Navigating a Way Out of the Public Pension Crisis

Q. What are the stakes for the U.S. economy if entire generations of Americans are heading for financial insecurity in their old age?

A. I think the most immediate question is, “why should we all care about the underfunded status, or lack of money, in public funds?”

We should all care because it’s a tax burden for current and future generations of taxpayers. That’s point one. 

Point two is that it’s potentially a burden on future state employees, in the form of potentially lower income.

The next challenge becomes putting mechanisms in place to help the vast number of individuals who are not covered by public pension funds.

Q. Can you briefly outline the challenges without sinking into a bottomless sea of details?

A. Sure. One challenge for corporate pension plans is putting mechanisms in place so that people save enough during their working life. 

A second is to provide default investment options that accumulate sufficient assets during their working life so that they can support a secure retirement.

A third is to manage investment risk during the asset accumulation phase.  A final issue is the provision of reasonably-priced annuities. 

Q. And for teachers, police, firefighters and other public employees?

A. For public funds, it’s a completely different set of issues. The single biggest issue is that they don’t have enough money to cover current and future generations of public employees. That’s it.

Q. What’s the size of the public shortfall?

A. Using the bizarre accounting that is used in public funds, roughly speaking, they have 75 cents on hand for every dollar in obligations. Most investment professionals and financial economists would say the accounting is Hollywood accounting, fairyland accounting.

If we use a more market-based approach to the accounting, the actual gap is more like 55 cents or 60 cents on hand for every dollar in obligations. We’re talking about tens of billions, hundreds of billions of dollars. It’s a substantial mismatch…

Q. How many state employees face the prospect of being shortchanged on their pensions?

A. The odds are pretty good that current retirees probably aren’t going to face a cut in benefits.

Future employees, if they get a different deal, I suppose would be getting stiffed, relative to the old deal.

The people who I would be most immediately concerned about are the people who are working now.

Q. Who is most at risk?

A. Think about a 28-year-old school teacher in Minneapolis, just starting his career. Or a 40-year-old state trooper in Hibbing in the middle of her career. They’re the ones who, basically, are going to bear the pain.

It’s not going to be current retirees or the aging taxpayers, who traditionally show up to vote in greater numbers than younger people. The incentive for that group, and the people who cater to that group, is to basically push solutions down the road. The people who are going to pay for current policy choices are the 28-year-old teacher and the 40-year-old state trooper.

Q. Economists like to talk about incentives. What incentives left many private enterprise pensions foundering? How did they differ in the public arena?

A. There are two things that make the difference. The first one is, how people value the guarantee of future income, of retirement income. The second is what penalties there are for being underfunded.

With corporate plans, for a long time, they basically were allowed to value the future obligation using a very high-interest rate. All that serves to do is decrease the value of the future obligation. They were allowed to not have the assets to cover the value of the obligations for a fairly long period. That actually was changed in 2006.

Q. What happened in 2006?

A. First, the interest rate used to value the guaranteed retirement income was decoupled from the rate of return on risky investments. Companies were told they had to value these guarantees with a market-driven interest rate, one that better reflected the low-risk inherent to guaranteed retirement income. Well, that was more sensible. Let’s leave it at that.

The second thing that happened was to assign a penalty for having insufficient assets.  If you were below fully funded – so the dollar value of assets was less than the dollar value of obligations – you have to kick in some money. And pretty quickly. You can’t prolong the pain.

Q. Was that simply a band-aid?

A. No. Corporate defined benefit plans were fixed.

It created another incentive, actually. Because they were putting all of this on the accounting statements – the surplus and deficit – it could show as a hit to earnings. That created an incentive to take the entire pension fund and move it off the corporate books. That’s another thing that shifted the responsibility for retirement saving to the individual, in the form of 401Ks and the like. As we discussed earlier, there are more moving pieces now for employees to think about when planning for retirement. If we’re honest, it isn’t obvious that simply shifting all of the responsibility to individuals completely solves the problem of secure retirement income.

Q. Describe the difference in public pension funds.

A. To oversimplify, they’ve had much more latitude to make up the rules for themselves.

There’s always an incentive for politicians to undervalue the guaranteed retirement income and assume their current retirement fund balances will grow faster than realistically likely. Why? Because if they valued retirement benefits with an interest rate that reflected the guarantee, they’d have to stump up more money into the plans, just like the corporations had to. The key issue here is that so far, public funds have not had to meaningfully decouple the interest rate used to value the guaranteed benefit from the return assumption on investments.

To go back to the 28-year old teacher, or the 40-year old state trooper for a moment – the question that I would be asking if I were them is why the pension system values their guaranteed retirement income differently than the state insurance commission values annuity payments from insurance companies.

If you can make up the rules, would you pick a higher assumed investment growth rate? Of course, you would. Especially, because no one’s going to hold you accountable. With corporations, shareholders hold you accountable. With public funds, there’s no short-term accountability. Pension fund accounting is kind of arcane, so taxpayers, who should hold politicians accountable, are kind of stuck.

Q. To what degree have false assumptions driven shortfalls?

A. If you say, I’m going to get everything I need for retirement from a high-return investment portfolio that means you don’t have to save as much now.

The risk that you take is that the investment doesn’t pan out the way you wanted it to and you wind up with a shortfall. The interesting thing with public pension funds has been that fairly systematically they’ve not adjusted the rate of return assumptions in accordance with market conditions. They’ve persistently had very high return assumptions.

Two things have kind of happened.

The first thing is that they’ve systematically taken more risk. I can actually document that. You can’t say the fund managers were irrational. They’ve done exactly as they should have done, given the incentives they faced. That’s a rational response. You can’t look at the Minnesota state pension board and say, “Gee, they’re being irresponsible.” They were given a target. They said that to hit our target we need to do the following things.

I would argue that the prudent thing to do is to be cognizant of the risk of underfunding.

Q. I was surprised to learn how much risk public pension funds take. I would have guessed most of their investments were in dull, but stable, investments like bonds.

A. It’s more like 70% in equities or equity-like investments. But, again, there’s nothing irrational about that.

Q. With the current level of the Dow triple the lows of 10 years ago, will stock market recovery be enough to keep public pension funds well?

A. No – a lesson that I hope we all know is that markets can go down as well as up. What matters for retirement security is the long-term.

Here’s what goes into figuring out long-term equity returns – how’s the economy growing? That’s pretty much it. If you’re willing to take the point of view, which I am, that the outlook for real economic growth is lower – between a half percentage point to three-quarters of a percentage point…

That effectively says that equity returns are going to be lower and long-term bond yields are going to be lower. It’s not to say that year to year couldn’t be good or bad. We’re coming off a really good year, which by the way, partly was driven by stock buybacks. It’s not obvious to me that that’s sustainable over a long period.

Q. How much risk will public pension funds have to take to deliver reasonable living standards to retirees?

A. If public funds get to a reasonable accounting standard and can figure out a transition from where they are to where they should be, you’d end up still taking equity risk. How much depends on the level of contributions and whether contributions are regularly made.

Think about the constituents. You have the current retirees and the current taxpayers. You have the current workers and future taxpayers. It’s all about who’s shifting what to whom and when.  Somebody’s going to pay and the issue is figuring out who and when.

At the end of the day, the resolution to the funding issue is political.  There are states that have successfully transformed their systems.  They seem to have done so in a bipartisan way, in partnership with employee unions, with strong political leadership and, I think importantly, a willingness to rely on sound financial economics.