risks obscured by
  dot-com run-up
• Instead of building reserves, legislators
  promptly increased pension benefits
• The trading of pension benefits for votes is
  obvious in retrospect
• Who sits on the boards of public pensions and
  decides investments, discount rates, benefits?
• Legislators (pension recipients)
• State and local treasurers (pension recipients)
• State and local employees and union members
  (pension recipients)
• State judges have their own state pensions
• Will they recuse themselves when the inevitable
  legal fights begin?
• Rating agencies paid by advisors, bankers,
  issuers
• Actuaries hired and paid by pension boards
• The same actuaries apply more conservative
  practices for ERISA plans

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How Does a DB Pension Work?

• Defined Benefit pensions are fundamentally simple
• Future, dollar-certain benefits are earned during
  a working career (pension liability)
• Employer/employee contributions are made to a
  pension trust fund (invested assets)
• The combination of contributions and trust fund
  investment earnings should cover the future
  benefit payments (assets liability)
• The actuarial forecasting of the pension
  liability can be complex
• Actuarial variables include mortality of both
  retiree and spouse also
• retirement age
• salary growth
• inflation
• Another key variable is the assumed rate of
  return on the invested assets, or the discount
  rate

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Future Pension Payments Comprise a Bundle of Many
Annuities
2080
2030
2010
2040
2020
2060
2050
retires at 50
Fireman, 25
Teacher, 45
retires at 60
Accountant, 65
already retired
Ex-employee, 35
retires at 55
DPW operator, 75
already retired
Because retirement systems have been around for
decades and are full of baby boomers,
the duration or mid-point of future benefit
streams for both public and private plans is
12-15 years--not 30! (I.e., the problem is
imminent)
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Present Value, Future Value The Fundamental
Principle of Finance

• Time value of money is expressed as an interest
  rate

PV
FV
2011
2026
15 years
100
8.00
31.52
100
56.13
4.25

• Rate of return is correlated to risk
• Higher return higher risk

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Pension Accounting Merely Misleading, or More
Institutional Fraud?

• The actuarial complexities are real, but they
  can obscure blatantly mismatched risk/return
  assumptions
• The pension liability is mandatory it must be
  paid
• Therefore, asset investment should be
  conservative and low in risk
• This means contributions should be conservatively
  ample
• Typical 8 discount rate creates inappropriate
  market risk
• Asset/liability risk intentionally mismatched to
  understate current contributions required to fund
  the pension trust fund
• Effectively forces a put on taxpayers to cover
  the future shortfall
• 5-12 year actuarial smoothing can overstate
  asset value and hide recent market declines (NJ
  SEC)
• This accounting allows politicians to buy votes
  with benefits and hide the real cost

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Is the Discount Rate Important?
40
25
62
80
Employees Age
Annually Required Contribution (ARC) to Pension
Fund
Pension Fund Assets Build Over Time
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Is the Discount Rate Important?
40
25
62
80
Employees Age
Future Value of Benefit Stream
Discount Rate
Present Value of Future Benefit Stream
Annually Required Contribution (ARC) to Pension
Fund
Pension Fund Assets Build Over Time
Discount rate determines how much has to be set
aside during working career from employer/
employee contributions for investment to ensure
adequate funds to pay future benefits
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Is the Discount Rate Important?
40
25
62
80
Employees Age
Future Value of Benefit Stream
Discount Rate
Present Value of Future Benefit Stream
High discount rate assumes more investment
earnings, requires lower contributions (but more
risk!)
Annually Required Contribution (ARC) to Pension
Fund
Low discount rate assumes less investment
earnings, requires more contributions (less
future risk to taxpayers, politicians restricted)
Pension Fund Assets Build Over Time
Discount rate determines how much has to be set
aside during working career from employer/
employee contributions for investment to ensure
adequate funds to pay future benefits
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Is the Pension Funded or Under-funded?
PV of future benefits earned to date Accrued
Liability
FV of Benefits
Discount Rate
If at any valuation date invested assets
are greater than the Accrued Liability, the
plan is fully funded or better

If at any valuation date invested assets
(past contributions) are less than the Accrued
Liability the plan is underfunded
-
Today
Use fair market value, not smoothed values
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What if the Assumption is Bad?

• The pension plans actuarial report shows the
  funding level based on the assumed discount rate
• Most public sector plans now officially funded at
  80 or less, even with absurdly high discount
  rates
• Since the discount rate is too high--as it
  usually is in public sector pensions, where 8.0
  is common--the plans underfunded situation is
  actually much worse
• Guess who gets stuck covering the shortfall?
• Since we know the average duration of the pension
  liability is 15 years, its not hard to calculate
  a more realistic funded level using a more
  conservative interest rate--such as the 15 year
  Treasury (4.25)

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And Now for the Really Bad News (remember that
taxpayer put?)

Reported UFPL FVd 15 years at plan discount
rate PVd back at 4.25 (15 yr Treasury)
Source State CAFRs, Actuarial reports
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And Now for the Really Bad News (remember that
taxpayer put?)

Reported UFPL FVd 15 years at plan discount
rate PVd back at 4.25 (15 yr Treasury)
Source State CAFRs, Actuarial reports
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And Now for the Really Bad News (remember that
taxpayer put?)

Reported UFPL FVd 15 years at plan discount
rate PVd back at 4.25 (15 yr Treasury)
Source State CAFRs, Actuarial reports
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How Does This End?(hint probably not well)

• State and local government revenue pie cant
  increase
• Economic activity not growing so revenues stay
  flat
• Tax rates cant increase given high unemployment,
  foreclosures
• Caterpillar, Sears threatening to leave Illinois
• Blue states already losing population
• Pension funding claims higher and higher share of
  annual budgets
• Public sector layoffs, service cuts result, but
  with no cut in taxes
• Economic death spiral as ranks of unemployed
  swell
• Unions forced to choose between active and
  retired workers
• Government will get increasingly desperate as
  Kick the Can finally runs out of time
• Hyper-inflation to pay debt and pension with
  devalued dollars
• personal savings destroyed
• IRAs/401ks forced into US Treasuries when no one
  else wants them
• State and local bankruptcies, defaults, as
  leadership fails