We know that public pensions are significantly underfunded, but answering the question of “just how underfunded?” is harder than you might think. This is because pension plans can make accounting choices that change their reported funding gaps without any change in the amount of assets they hold or the liabilities they owe. Sometimes, these choices hide the true extent of pension underfunding, leading lawmakers and taxpayers to underestimate the true cost of promises to public employees.
This primer covers two key accounting concepts that are used and misused to determine a pension plan’s funding gap. One, selection of the “discount rate,” regards the amount of money that must be set aside in the present to cover a liability due far in the future. The other, “asset smoothing,” refers to the way pension plans recognize unusually strong or weak asset returns, such as those we have seen since the second half of 2008... continue reading >>
While there has been much focus on some states' spending problems, there are revenue problems squeezing state budgets as well. State and local government depend on three sources of revenue: federal transfers, fees and charges, and their own taxes. The latter make up about 51 percent of all revenues. Yet state and local tax revenues are coming from sources that are drying up. For example, sales taxes, on average, now constitute about one-third of state tax revenue across the 50 states. But sales-tax revenue lately has become more difficult to collect because millions of consumers have moved at least some of their shopping online, making sales taxes nearly impossible to collect. This has eroded the sales-tax base. Hence the Senate has begun to consider an internet sales tax to try to replace some of state's lost revenue.
The main drama in Stockton's bankruptcy proceedings concerns a fight between CalPERS and a group referred to in legal documents as the "Capital Markets Creditors" (two bond insurers, a money manager, and a bank (herein "creditors")). The latter argue that CalPERS is just another "garden variety creditor" whose claims should be subject to impairment. CalPERS denies this, arguing that the true creditors of Stockton's almost $1 billion in pension debt are its retirees, for whom CalPERS acts as trustee.
This is essentially a legal question, but, as a fiscal management question, it's easy to be sympathetic to the creditors' position. CalPERS has $255 billion in assets. Why couldn't it take a $1 billion hit without passing the pain on to retirees? Calpensions' Ed Mendel believes the soft underbelly of CalPERS' argument is the agency's own controversial actuarial assumptions (emphasis added):
Andy Kessler's wrote a timely article and a worthwhile read published in the April 9th edition of the Wall Street Journal. He deals with the rosy annual investment expectations, in the 7.5% to 8%, range underlying most public sector defined benefit pension plans. As he correctly notes, the important question is not what been achieved in the past but rather what does the future hold?
Even using existing assumptions, the projected liabilities and the related contribution levels of many plans are simply unsustainable. A related problem is any resulting investment shortfalls are often spread over excessively long periods - some pension systems, such as the major pension plans in Montana have infinite payment durations.
Andy suggests something in the 3% range would be a better benchmark for the following reasons:
One of the most common fallacies confronting pension reformers is the accusation that we are "projecting" low rates of return on public pension investments. This is public pension fallacy #5 in my recent paper, "Nine Fallacies Used to Defend Public-Sector Pensions."
The cliffs-notes response is that we are not projecting anything--we're simply following Financial Economics 101 by incorporating the price of risk into cost estimates. When public pension fund administrators assume their risky investments will achieve the expected return, they are failing to account for the risk that their investments will underperform expectations. Lowering the discount rate measures the cost of that risk, which comes in the form of a contingent liability on future taxpayers.
Most people probably think of America's Red States--where people cling to their guns and religion and clamor for lower taxes--and the Nordic countries--the pacific, secular home of social democracy where people assemble their own furniture and listen to Abba--as antithetical. But there are some interesting connections...