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Posted at 5:45 PM ET, 03/ 2/2011

Are state pensions underfunded? And if so, what should we do about it?

By Ezra Klein

Tyler Cowen read Dean Baker's take on state pensions and says he prefers Josh Barro's more alarmed assessment. I read Barro's piece and was surprised to find that it agreed, in many respects, with Baker's piece, though the two articles had different emphases and different prescriptions.

In particular, they agree that the central question afflicting pension plans is the returns they'll see in coming years. Barro argues that the commonly quoted figures "understate the cost of benefits to be paid in the future by counting on high investment returns that may not materialize," while Baker argues that the gigantic shortfalls that some observers are now estimating are overstated and that pension funds can "reasonably assume" returns in the 7 percent range. It's worth noting that before the financial crisis, Baker was trying to sound the alarm about pension funds using overly rosy estimations of future returns, so it's difficult to accuse him of being overly bullish. That said, read David Leonhardt making the case for more pessimism on future returns.

The major disagreement comes over the question of what to do next. Barro argues that existing pension promises should be honored. "Short of defaulting on these debts," he writes, "the only way states can eliminate unfunded pension liabilities is to fund them." But going forward, he'd like to see states move to 401(k)-style programs, as that protects taxpayers from having to shell out more cash during economic downturns. Under the current system, he says, "state governments are long in the stock market on taxpayers’ behalf."

Baker strongly disagrees. He argues that the point of an actor such as the state, at least when it comes to pension policy, is that it has a long time horizon and so can ignore cyclical ups and downs in the stock market. "In principle," he writes, "state and local governments will exist into perpetuity, so a period in which the market is depressed need not be of great consequence." Add in, as Teresa Ghilarducci does, that "401(k) management and investment fees are three times higher" than traditional pension plans and "professionals who manage money in pooled pension funds usually get higher returns than workers who manage their own 401(k) accounts," and it's hard to argue that defined benefit plans should be done away with for states, though it's not hard to argue that they should be funded honestly and based on realistic projections for eventual returns. Felix Salmon agrees.

But the bottom line is that the correct questions to ask about pension plans are: 1) Are they estimating a realistic rate of return going forward? 2) If so, are they sufficiently funded? And 3) If not, what should be done? I think there's less disagreement about the underlying nature of the problem here than some people might think. The disagreements, rather, are about the country's likely economic performance going forward (as that will ultimately decide returns) and what our state pension system should look like in general.

By Ezra Klein  | March 2, 2011; 5:45 PM ET
Categories:  Budget  
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Comments

As a young public school teacher living in Illinois, I've been thinking lately that I wish I had a 401k instead of a promised pension. Even if the returns on the pension are theoretically higher, at least I know a 401k would be safe from political meddling. I'm worried about what might happen to my pension if Republicans ever take control of Illinois state government.

Posted by: ChicagoMike | March 2, 2011 6:05 PM | Report abuse

Worth noting new Federal employees were put on a reduced pension/401k type plan in 1986. Would be interesting to read some research on how that change is working out. Myself, I decided to stay with the old defined benefit Civil Service retirement system.

Posted by: bharshaw | March 2, 2011 6:10 PM | Report abuse

Even if it did make sense for a state government to use it's long time horizon to offer pensions in place of current income, how ultimately stable is that promise going to be if non-government workers are largely using 401K type plans. At some level, the solution to problems in 401k is to fix the 401k for everyone and not try to save pensions for the fewer and fewer.

Even if the math works, the argument itself really doesn't work. Pensions get underfunded in good times and eliminated in bad times.

Posted by: windshouter | March 2, 2011 6:35 PM | Report abuse

"while Baker argues that the gigantic shortfalls that some observers are now estimating are overstated and that pension funds can "reasonably assume" returns in the 7 percent range. It's worth noting that before the financial crisis, Baker was trying to sound the alarm about pension funds using overly rosy estimations of future returns, so it's difficult to accuse him of being overly bullish."

No not really. The only way to achieve those 7 percent returns would be to use some variation on the type of risky investment that caused the crisis in the first place. Baker is just being political here not economic. Much like a certain NYT columnist often quoted in these pages.

Posted by: johnmarshall5446 | March 2, 2011 6:44 PM | Report abuse

bharshaw:

It was actually 1984 that FERS was introduced, and the results are pretty terrific unless one was stupid enough to move their funds when the market cratered.

I shouldn't say that. It tkaes a lot of fortitude to be an investor, which is why a self directed 401 is not for everybody.

Posted by: johnmarshall5446 | March 2, 2011 6:49 PM | Report abuse

A couple things worth mentioning:

- One thing that doesn't get looked at is the unprofessional way many state pension funds are managed. Both New York and California have had scandals involving bribes by fund managers to pension fund administrators. And even when there are not bribes often politically favored fund managers end up managing much of the money.

- The other thing that doesn't get mentioned is that 401Ks work for almost no one. The average person between 55-65 with a 401K has < $100,000 saved. Good luck living on that.

- Managing pension funds is not rocket science - insurance companies have been successfully providing annuities for over 100 years. What's needed is to offer well managed funds to everyone.

Posted by: lmnop2 | March 2, 2011 7:08 PM | Report abuse

"As a young public school teacher living in Illinois, I've been thinking lately that I wish I had a 401k instead of a promised pension. Even if the returns on the pension are theoretically higher, at least I know a 401k would be safe from political meddling. I'm worried about what might happen to my pension if Republicans ever take control of Illinois state government."

And the man gets a cigar!

"401(k) plans are bad deal for taxpayers. Dollar for dollar, a traditional pension plan yields more pension benefits than do 401(k) plans because 401(k) management and investment fees are three times higher. And professionals who manage money in pooled pension funds usually get higher returns than workers who manage their own 401(k) accounts."

Source?

Posted by: justin84 | March 2, 2011 7:28 PM | Report abuse

In this instance, the appropriate discount rate is always going to be the risk free rate. Its not a matter of conservative estimates versus more optimistic assestment, its just a matter of what makes sense.

Lets say you owe $1000.00 in credit card bills in the future. Using Bakers method of discounting, you would owe $1000.00 if you had your money in a bank account, $934.00 if you had your assets in the stock market, and $833.33 if you invested in an ice cream truck that returned 20%.

Antoher example: Lets say Warren Buffet and an index investor both owe $1000.00 one year in the future to the same credit card company. Does Warren Buffet, who averages a 22% annual return, only owe $819.00 while the index investor owes $934.00?

Discounting on the basis of your expected returns does not make any sense. The value of your liabilities will not fluctuate based on where you put your assets, you owe what you owe what you owe.

The discount rate is meant to address the fact that a dollar today is not worth a dollar tomorrow, but the time value of money is not a relative concept. If your assets or obligations are certain, the risk free rate is always the rate you will use, regardless of whether or not the market is returning 10%, 20% or -20%.

You're a 'wonk,' you must work with wonky friends or have access to wonky financial professionals. Ask any finance professor at any major university what rate you should use to discount liabilities, they will all tell you the most appropriate rate is the risk free rate.

Posted by: kevinadolph | March 2, 2011 7:42 PM | Report abuse

- The other thing that doesn't get mentioned is that 401Ks work for almost no one. The average person between 55-65 with a 401K has < $100,000 saved. Good luck living on that.

Truer words were never written. The defined contribution plans have utterly failed working class and middle class (defined as 1 standard deviation above and below the median income). The retirement disaster is just becoming apparent as more people with 401 k accts begin to retire into virtual poverty, hostage to the insider trading on wall st.

Posted by: srw3 | March 2, 2011 7:54 PM | Report abuse

2 comments:
First, when they first started IRAs, the precursor to the 401k, the biggest selling point was, if you invest the max you could end up with $1million! What they didn't tell you was that you would NEED $1million to retire. To wit: $1M withdrawn at 5% per year, a fairly conservative rate but risky enough that you may run out of money if you live too long and the investments do poorly, 5%/yr is $50,000. That is probably an average to average+retirement income.

Second, I actually took my lifetime earnings by year (this can be found on your annual SS statement) and got my financial planner to do a theoretical investment for me. I used my portion only because if SS were to be privatized my employer would not be contributing to my SS. The result was an amount that, if withdrawn at 4%, a rate virtually guaranteed to last my entire lifetime, this resulting amount was within $10/month of what my projected SS will be. Not bad, but no better than what I will get anyway. The point will be made that my employer does not have to contribute to my privatized SS IRA. True, but somebody has to pay for the people already on SS. I assume that my employer's portion will pay for that. So, basically, nothing changes. I pay the same, my employer pays the same, and everyone gets the same. So why mess with it?

Posted by: paulyheins | March 2, 2011 9:22 PM | Report abuse

I began working as an actuary in the late 90's. Everyone talked about how pensions were now free (because of sky high returns). I even remember a book called Dow 36,000 or something like that.

Now, everyone says they are simply unaffordable -- following a dismal decade in the markets.

People were wrong both times.

Returns over 30 years have been 8%+ for large plans (like public plans). But, everyone says that is now wrong.

I think, we just tend to weigh recent experiences too heavily. We loose sight of the long-term, which pension funding should focus on like a laser.

Just as people believed 20% returns were normal in 2000 (and were wrong), people now believe 8% is way too high. Hmmmm...

When the next couple of valuation reports for these plans come out, there will be good news. Markets have already rebounded a great deal, but they are not recognized. Soon, right wingers will have to start talking about the 'actuarial value of assets' -- so they can have worse numbers. Watch the switch, as no one in the media will blink!

Posted by: rat-raceparent | March 2, 2011 11:52 PM | Report abuse

While using the "riskless rate" for accounting purposes is one thing, recognizing that large funds, such as pension funds, will earn 8% over a very long time horizon is realistic.

Another realistic facet is that pension fund requirements and short-term budget issues weighed upon by an unusual economic climate involve two very different time-horizons. Republican governors, and kitchen-table "economists," are putting the ideology cart before the horse to attack pensions due to short-term budget issues that do not in any realistic way affect massive pension funds with long-term liabilities (except, perhaps, in very few states). Thus, the attacks on pensions in multiple states with Republican governors.

But driving workers away from public sector jobs is a short-term fix with the resulting prospect of the kind of long-term corrupt cronyism that led to incompetence and corruption prior to the rise of civil service positions. But how else will all those Republican governors re-pay their campaign contributors unless there are jobs and, in this case, whole businesses to hand out to them?

Posted by: gary45 | March 3, 2011 8:49 AM | Report abuse

Interestingly enough, in my state, a few years ago a Republican controlled state house decided to push for early retirements when the economy was booming to get the most senior (consequently highest paid) teachers out of the system figuring they could hire 3 new teachers for every 2 retirees and in some cases even 4 for 2. They even offered me a bonus to retire. No thought was given to a possible economic downturn and now that the economy is in the tank the new Republicans in the statehouse begin to talk of changing their minds?

Instead of setting aside the excess funds they had for the rainy day they spent it like drunken sailors and now you say oops...I guess we should have hung on to the excess..... Not being fools many of us took what was offered, and now we have a new legislature and they go through a lot of hand wringing about the budget. The pension will weather the storm as we have a sound pension board who cut COLA's and immediately jumped on reducing early retirements.

To come back on people who 'you,' meaning government, made a contractual promise when the economy goes into the slumps is total hypocrisy. If those of you who are jealous of what teachers get in retirement had simply become teachers (at $7000 a year starting salary) instead of taking private sector jobs (the one I had paid a starting salary more than double that) you would be in our shoes. Most of my friends laughed when they found out what I made as a teacher. None of them are laughing now!

I worked for 30 years and no I did not "just show up" I did the job that most of you would be incapable of doing I don't mean that disparagingly, just a fact, teaching is damned hard work and should be limited to those who are 'suited' for it. That being said, I will add that I was not a union member knowing the shortcomings of allowing poor teachers to stay on the job. Certainly changes are due, but to punish those who did their duty, and played by the rules, after the fact is dishonorable!

Posted by: marnold4 | March 3, 2011 9:52 AM | Report abuse

Ezra wote: "state and local governments will exist into perpetuity"

Which is true but they can go bankrupt in which case a judge can give the pensioners a reduction.

Posted by: jwogdn | March 3, 2011 9:57 AM | Report abuse

Of course they are underfunded (or perhaps even UNfunded). the 'fedrl gubmnt' put stict controls on private enterprise in the 1970s - assuring a solid foundation for privgate pension plans. This was one of the reasons Corporations went from defined benefit to contributory plans. No such control was placed on 'publik emplees.' What to do about it is simple ... remove the plans from union control, put them on a 401k contributory plan and have the plans professionally managed.

Posted by: IQ168 | March 3, 2011 11:34 AM | Report abuse

sadly didn't see this until now but the reason that NJ's pension is underfunded is partially that Governors didn't fund it for the last 10+ years but also because its needed reforms. Part time employees were added, patronage was handed out like candy and most importantly (especially if you undertand compounded interest) Republican Governor DiFrancesco in 2000 assumed a 9% rate of return.

Posted by: visionbrkr | March 3, 2011 12:34 PM | Report abuse

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