Yes, We Should Worry About Public Pensions

By James Kwak

In the wake of the Detroit bankruptcy, Paul Krugman has a post pooh-poohing concerns about public pensions. His conclusion:

“Nationwide, governments are underfunding their pensions by around 3 percent of $850 billion, or around $25 billion a year.

A $25 billion shortfall in a $16 trillion economy. We’re doomed!”

(Yes, that’s sarcasm.)

I know why Krugman wants to argue that this isn’t a problem. If everyone believes that public pensions are a big problem, then the austerity crew will convert that belief into a push to cut public pensions—just like they have tried to use future shortfalls in the Social Security and Medicare trust funds to insist on privatizing or voucherizing those programs.

But for people who care about retirement security for middle-class Americans—and, more importantly, middle-class Americans who depend on public pensions—public pension shortfalls are a real problem. The public sector is the last major refuge of defined benefit pensions—the kind that provide a guaranteed annual income after retirement—and public employees paid for those pensions with lower wages while working. Shortfalls today mean a higher likelihood that those people will get stiffed when they retire, or at some point after they retire.

How big is the shortfall? Krugman focuses on the annual under-funding amount, which makes sense conceptually. In theory, if governments chipped in an extra $25 billion, then eventually the shortfalls would be made up. (All numbers are from the Center for Retirement Research at Boston College.) But this rests on a huge assumption: that pension plan assets will generate investment returns of 8 percent per year.

Using an 8 percent discount rate is like taking out a second mortgage and investing the proceeds in the stock market. You may think you’re making money, but the higher expected return of the market is entirely due to the fact that you’re taking on more risk. Pension benefit payments, like mortgage payments, are essentially fixed, so they should be discounted at the risk-free rate, not the expected rate of return of pension plan investments. Simply reducing the discount rate of future pension liabilities from 8 percent to 5 percent (still well above the risk-free rate even for thirty years) reduces the funding ratio (current assets divided by the assets necessary to pay future benefits) from 73 percent to 50 percent, which makes the annual shortfall bigger.*

Not setting aside enough for pensions is a serious problem for the millions of people who are relying on those pensions. It’s not a huge problem in the grand scheme of things, but it’s not insignificant, either. Krugman understandably doesn’t want people fastening on pension shortfalls as an argument for cutting benefits or raiding other government programs (like schools). I agree. And balanced budget rules make it difficult or impossible for states to issue debt to meet their pension obligations. So there are no easy solutions. The best (leaving aside federal aid) is probably to increase state taxes—which are modestly progressive, at least in states with an income tax—to make up the gap. But it’s still a problem we need to face.

* The shortfall is based on an “annual required contribution” that includes both new liabilities and an amount required to amortize the current shortfall.

52 thoughts on “Yes, We Should Worry About Public Pensions

  1. I am continually astounded to hear that “pension plan assets will generate investment returns of 8 percent per year”. There have been no secure investments that produce that rate of return for a very long time and I do not understand why this well-written blog entry should be one of the first I’ve read that points this out. (I’m a long-time reader of many financial blogs btw)

  2. Yes, and there is a reason that it is called a higher “expected” return. That’s the math, but it’s not “if, then.” Taking on greater risk can result in a greater return but what it also results in is great volatility, both in reward and loss. As Benoit Mandelbrot wrote, much of the probability theory that “allows” one to tune risk and reward like a radio (for those of us older folk) is the financial equivalent of alchemy. If Gross and the “New Normal” folks are right, for example, it doesn’t bode well. It seems to me that assuming 8% and crossing fingers doesn’t make the problem go away by any stretch.

  3. Before pensions or any other working class programs are moderated, we need to eliminate the tax exempt status of foundations. Foundations are just a way for entrenched wealth to stay entrenched.

  4. The real problem with pensions is that municipalities have been spending tax dollars poorly leaving too little to fund their pension obligations. What we should learn is that perhaps these pension benefits are too rich relative to the open market for compensation for those employees. For years municipalities have told us that they are able to pay relatively low wages (presumably to the benefit of taxpayers) because they can offer “rich” pension benefits thereby making municipal jobs competitive in the job market. Problem is those rich benefits have a cost today as well as in the future. Perhaps municipal employee compensation should be more like the rest of the job market where pensions are a thing of the past for a reason.

  5. Boy, where i live in northern california we have people making really good salaries, 85K is the average public employee salary in the city I live in, lots make more than that, and they can retire with 75% plus of that in their 50’s. The firefighters average 150K, many more, and retire at 50 with 90% of that. I think that is part of the problem, too rich of benefits.

  6. Wow, you fixed a problem of not having enough money by raising taxes to fill the hole! We should do that to fix more problems! Oh, yeah, that is how this blog solves most problems……

    While what you suggest is surely to happen… is not a sustainable solution as public sector executives will continue to offer more than they have and you will continue to fix it with tax increases until there is nor more income to tax or bankruptcy happens, or worse, money is printed and those who made bad decisions are bailed out.

    In the end, we are of limited resources and the best way we have found to allocate those resources is by and large (with some small exceptions) with market pricing.

    Public-sector bankruptcy is the states way of telling public employees to beware of offers that are too good to be true as described in the many examples provided by others above.

    California is going to be spectacular.

  7. The thing of it is, it is hard to generalize across the country, or even within the same states sometimes. Pensions are mostly set by local governments, and teachers are on different ones than safety which are on different ones than the rest of the employees.

    When so many people are retiring on 90% or more of their highest salaries and studies show that you need about 70% to maintain the same lifestyle, you have a problem.

  8. 8%/yr … Sounds like the assumption credit rating agencies made on housing CDO’s…

    Also, the problem compounds when taking into account increased costs due to an increasing number of retirements from baby boomers who also happen to be living longer. Just one of the reasons people in my generation (gen Y) think pensions are archaic and don’t expect to get any help in retirement from pensions or social security.

  9. Pensions aren’t archaic but you can count on corporations or governments for them. You have to create a personal pension on your own. Defined contribution plans (401(k)s, etc.) have largely failed. People need the pension mind set but have to do it themselves.

  10. I agree that a number of parties, especially pension fund managers, have incentives to overstate future expected rates of return in pension fund investments, thus allowing lower contributions from current payors. We can force fund managers and others to remove their rose-colored glasses by legally compelling them to use past returns as a basis for predicting future returns. What we lack to effect this is not knowledge, but political will.

    You refer to “budget rules [that] make it difficult or impossible for states to issue debt to meet their pension obligations.” Whether you’re merely noting this or endorsing it, either way, it’s a bad idea. Pension funds should be fully funded by a combination of current member contributions, negotiated matching state contributions (if any) and investment returns. Issuing public debt to fund pension plans simply shifts unfunded pension liability from the present to the future and from current and future retirees to the general public. Worse, it creates the same moral hazard for pension funds that public bailouts have created for banks considered too big to fail.
    That the benefit is defined shifts the risk from the future recipients to the pension fund, and possibly the general public. As a result, defined pension benefit funds should be more conservative and cautious than 401k funds, which put the risk on the account holder. If long-term market performance lowers the return or increases the variability of expected future returns, current payors into the system should have their current contribution increased, so as to avoid the need for public support later.
    Nationally, public pension funds are underfunded by roughly $1 trillion. Americans are living longer, increasing the number of years they will draw on pensions. While some choose (or are forced!) to work longer, unemployment forces many others to retire early. Longer life spans tend to be sicker life spans, requiring more medical care. All these factors strongly support the need for current contributors to contribute more now and/or accept less upon retirement.
    Aram Hollman

  11. Agreed — little is more basic to organized civilization than public support, through taxes or similar means of police and firefighters who, because their jobs are dangerous and debilitating deserve public pensions. Blanket opposition to taxation to support contributions to cover the conservatively-estimated liability for these pensions is an endorsement of anarchism.

  12. The basic cause of our public sector bankruptcy is decades of free-trade agreements. This is “Shock Doctrine” on steroids; put us into recession, and we’ll sell off our grandmother. If you think this is bad, wait until the TPP goes through, and we’ll all be working for 25 cents a day in a cesspool. Corporations will be granted rights above governments through the WTO, even more than now. Let our elected representatives read the secret negotiations. Stop the TPP and Fast Track!

  13. Looking at this issue from a purely political point of view, and as a recipient of a state government pension, I think that in the next ten years, varying from state to state, pension contributions will be reduced a few percentage points at a time. In 20 years I think pensions will be 50% of their current value. (The effect on consumer demand, and thus the whole economy, will be very harmful.) This decline would be greater but for the fact that many politicians are current and future pensioners. The first state employee benefits to be cut will be the health insurance benefits of retirees. I think there is a feeling that pensions promised by the state are a more legitimate entitlement than health insurance benefits.

  14. Dean Baker and Paul Krugman both noted that this 8% expected return assumption was a bit phony. But neither fully fleshed out the implications of using a more reasonable assumption.

  15. Maybe you people should actually look at public pension results over time before assuming that the 8% assumption is too high–talk about non-empirical debates!!

    There is an actual real association of people involved in public pension management and it may surprise some of you that the National Association of State Retirement Administrators (NASRA) studies exactly these types of issues. But of course it is so much, much more fulfilling to debate with data that is pulled out of thin air or your A**, or based on political ideology.

    In fact, the average earnings assumption is below 8% and also, NASRA members have beat the 8% earnings assumption, year in and year out, with the exception of 2008-2009.

    Read the results:

  16. It’s not whether 8% or thereabouts is an unrealistic “expectation” (and that’s what it is), it’s that they are funding a guarantee (bond like) and funding it with risk.

    There is no law that demands 8% is necessary.

    Other countries recognize this in their planning.

    Best Stearns and other went bankrupt because they used short term funding for long term purposes.

  17. Aren’t insurance companies funding a guarantee (more than bond like) and funding it with risk? Aren’t banks funding a guarantee (although an insured bond in this case) and funding it with risk. I fail to see the difference.

    I hope you are as concerned about the banks and insurance companies.

  18. @Jeff Brazel
    “For years municipalities have told us that they are able to pay relatively low wages (presumably to the benefit of taxpayers) because they can offer “rich” pension benefits thereby making municipal jobs competitive in the job market. Problem is those rich benefits have a cost today as well as in the future. Perhaps municipal employee compensation should be more like the rest of the job market where pensions are a thing of the past for a reason.”

    Let’s be explicit here. So you support raising municipal salaries, potentially by quite a lot, and cutting pensions to offset?

  19. Insurance companies are tightly regulated and although they do take on longer term bonds, many of their liabilities are out in the future as well. Show me an insurance company with even close to the % of assets in equities as most state and municipality pension plans.

    There is also another significant difference. Insurance companies and banks (in a functioning system) should be allowed to fail without cost to the taxpayer. FDIC premiums should cover expected losses for bank depositors and no bank should be allowed to be too big to fail.

    But, generally, yes I am and all should concerned with the future solvency of their bank and insurance company.

    I don’t think it is necessarily irresponsible to invest for an expected return of 8% and using equities to do so. BUT, I think the pensioners should be informed upfront that if that method is persued and if it results in underfunding, then their benefits will be reduced accordingly. Not fair for pols to make promises and then put the rest of us on the hook for the moral hazard.

  20. Well, there is something to the idea of higher (or let’s say “competitive,” whatever that means) current compensation, which is knowable, versus something down the road. Pols will always defer expenses to a time beyond their service. Payments later always seem easier than payments today.

  21. Odysseus: Look municipal employees deserve the pay they are able to achieve. My view is that the present value of the pension benefits (I know I am generalizing here) added to municipal salaries is greater than the total compensation that some municipal jobs would or should garner in the private sector. The true cost of compensation for the municipalities seems to be ignored. The private sector figured this out long ago. These public pensions are supposed to be a bargin for municipalities if the proper balance of employee contribution, investment return and employer contribution is made, but too often the municipal employment agreements require too little in employee contributions, and investment returns are treated like a guarantee.

  22. One of the elephants in the room is that these public sector employees do not participate in social security. They should be required to participate just like everyone else. Furthermore, their pension payout formula should be tied to the ages used for social security. So, for example, let’s say a big city firefighter gets an $80k/yr pension after 25 years of service, retiring at age 50. That $80k/yr should start at age 67. Until age 67, s/he should receive a progressively larger share of this. For example, at age 51 the amount would be $20k and then rising from there. These folks are retiring during prime working years and society should demand they continue to participate.

  23. To start with a couple of minor changes, Move to a highest 3 out of 5 years of base salary for pensions, and do not count more than say 10% of overtime towards the pension. (How many work a lot of overtime their last year to spike their pension). that would cut the egregious cases out where the pension might be more than the base salary before retireing. I also agree that putting them on social security makes sense.

  24. It is sad to see the worst examples of pension problems gerneralized to all public pensions. These plans and programs are not all the same. The lack of care in making these arguments borders on the surreal.

  25. The heart of the problem is that public entities probably will not contribute an extra $25 billion to their pension funds because they are looking for ways to minimize their current contributions. In fact they are looking for every possible way to minimize their contributions. A pension plan requires contributors to actually contribute an adequate amount to the plan’s assets to assure that resources will be available when needed. Minimizing contributions will virtually guarantee shortages. At the same time, pension funding entities have, in fact, promised to provide pensions at a given level. It is not the fault of retirees that those responsible for pension plans make irrational decisions about funding them.

  26. Right. I should have stipulated that my comments were aim solely at those underfunded plans that use 7-8% as an actuarial target. I made no value judgement about the richness or deservedness of them. I did say, and do believe, that negotiations should tilt towards current comp (which can be known and controlled and invested by the recipients) over the unpredictable future benefits. But I also see the paternalistic benefits of a DB plan in general. Also, I did say that pols will tilt towards future costs because it easier for them to promise future benefits rather than current benefits. And I also believe that whatever actuarial assumptions are made, other taxpayers should not be called in to make up investment shortfalls because both the pols and the bargainers are will to set a higher actuarial target.

  27. Looking at only unfunded pension benefits misses the elephant in the room. Accounting rules force governments to fund these post-retirement benefits so there are assets there. On the contrary, governments have accrued large non-pension employee post-retirement benefits that are frequently not even funded.

  28. I have strong mixed feelings on this. This largely is connected more to municipal and state budgets than to federal, yes??? (if Mr. Kwak would make one of his rare comment thread appearances to answer that would be nice). I think the bottom line here is not the discount rate used (is it going to be the end of the world if 8% turns out to be 4.5%???) but the quality of the assets in the accounts. If it is garbage ETFs, garbage mutual funds, or the garbage in your average PIMCO fund, I’d say you’re s h i t out of luck. If they are in well chosen equities and commodities bought on the “dip” I think you’re going to be ok. What % fit in the latter?? Not as many as think they do.

    I tend to side more with Krugman on this, but it’s very debatable.

  29. It may or may not be the end of the world. For some municipalities, maybe that is the amount that is the final straw. But if it’s 4.5% and they had planned on 8% then employees get screwed on what they were promised/counting on or taxpayers get fleeced for more money (all because of poor planning), or both.

    If the retiree promises are kept, the difference has to come from somewhere.

  30. Also, I think we have a different view of market efficiency. The idea that some states could just choose to buy “better” assets or just wait for “dips” as though that is a simple strategy strikes me as unplausible. I certainly wish that world for all investors but I don’t think it exists.

  31. I guess my reading comprehension was bad on this one, as Mr Kwak seems to be saying that 8% discount rate to 5% discount rate would indeed create a large funding shortfall (pension liability). But do we REALLY believe that 8% is a realistic discount rate??? If you believe 8% is a realistic number maybe you should join the Thain Fan Club, headed by Maria Bartiromo and CNBC twats:

    “Chatter increased Tuesday among Summers’ opponents when Fed Governor Sarah Bloom Raskin’s name was floated as a possible deputy to Treasury Secretary Jack Lew. Raskin, who has been harshly critical of the Fed, is broadly popular with progressives. Liberal Fed watchers suspected the move was aimed at people pressing Obama to name a woman to the Fed, and they worried selecting Raskin for Treasury would give the president cover to name Summers Fed chairman”

  33. Agreed about a strategy of buying on the “dip” — implausible, and even if you got one right it wouldn’t improve 30-year return much. Looking for some kind of investment return salvation is not the answer and will only dig a deeper hole if it means more investment management fees. Actuarial valuations need to be aligned with present-day realities: low yields. The shortfall should be covered by a combination of taxes to increase pension fund contributions, and pensions renegotiation where appropriate.

  34. One problem or potential source of confusion is that I think we can all agree that 8% is indeed possible. The question is whether it is an appropriate rate to use to “count upon.” There could be many reasons to believe that that is not an appropriate figure upon which to base actuarial assumptions.

  35. GP, I read your linked “NASRA Issue Brief”, it seems to claim an 8% return on pension investments is real w/o stating what those ‘real investments’ are. I have been an investor for a long time and there are no safe investments available to me that will return anything near 8%/year and have not been there for a very long time. Pension funds should not be invested in junk bonds or penny stocks…

  36. @ commenter George Peacock
    I have to respectfully but strongly disagree with you.
    George Peacock: “I think we can all agree that 8% is indeed possible.” No we cannot all agree on that. This is not a 1 year return number, you’re talking multiple years returns. Let’s say in the first 5 years you have a 6% return (5 years of 6% returns is enough to make you into a fund manager super star in even bull markets). So think about it, you’re talking 5 years straight of 2% funding shortfalls. What returns (discount rate) would you have to get after 6 consecutive years of 2% funding shortfalls to get back to your 8%??? This is assuming 5 consecutive years at a rate that would beat a huge segment of the market.

    If you’re a baseball fan it’s nearly the equivalent of saying you got a .365 batting average for 5 years and you’re trying to figure out what average you need to bring your 10 years average back up to .395.

  37. California gave a huge increase in pensions to its employees in 2000 based on an 8% return policy. In fact the return has been less than 5% in that time period and California now has huge pension problems. Pension costs are around 30% of payroll. A ridiculous number. And as someone said, the other unfunded liabilities, ie promised medical benefits, are even bigger.

    Although I generally agree with Krugman, he is completely wrong about this one.

    People don’t need the kind of pensions they are getting anyway. Public employees in most big liberal states get salaries comparable to private plus much better benefits. In California, state employees get medical for life if they work 20 years, for themselves and their families. That means if you start at 23 and work til 43, you can quit and get a job in the private sector and the state will stay pay your medical benefits for you and your family until If you are 65. It is ridiculous, no one offers that kind of benefit except the state of California.

  38. Not sure where you get that “5 years of 6% returns is enough to make you into a fund manager super star in even bull markets” — were you not around in the 90s? — but if you got 5 years of 6% returns you’d have to average 8.5% after that to achieve 8% over 30 years. Sure this is possible, it’s just not likely and not what can be expected — certainly not in conservative investments — given today’s 3.6% 30-yr T-bond yields.

  39. I am not sure we strongly disagree at all. I merely said that 8% on average is possible. I actually don’t believe it’s likely and I certainly believe that we should not be using (counting on) a number close to that for actuarial purposes. Nor do I think pension portfolios should have taken on nearly as much risk as they did to “justify” using 8% in the first place. I may not have been clear on those points. My fault.

  40. Mr. Edesess, I’m sad to inform you that people cannot plan their pensions around a 5 year period of tech madness. There are things called “outliers”. I promise you, if you have a fund manager who can give 6% returns over a 10 year period, he’s going to be attracting so much inflows he’s going to have minimum investment barriers. Jeffrey Gundlach is a prime example.

  41. I didn’t say to plan around 8% only that it was possible — possible and likely are different. For planning 4% or 5% now seems judicious, even with some risk.

  42. @moses. As for Jeffrey, there is also a huge difference between “can give” and “has given.” Given the role of luck in investing, one can not “count” on either 8% or Jeffrey or any other investment advisor.

  43. If you are predatorclass and superrich – the 1%, – all is well in the land of Oz. if you are not – get stocked, locked, cocked, and ready to rock biiiiaaatches!!! The game is on! The predatorclass is bent on robbing, pillaging, incarcerating, enslaving, or eliminating the rest of us. What you think you hold in a bank or this or that fund is purely digits and it will all be devoured and wiped out to feed the predatorclass!!! Any and everyone NOT predatorclass will be smudged off the books and liquidated!!! We deny this truth and horror to our great peril, and what little remains of our children’s future.

    Burn it all down! Reset!!! It’s the only option for working Americans!

  44. You can argue the return rate and you can argue the benefit size, but the fact remains that the pension obligations have been underfunded in many states and localities without regard to the above. Once you have an obligation, then you must fund it. Sure you can do some temporary gyrations for recessions, but the tricks that the politicians have engaged in that caused the underfunding created the problem.

  45. Since the predator class is “too big to prosecute” for smudging everyone off with an algorithm, the default falls back to seizing power in the “Now”.

    Everyone is in it, no one controls it. And the real truth of the physics is that VIRTUAL is trying to control a “Now” that is not the “Now’.

    FRAUD by any other name STINKS as bad.

  46. Greetings James,

    Late to the game in terms of leaving a comment (I haven’t visited this site in a year or two) but I’ll leave my two cents:

    Pensions (both public and private) are in rather perilous shape. In both sectors they tend to be underfunded. In the private sector, there was an institutional investment firm that erroneously refunded to the clients tens of millions of dollars as the pension fund was over-funded, due to the success of the institutional investor at generating superior returns. While the institutional investor looked brilliant, they were wrong! The computer application that they were using (a common third-party app used by Wall Street) used an incorrect term structure to determine the value of the future stream of liabilities (payments to pensioners, which as James Kwok correctly pointed out, should have been discounted using the risk free rate or more accurately the risk free term structure). Horrific, and of course never reported to the customer, who of course felt the institutional investment firm was simply brilliant. Of course this problem wasn’t recognized at the time, but eventually will be as the workers age. While this is an isolated incident I have a feeling it illustrates a wider problem, both in the financing, accounting and accountability of private pensions.

    Public pensions likely share the problem, but they have one more potential bomb. Unlike the private sector where unions are weak, public sector unions (police, fire in particular)) wield significant power over the city, county and state public sector managers. Due to the political fallout of a potential public safety strike (and the lack of alternatives such as strike breakers) the politicos tend to appease increase pension demands by the union. It has been politically expedient on a historical basis, it averts a strike and shifts the burden of payment on future administrations. Hence the problems we see in Detroit will reappear in other cities… Detroit just happened to be the first due to negative growth in both tax revenues and population.

    When you think about the wonders of interest and compound interest (a tune from an old Broadway musical) an underfunded pension liability is like our deficit, in will continue to mushroom over time. Unresolved, it will take an increasing share of resources (tax revenues or corporate free cash flow) to satisfy the demands. Of course there is one more remedy, and that is bankruptcy.

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