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Posted at 4:44 PM ET, 03/ 1/2011

What you need to know about state pension systems

By Ezra Klein

www.cepr.net documents publications pensions-2011-02.png

Let's forget about unions and collective bargaining. Wisconsin Gov. Scott Walker says this is all about state pension funds. So let's take a look at them.

This paper (PDF) by Dean Baker is one of the clearest examinations of the pension funds, and what's happened to them, that I've seen. The big takeaway is this: "the main contributor to the current funding problem facing public pension funds was the collapse of the housing bubble and the subsequent downturn in the economy and the stock market." Before understanding what may or may not happen to state pension funds, and what can or cannot be done about it, you need to understand that.

Pension funds invest in various financial products. That means their projections assume some sort of rate of return on those investments. Before the crisis, their projections were perhaps a bit more optimistic than the data supported, but they weren't much more optimistic. The problem, as Baker says, is that we then had a financial crisis that was deeper and longer than anything we've experienced since World War II. "The managers of these funds obviously failed to recognize the housing bubble and the dangers it posed to the economy," Baker writes, "but this was true of the vast majority of economic and business analysts at the time."

This miscalculation, not union greed, is what has left state pension plans in apparent crisis. The conventional analysis right now is that pension plans are underfunded to the tune of about a trillion dollars (though there are good questions about how honestly state pension data are reported). If the stock market had simply performed as well as Treasury bonds in recent years, about $850 billion of that shortfall wouldn't exist. Much of the remaining gap is explained by states cutting back on contributions because they need to balance their wrecked budgets.

But Baker -- who did predict the housing crisis and so has some actual credibility on this subject -- thinks that some analysts have perhaps overlearned the lessons of the past few years. They're predicting rates of return going forward, he argues, that are much lower than what we should expect. He expects returns averaging around 7 percent from 2012 to 2022 -- not the 4 percent or so that some analysts are predicting.

In the final part of his paper, Baker warns that the dire talk of trillions in unfunded liabilities mainly confuses people. "The relevant context is the size of the projected shortfalls relative to the size of the state economies," he writes. Using data from the National Association of State Pension Fund Administrators -- which show a shortfall of about $650 billion over the next 30 years -- he calculates that the states are looking at funding gaps that range from 0.2 percent of their economies to 0.5 percent. Not nothing, but not an unmanageable crisis. The only way it becomes an unmanageable crisis is if the economy never recovers and thus the rates of return end up lower than we would expect and state economies end up smaller than we expect. But in that case, state pensions will be the least of our problems.

By Ezra Klein  | March 1, 2011; 4:44 PM ET
Categories:  Budget  
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Comments

"Pension funds invest in various financial products. That means their projections assume some sort of rate of return on those investments. Before the crisis, their projections were perhaps a bit more optimistic than the data supported, but they weren't much more optimistic."

This is more than true. All pension funds, especially union pensions, have to file papers stating what they expect their return to be. ALL of their projections are based on these returns. They typically cannot change them on a whim. These are pensions after all. They can be changed, but then all their projections have to be changed, too. This all has to pass muster with actuaries and auditors. There is also oversight by pension fund trustees.

This said, it is incredible that this pension and healthcare shortfall issue just "sneaked up" on this gov.

Posted by: paulyheins | March 1, 2011 5:20 PM | Report abuse

"Pension funds invest in various financial products. That means their projections assume some sort of rate of return on those investments. Before the crisis, their projections were perhaps a bit more optimistic than the data supported, but they weren't much more optimistic."

This is more than true. All pension funds, especially union pensions, have to file papers stating what they expect their return to be. ALL of their projections are based on these returns. They typically cannot change them on a whim. These are pensions after all. They can be changed, but then all their projections have to be changed, too. This all has to pass muster with actuaries and auditors. There is also oversight by pension fund trustees.

This said, it is incredible that this pension and healthcare shortfall issue just "sneaked up" on this gov.

Posted by: paulyheins | March 1, 2011 5:21 PM | Report abuse

One way to make the economy worse is to put a lot of public employees out of work.

Posted by: crosspalms | March 1, 2011 5:26 PM | Report abuse

Excellent post.

It would be useful to have the state specific data for Wisconsin as well. What are they fighting over as a % of their economy? What does it translate into in terms of a tax increase or cutting of other programs to address the issue. And, how does it change if rates of return differ from their targets?

Posted by: BHeffernan1 | March 1, 2011 5:40 PM | Report abuse

"If the stock market had simply performed as well as Treasury bonds in recent years, about $850 billion of that shortfall wouldn't exist."

Yes, but the pension funds are assuming equity-like returns, and thus must invest in equities. Feel free to do that, but then also commit to cutting pension checks if returns don't materialize.

You can invest in risk free assets all you like, but then you need to lower your expected return.

"But Baker -- who did predict the housing crisis and so has some actual credibility on this subject -- thinks that some analysts have perhaps overlearned the lessons of the past few years. They're predicting rates of return going forward, he argues, that are much lower than what we should expect. He expects returns averaging around 7 percent from 2012 to 2022 -- not the 4 percent or so that some analysts are predicting."

Then he should be in favor of privatizing Social Security, since that program is expected to return far below 7% - for some workers, real returns will be negative under Social Security.

Why does he think equities are a bad investment for the retirement of individuals, but a great retirement investment for a collection of individuals? It can't be because the government would be a better fund manager, because he shows that pension funds have performed just as poorly as most investor's individual accounts. The only possible answer is that he's really not all that confident in the market return, but that's okay because he thinks he can steal the difference if the expected returns fail to materialize.

Posted by: justin84 | March 1, 2011 5:59 PM | Report abuse

Why is _anyone_ still offering pensions?

The topic of pensions was discussed in depth back in the early 1970's and ERISA was the result. Greedy corporations -- union corporations -- carved out some loopholes allowing their own mis-designed and under-funded pension plans to exist. Now, these same big-money corporations expect someone else to pick up the tab for their misdeeds.

It's clear that the Pension Benefit Guarantee Trust is nothing more than a safety hammock; however, simply eliminating it doesn't have the effect of shifting the financial responsibility back to the union membership. Somehow, we have to arrive at a means of making union members pay for their own stupidity, thereby offering an incentive for sensible behavior.

Posted by: rmgregory | March 1, 2011 6:05 PM | Report abuse

This is a dumb chart.
He is essentially arguing that if pension managers knew exactly when to time the market, the shortfall would be much less. Of course, the starting value of all these pensions in 2007 directly benefited from the run up in valuations in risky assets.

Also Ezra, you may be aware or not aware that the discount rates these pensions use dramatically understate the liability. They use what they claim is the expected rate of return on their assets, but that should have no bearing on the value of the liability. The value of the liability should be calculated based on the riskiness of the liabilities' cash flows.

You should read the work of Novy-Marx and Rauh... Baker essentially copies their methodologies, but they arrive at drastically different results.

Also your discussion about sub par asset returns and the economy recovering show you understand very little about the drivers of stock market returns (ie, starting valuation)--

Posted by: cdosquared5 | March 1, 2011 6:43 PM | Report abuse

"If the pesions had purchased treasuries...." Clearly, (to me anyway), the reason they didn't "just take the treasury rate" was that they had an incentive to gamble... after all it wasn't really their money and if they ran into any problems they were backed up by the taxpayers... if they gambled and "won" then they handed out "thirteenth month" checks. While the rest of te country had to make choices and live with them the guys running the government pensions knew full well that they had the tax payers as a back stop... and now, as those managers tell us "gosh, we were caught by surprise" the average Joe in the private sector is presented with a double whammy, his 401k is also down and now the public sector folks are demanding "their" money out of his wallet.
When Joe private sector says, "OK, whatever, we'll cut our personal expectations to keep the public workers in the style they have become accustom to but in return we want to take the steering wheel so you guys don't drive us into the ditch again" The public workers go nuts... "We drive, you pay!, that's the social contract, aheee! you're killing democracy aheee!, your hosni. Gaddafi, Hitler! Aheee!"
In the meantime, slowly but surely, the productive members of society are slipping out of town, the idea guys are going overseas, the public retirees themselves are taking their pension payments in Florida so9 they don't have to pay any Wisconsin income tax... cause at the end of the day all these taxes are headed downstream to the poor hicks in Hooterville who just aren't quick enough to dodge this bullet. If they die off before their obligations to the public employee union bosses are met, no problem, their children and grandchildren will do just as well....
s

Posted by: Cheesy1959 | March 1, 2011 6:45 PM | Report abuse

"They're predicting rates of return going forward, he argues, that are much lower than what we should expect. He expects returns averaging around 7 percent from 2012 to 2022 -- not the 4 percent or so that some analysts are predicting."

Given the limited range of investments available to most state pension funds, 7 percent is wildly optimistic, unless you forecast the type of inflation that I do. In that scenario there are a whole other set of numbers that have to be created, and all of the current projections are junk anyway.

Ironically the only way to achieve the type of return that Baker projects is to use some type of security similar to the ones that went bust.

When he says:

"Before the crisis, their projections were perhaps a bit more optimistic than the data supported, but they weren't much more optimistic."

he is being disingenuous.

He is in effect saying that were imprudent managers because they relied upon other imprudent managers for their mumber projections. He is making the legal arguments that Goldman and all the other financial houses are currently making in court, namely that

1. everybody had the same information and made mistakes together including the financial companies themselves, no conspiracy or

2. these were professional money managers and they should have been aware of the risks they were taking

One can only enjoy the irony of Baker being called as a witness for the defense in these cases!

Posted by: johnmarshall5446 | March 1, 2011 7:27 PM | Report abuse

Oh, one last thought. If Baker "predicted" the housing crisis, why wasn't he next to John Paulson testifying on the Hill about why he was able to make one billion dollars from it?

Be VERY sceptical every time an economist says they predicted something, on the right or left. Sometime in the next year, I predict that we will get a column from Krugman of how he "predicted" inflation was going to be a problem because of some obscure paragraph he wrote in one particular column.

Posted by: johnmarshall5446 | March 1, 2011 7:40 PM | Report abuse

They're bankrupting the USA. Do nothing for 25 years; work (actually just show up) lots of overtime during your last three years and, leave with 25% more than your salary.

Posted by: fregameeate | March 1, 2011 8:15 PM | Report abuse

this is terrible finance. very unimpressed with the post.

http://siepr.stanford.edu/system/files/shared/GoingforBroke_pb.pdf

or Novy-Marx and Rauh = much better

Posted by: stantheman21 | March 1, 2011 8:21 PM | Report abuse

"If the stock market had simply performed as well as Treasury bonds in recent years, about $850 billion of that shortfall wouldn't exist."

Or if pensions stuck with safer asset classes instead of investing in hedge funds in order to increase their RoR and pay less.

Posted by: chrisgaun | March 1, 2011 9:06 PM | Report abuse

Defined benefit just doesn't work. "Risk-free returns??" In a world where the UAW can steal value of the bonds owned by public employee unions in other states, they just don't exist.

Posted by: staticvars | March 1, 2011 11:59 PM | Report abuse

In Pennsylvania in 2001 all public employees were given a 25% increase in pensions by state law (legislators got 50%). The actuarial assumption was 8% return and the employer contribution was reduced to under 5% which left an incredible shortfall. The legislators kept kicking the payments down the road until the problem became insurmountable. To correct the problem we passed the costs onto our grandchildren. The Madoff wantabees who call themselves guardians of the public welfare limited the increase of taxpayer contributions to the teachers pensions plan to avoid a revolution in the state by delaying making the plans solvent. By the way, if all our teachers retired this year they would each have an average retirement income of 160% of the average income for a family of four. Our Superintendent would have a retirement in excess of $150,000 per year.
The real question facing the taxpayers today is if they are willing to have their taxes double to pay the debts of the last decade or will they force reality on the bargaining table.

Posted by: duncan11 | March 2, 2011 8:11 AM | Report abuse

Ezra, most of these comments on your column reflect an impressive understanding of our financial system as well as a strongly held conclusion that there is no way we can realistically support reasonable pensions for our workers, either government or private. How does Germany do it?

Posted by: jimhughes99 | March 2, 2011 12:57 PM | Report abuse

This is why Companies (private and public) have basically eliminated pensions. Should the states do the same?

Yes.

Posted by: marteen | March 2, 2011 4:54 PM | Report abuse

Why do the voters/taxpayers always escape blame for this? They wanted more government services but were unwilling to pay for it (typical). They can't borrow, so they "promise" their workers more compensation later in the form of Pensions for less now. Not only do they put off the expense, but even what they do pay is underfunded and requires unrealistic stock market winnings.

This isn't union greed: this is taxpayer greed, pure and simple.

Posted by: quarkgluonsoup | March 2, 2011 5:02 PM | Report abuse

This analysis is irrelevant to Wisconsin's pension fund, which is still more than 99% fully funded, despite the recession. There is NO pension crisis in Wisconsin and the suggestion that there is may be only the least of the misrepresentations made by this governor in Wisconsin. He basically wants the state employees to give up part of what they bargained for, which is a monthly contribution to the pension fund that is part of their compensation, as part of his effort to balance his budget, despite the fact that the pension system is NOT part of his budget problem! People still don't seem to get this, possibly because the media don't seem to get it.

Posted by: rewriter | March 2, 2011 7:55 PM | Report abuse

Klein is wrong for two reasons.
First, state and county legislators have consistently raided pension reserves whenever they've deemed it necessary to fund ongoing operations -- not just recently in order to balance their budgets. The underfunded nature of the funds is a combination of not realizing the unrealistic rate of returns over the long term, but also not making the necessary annual contributions to the capital base o the funds. Legislators have done this consistently over the years, and "balanced" the books by simply estimating a higher rate of return in the out years.
Second, public sector defined benefit pension funds suffer the same "actuarial death sentence" as Social Security. Every year there are more and more retired public employees, who are all living longer lives in retirement, yet the tax base that exists to pay their pensions continues to shrink. Example -- there is a city of approximately 100,000 people in central California that is currently paying 6 police chiefs their full salary plus benefits. Five are retired, and the terms of the contracts called for them to receive 100% of their salary in retirement based on full vesting with 25 years service. Each of the 5 retired upon reaching the 25 year mark -- all in their mid-50s to early 60s -- as each had come up through the ranks in the Department. Some served as Chief of Police for less than 4 years. But, right now all 6 draw 100% salary as Chief or Retired Chief. So, that City's expense in terms of salary and retirement benefits is approximately $850,000 for one position annually -- and will remain that high until the retired chiefs begin to pass. The current occupant of the position has 23 years experience, and would be able to make the same decision to retire in 2013.

Posted by: williamshipley1 | March 3, 2011 12:46 PM | Report abuse

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