March 14, 2011

Apparent Public Pension Debate Strategy: Keep It Confusing

by Hal Gershowitz

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The mind-numbing, esoteric mumbo jumbo that dominates so much of the reporting and commentary on public-sector pension funds seems designed to cause the tax-paying public to surrender and acquiesce to letting their civil servants or elected officials iron it out.  Well, unfortunately, that’s how we got into this mess in the first place. Fact is though; it isn’t really all that confusing.  Trudge through the technical thicket of defined compensation versus defined benefits, or unfunded liabilities versus deferred compensation, or present-value discount rates predicated on zero-risk returns versus discount rates predicated on highly leveraged exchange-rated funds and we find a rather simple issue.  Will there be a fund with enough money to pay the workers’ pensions when they retire? And if not, do the voters understand that the typical public employee pension fund has, in effect, an open call on their checking or savings account through a contractual agreement that requires the local or state government to raise taxes (or lower government services) in order to cover fund deficiencies? Yes, we understand that the state can go into additional debt to cover the shortfall, but that ultimately becomes the responsibility of the taxpayer too.  If the voters are fine with that, then they have no complaint.

We don’t mean to pick on public-sector pension funds.  Certainly, private sector pension funds can be just as underfunded as public-sector pension funds. There is, however, a big difference.  An unrealistically generous private-sector pension fund (one with over zealous return-on-investment assumptions, or too small an employer/employee contribution) may simply put a company out of business. At some point, the company may not be able to pass along the high cost to its customers (think pre-bail-out General Motors). An unrealistically, generous public-sector pension fund, on the other hand, doesn’t really ding the government that employs its members. It simply dings the taxpayer.

Much of the current debate has, in our opinion, been unhelpful.  One commentator railed that unfunded pensions are not unfunded liabilities but merely deferred compensation.  Fair enough.  He is correct.  All pension programs are really deferred compensation.  So what?  If there are not adequate provisions to pay that compensation when the worker reaches retirement, someone has a big problem.  In the case of public sector pensioners the problem is the taxpayers’ problem.  And in states where citizens already feel burdened by high taxes, taxpayers are calling for reductions in government spending to cover current and future pension expenses, or they want to see saner pension plans for public sector workers.

In many states, such as Wisconsin, public sector workers already earn higher wages than their private sector counterparts, they get more attractive benefits, better vacation time, and better sick leave, the cost of all of which is, of course, covered by taxes paid primarily by private sector wage earners.  Attractive wages, benefits and very generous pensions are not the only advantages of taxpayer-supported public-sector careers.

Those who work in the public sector also will generally retire at a much younger age. For example, The Economist reports the average retirement age for state workers in Ohio is just 57.  Many public sector employees routinely retire at under age 62, and as early as age 50. Many workers such as firefighters and police officers often have retirement programs that allow them to retire, at close to full pay, while they are still in the prime of life.

Interestingly, the wage and benefit advantages of public sector employment are not the cause of so much of the frustration and resentment.  Taxpayers are pushing back because of the pension liabilities that have been, and that are, piling up for which they, their children and grandchildren will be held responsible.  Taxpayers have assumed that the pension funds, which are comprised of contributions (and earnings therefrom) that public employees and their public employers pay into these retirement funds were sufficient to take care of the obligations these plans have to their retiring members.  As hard working taxpayers began to realize that there yawns an enormous gap between what is owed to their public sector retirees and what has actually accrued to meet those obligations they have begun to dig in their collective heels and demand that that which they see as a broken system be fixed — and quickly.

The taxpayer has every right to be confused.  Accounting rules for public sector pension plans are in need of serious attention.  They have really allowed the perpetuation of a fiction that all is well when, in fact, public pension plans have been an impending train wreck for a long time.  Accounting rules for public sector defined benefit plans require that liabilities be predicated on an arbitrarily selected expected rate of return, and today the average assumed rate of return by public plans is 8.0%, an assumption not justified by market reality. That simply means that income from investment earnings will be woefully short of what these plans will actually require.

Because governments can’t go out of business, the taxpayers will ultimately pick up the shortfall.  Public sector unions have succeeded in many localities in making it illegal for government to adjust the employee contribution to cover these shortfalls.  If the plan managers are overzealous (and they are) in their assumptions of the assumed rate of return, the taxpayer covers any inadequacy, although few taxpayers realize this.  Accounting rules for private plans, on the other hand, require that the yield be predicated on AA corporate bonds, a far more conservative assumption. For public pension plans to be fiscally sound the general economy would have to be perpetually booming.  If only it were so.

Considering the certainty of economic cyclicality, using the expected rate of return as the basis for public sector pension plan accounting is absurd.  The liabilities will be there regardless of how well or how poorly the economy is performing.   Also, some economists, such as Robert Novy-Marx of the University of Chicago, and Joshua Rauh of the Kellogg School of Management at Northwestern University, have voiced concern that states that base their pension plans on an expected rate of return may be encouraged to invest in riskier, higher-yield assets.

Novy-Marx and Rauh recalculated the accrued liabilities of the nation’s 116 largest state and local-government pension plans using the more conservative Treasury bond yield instead of the 8.0% yield on which these plans rather arbitrarily project earnings.  Lo and behold the more conservative (and rational) calculation shows that these public pension plans are underfunded by $3.12 trillion, which is better than three times more than the states estimate their unfunded liabilities to be.  This does not merely suggest a need for a minor course correction, but rather a need for major reform.

This accounting anomaly is not a minor technicality. The unrealistic accounting for public sector pension plans leads to the assumption that state and local governments only have to contribute about 18% of payroll, but when the more conservative (and sensible) treasury yield is used as the discount rate, governments would have to contribute 29% of payroll.  The fact is that plans that look good on paper because of economic assumptions that have no reasonable chance of being maintained over time represent a very large bill to future taxpayers (312 trillion according to the Novy -Marx and Rauh study) of which those taxpayers are largely unaware.

It is, then, no small wonder that new governors in Wisconsin, Ohio and a host of other states are endeavoring to assert more control over the process that produces these pension plans.  It seems the responsible thing to do, and the well-orchestrated mass protests, and unrelenting vilification of these elected officials are clearly not in the interest of the tax-paying public whose private sector earnings produce the taxes to pay for public sector wages and benefits.

As the spectacle in Wisconsin makes clear, the entire process of compensating the teachers who teach our children, the policemen who protect us, the firefighters and others who are the first responders in all manner of emergencies has become extremely politicized.  It is now well-established law that unions can, and do, allocate a portion of their dues income to politicians who support their agenda, regardless of the political preferences of the taxpayers whose taxes provide those payrolls.

What we have is the closest thing to a perpetual motion machine. As James Taranto stated in his Wall Street Journal online column on March 11, “This is a scheme in which unions…collude with politicians to direct taxpayer money to the unions in the form of dues.” The union then apportions part of these dues back to the politicians as campaign contributions.

Let us also hasten to add that it is no less true that corporations can, and do, allocate a portion of their profits to politicians who support their agenda regardless of the political preferences of the customers whose purchases provide those profits. However, those customers can choose to shop elsewhere if they don’t like the political preferences of the companies whose products they buy.  Furthermore, a company’s shareholders can stop the company from making contributions if they choose to.  The taxpayer, on the other hand, cannot shop elsewhere for government services or selectively question how his or her tax dollars are being allocated.

Thus, the need has never been greater for every stakeholder in these processes to understand the plain facts that are at the heart of these very contentious issues.  If the taxpayers in Wisconsin understand that they are on the hook for funding pensions that agency and employee contributions are inadequate to fund because of the chimerical accounting of public sector pensions, then they should cheer on the public sector protestors whose wages they pay.  If, on the other hand, they expect the officials they elect to be responsible stewards of their tax dollars, they might think twice about the propriety of protestors storming the state house or their legislators holding up in Rockford Illinois in order to stymie the operation of the legislature.


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2 responses to “Apparent Public Pension Debate Strategy: Keep It Confusing”

  1. Peggy Jacobs says:

    Each week I am saddened by the plain truth of which you speak. This perspective should be covered in the Wisconsin papers.

  2. peter solomon says:

    The more transparent the discussion of govt pensions, the more people might (hopefully) understand how dire the situation is and, by vote, take action.

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