The current issue of Barron’s highlights the crushing burden that employee pensions are putting on state and local governments around the nation. The situation is so dire that some dismaying-enough estimates fail to capture the entire scope of the problem. Barron’s writer Jonathan R. Laing cites a Pew Center of on the States study that finds that, “eight states — Connecticut, Illinois, Kansas, Kentucky, Massachusetts, Oklahoma, Rhode Island and West Virginia — lack funding for more than a third of their pension liabilities. Thirteen others are less than 80% funded.” That sounds bad, but it is a relatively optimistic estimate! As Laing notes:
The size of the legacy-pension hole is a matter of debate. The Pew report puts it at $452 billion. But the survey captured only about 85% of the universe and relied mostly on midyear 2008 numbers, missing much of the impact of the vicious bear market of 2008 and early 2009. That lopped about $1 trillion from public pension-fund asset values, driving down their total holdings to around $2.7 trillion.
Other observers think the eventual bill due on state pension funds will be multiples of the Pew number. Hedge-fund manager Orin Kramer, who is also chairman of the badly underfunded New Jersey retirement system, insists the gap is at least $2 trillion, if assets were recorded at market value and other pension-accounting practices common in Corporate America were adopted.
Finance professors Robert Novy-Marx at the University of Chicago and Joshua Rauh of Northwestern University asserted in a recent paper that the funding gap for state pension plans alone might exceed $3 trillion, in part because state funds are using an unrealistic long-term annual investment return of 8% to compute the present value of future payments to retirees, as is permitted in government standards for pension-fund accounting.
This establishes a “false equivalence” between pension liabilities and the likely investment outcomes of state investment portfolios, which are increasingly taking on more risk by beefing up their exposure to stocks, private-equity deals, hedge funds and real estate. Using a much lower expected return — say, one at least partially based on the riskless rate of return on government securities — would both properly and dramatically boost the present value of the pensions’ liabilities while decreasing their likely ability to meet them. The academic pair, using modern portfolio theory, claim that state funds, as currently configured, have only a one-in-20 chance of meeting their obligations 15 years out.
Of course, 15 years out, the politicians who helped to perpetuate this debacle will likely be out of office — which gives them an incentive to back load benefits in the form of pensions. By the time the bill comes due, it’ll be somebody else’s problem. So, while union-friendly office holders can’t give their public employee union supporters everything they ask for today, tomorrow is a different matter.