STUMP Classics: Public Pensions "Truths" and "Myths" -- Now Exposed

And by "now", I mean June 2020.

Jun 19, 2020

One of the reasons I’m doing this “classics” series on Fridays (other than it cuts down some of the blogging work) is that some things I wrote years ago are being proved true by reality. Amazing how that happens.

Some of these posts, like the following, aren’t that old… but because of COVID-19, etc., it seems like decades ago.

The following edited post was originally posted in November 2018, but it was based on a presentation from 2016: Arguing against the Public Pensions “Truths” and “Myths”.

November 2018: A list of supposed public pension myths

I want to respond directly to some of the usual arguments being given against changing the status quo on public pensions.

I’m using a NASRA presentation by Keith Brainard — Public Pension Funding Issues: Myths and Realities – from 2016. I’m not picking on this one in specific… these are arguments I see often, and with regards to NASRA, at least, it’s not coming from a place of ignorance (I’ve seen a lot of that, of course).

I want to air the best arguments, not attack the weakest.

These are the “myths” addressed in the presentation:

1. Unfunded liabilities are unsustainably high
2. Public pension liabilities should be discounted using a risk-free rate
3. Taxpayers cannot afford it
4. Defined benefit plans should be closed and switched to defined contribution plans
5. Pension plans are seeking a federal bailout

Let me take the arguments in turn (by the way, I agree with them on some points – I don’t think that public employees should be switched to defined contribution plans, though those have particular pros/cons.)

Remember — they are framing these as myths. We will see how mythical some of them are.

“Myth” 1: Unfunded liabilities are unsustainably high

Let us see how they handle that one. I am putting in labels so it’s easier to reference.

1.1 Unfunded pension liabilities vary widely among states, cities, and plans
1.2 Unfunded liabilities for the vast majority of states, cities and plans are manageable
1.3 The largest unfunded liabilities are attributable primarily to employers’ failure to pay actuarially determined contributions
1.4 Pension plan obligations are paid over many years, which provides time to generate contributions, investment returns, and to alter benefits and financing arrangements
1.5. As a percentage of all state and local government revenues projected over the next 30 years, required
pension costs are only a small portion

The first point (1.1) is obviously true.

The second (1.2)… I’m not sure about, but let us pass over that for now.

The third (1.3)? It’s somewhat true, but misleading.

The worst funded plans have been grossly underfunding their pensions. Even with optimistic valuation assumptions, if employers are not contributing even the low-balled contribution amount, obviously things are going to be very hairy.

But the problem is — those making “full” contributions are also falling behind. And theoretically, they shouldn’t be — if all is as it should be. My graph:

That’s not good. See my post on why this may be happening.

The fourth point (1.4) — well, yes, until all of a sudden the sponsoring employers can’t deal with a too-large unfunded liability, and go bankrupt. Also, those states disallowing the decrease in benefit formulas, even on years of service not yet accrued, not allowing COLAs to be cut, etc.

And the fifth point (1.5)? If they’re using the same assumptions to project costs and revenues as was used to develop clearly inadequate contributions… I don’t trust it. At all.

“Myth” 2: Public pension liabilities should be discounted using a risk-free rate

Now, I’m obviously going to disagree on this one, so let’s see what they write. Again, I’m adding numbering.

2.1 Using a risk-free rate to discount liabilities is based on an economic theory
2.2 Using a risk-free rate implies that public pension fund returns are or should be linked to bond markets
2.3 Current risk-free rates are around 2.35 percent
2.4 Public pension fund assets are invested in diversified portfolios that can be expected to generate long-term investment returns of 3 to 5 percent above the rate of inflation
2.5 Discounting public pension liabilities at a risk-free rate would cause unfunded liabilities to skyrocket and would lead to misunderstanding and misuse of the calculated numbers
2.6 Using a risk-free rate to discount liabilities falsely implies that public pension liabilities are for sale

2.1: Yes, it’s based on a theory. A THEORY THAT THE REST OF FINANCIAL WORLD USES TO PRICE SECURITIES AND LIABILITIES (the difference between risk-free valuation and market/fair valuation is due to embedded options/features)

2.2: And your point is? You are promising bond-like payments. We are valuing cash flows based on what you’re promising.

2.3: True at the time. They’re still very low. [And now, in 2020, the interest rates are incredibly low]

2.4: I dispute this. There is no guarantee on those long-term returns. Why not recognize the risk? Interestingly, securities with a hell of a lot of embedded risk haven’t been doing too hot. (Here is a critique from the left.)

2.5: Yes, it would cause liabilities to skyrocket, which is why so many don’t want this. As it is, valuation numbers are currently misunderstood, so switching to a risk-free rate doesn’t change a damn thing there.

2.6: No, that’s not what it means. It means that we are assuming that pension benefits are risk-free, as in, they’re being guaranteed to be paid.

I am very willing to let public pensions continue on with their clearly-underballing valuation approach, with the following concession: just admit they’re not risk-free.

Do both calculations – and indicate the difference between the official number on the books and the risk-free valuation is the value of the embedded option that the pension benefits won’t get paid in full.

Alas, not many take me up on this compromise.

“Myth” 3: Taxpayers cannot afford it

Well, let’s check this one out.

3.1 Spending on pensions accounts for approximately four percent of all state and local government spending, excluding spending from federal funds
3.2 Required spending levels need to be higher for some plans and are sufficient for others
3.3 Many studies have documented the positive economic effects of pension plans
3.4 Pension plans help prevent participants from becoming reliant on public assistance, which is much more expensive than a pension plan

3.1: I will just have to take that on faith. Keeping in mind that 4% is grossly insufficient to fund the benefits already promised, forget about future benefits.

3.2: This is obviously true. It is dependent on the promises made, and not all plans are structured the same.

3.3: So… does it factor in what economic activity comes from other expenditures of the dollars spent on pensions? Such as, money from defaulted-on bondholders? Taxpayers seeing their rates go up? I’ve yet to see such a study where it includes costs imposed on others. It looks at the economic buying power of the pensions without reference to what taxpayers and bondholders would do with their money.

3.4: I have a very modest proposal: put all public employees on Social Security. That was to prevent senior indigence. I understand it has worked fairly well in fighting senior poverty, along with Medicare. (All public employees should be part of Medicare, too)

“Myth” 4: Defined benefit plans should be closed and switched to defined contribution plans

4.1 Closing a defined benefit plan does not reduce costs and usually will increase costs, at least in the near-term
4.2 Public pension obligations are promises that must be fulfilled
4.3 Defined contribution plans are poor vehicles for delivering an assured source of retirement income
4.4 The appropriate response to a public pension funding problem is to properly fund the plan, make needed adjustments, or both

4.1: This is just stupid. If one has a fully-funded DB plan for retirees and you just stop accruing further DB benefits for participants and their part is already fully-funded, then nothing is more expensive. You go from an uncertain cost to a certain cost. That uncertain cost would have existed as a smaller portion of the pension if it hadn’t been cut off.

But what they mean here is that if the plans are underfunded, and you have no new entrants, you can’t do certain tricks that help low-ball contribution amounts. Because, as Warren Buffet said, when the tide goes out, you find out who has been swimming naked.

The pension promises cost what they cost, ultimately. Changing not-yet-accrued benefits to a different system doesn’t make the already-accrued benefits more expensive.

4.2: That’s nice. How are you going to enforce that?

4.3: I agree with this one. That’s why I supported the idea of transitioning to a plan with income guarantees, albeit much lower than standard DB plans.

4.4: I agree here, too — and the needed adjustments are risk-sharing. A variable component floating above a relatively low guarantee means costs won’t spiral, and that the pension plan is sustainable.

“Myth” 5: Pension plans are seeking a federal bailout

This one is fun.

5.1: No public pension plan has requested a federal bailout
5.2: The public pension community and its sponsoring states and local governments expect and intend to resolve their funding challenges themselves

5.1: YET [in 2018]

5.2: That’s cute.

Detroit definitely wanted something of a federal bailout.

This is what they got:

Two months after Detroit became the largest city ever to file for bankruptcy, top Obama administration officials will be there on Friday to propose nearly $300 million in combined federal and private aid toward a Motown comeback — only a fraction of the billions the city owes and a reflection of the budget and political limits on President Obama.

That was in September 2013.

It’s not like Obama didn’t want to bail out Detroit:

The package follows weeks of meetings in Detroit and at the White House between the administration team and local business, labor and philanthropic leaders on how best to pool existing resources. Final details are to be worked out in a two-hour meeting of the federal and local officials at Wayne State University, participants said.

It’s just that this is what the political situation was:

Yet the idea of the federal government’s responsibility toward Detroit is hardly a settled issue in Washington. Instead, divisions over the question reflect the fundamental divide between the two parties over the size and role of government.
Congress, preoccupied with reducing federal deficits, has been all but silent about helping the birthplace of the auto industry and, some say, of the American middle class. The Republican-controlled House is hostile to any spending initiatives from Mr. Obama. In the Senate, two Southern Republicans separately and unsuccessfully proposed legislation intended to ban bailouts — Detroit leaders have not sought one — briefly churning the racial currents at play over a city where four out of five residents are black.

They didn’t seek one? I assume they went to DC in search of something.

The point was this:

So with the chances that Congress would pass any legislation for Detroit “somewhere between zero and zero,” as an administration official put it, Mr. Obama has fallen back on what he can do through executive actions, with available money and tax credits, or through partnerships with local businesses and foundations.

He gave them what he could do with existing resources available to him as head of the Executive Branch.

The NASRA presentation was in 2016. Now, with hearings on a possible MEP bailout [in 2018], you better believe various public plans would be slathering for their own.

Only problem is… their hole is a lot bigger than the MEP hole.

The federal government is not going to bail out the pension plans of California, Illinois, and New Jersey, because it can’t. It’s just too large.

The AIG bailout was “only” $180 billion. And the government owned it, essentially, and did end up making $22.5 billion on the deal…. or a 3% per year return. That’s not a great investment.

But back to the states and all the muni plans. They are in the hole to the tune of trillions. They’re not going to be bailed out. The reason states haven’t asked for one is that they know they won’t get one.

Think about it

The next presentation in the file is even less to look at, but I want to point out something from its conclusion.

One last thing….
How about a different approach to the way in which we discuss our unfunded liabilities.
We only have them because pensions are pre-funded. Think about it!
What about our $3 trillion in funded liabilities? Why don’t we talk more about that number, and what it means to our economy?

A. You’re no Columbo

B. I agree

C. I’ve thought about it. Do you know why pensions are pre-funded? I do. Are you one of those dirty evil never-fully-funders? Do I have to put you on my list?

D. Yes, I think the $3 trillion in public pension funds is important. And even more important is to know exactly how much in promises that represents — the full promise of benefits? Only 70%? Less?

Because it would be best to guarantee a reasonable amount, and then share ups-and-downs for a level above that.

A risk-sharing plan, if you will.

Back to 2020

I could have written the above any time after the Detroit bankruptcy, as these arguments have been around since at least 2010, and I know earlier. But 2011 is when I first heard about state bankruptcy concepts, after a rough muni ride in 2010 into 2011.

At this moment, I want to address one item in the above list of “myths”. That of the federal bailout.

Here is what I have so far on state bailouts (and bankruptcy), just from this year:

Heck, I have even more reactions, that I may run at some time. It seems Congress’s attention keeps shifting away from a state bailout, so it gives people time to write more op-eds and white papers. I collect them.

Here is the crazy thing about the “ask” for bailouts right now: they’re not asking for a balance sheet bailout (aka paying off the unfunded liabilities), but a bailout of one year’s worth of contributions. That’s what the $10 billion Illinois was asking for: their unfunded pension liabilities (not counting retiree healthcare) is over $100 billion. Just for the state funds. They need money to cover the pension benefit accrued for 2020… AND pay for some of that unfunded liability. They’re not asking for a full bailout.

(yet)

Expect these “myths” to be back

I am sure many of these same groups still parrot the above list of myths and supposed rebuttals. I am willing to concede some of these items, but many merely assert that something is not true, without adequate support.

The worst one of the above, in my opinion, is this: stating that only 4% of state and local expenditures are spent on pensions does not indicate whether they are paying for the full costs of the pensions [they’re not, even when they say they are]. Also, it would be useful to see what all the other expenditures are…. there may be some items in there of large magnitude that people weren’t expecting. [I have Medicaid in mind. That has only been increasing.]

I do expect many to get a re-run, as many state and local budgets are under even more pressure, and looking for a way out. The problem is that it becomes very evident that the pensions are quite costly, especially since, even before COVID-19 hit, pensions were, on the whole, only 70% funded.

With that funded ratio being measured at a discount rate many people still say is too high.

Some governments, thinking they were behaving prudently, were dutifully contributing what the actuaries said was required… and yet the funded ratio kept slipping! Just to stay in place took more and more as a percentage of payroll, even as actuaries were supposedly pursuing level-percent-of-payroll approaches. Hmmm, a puzzle.

I have seen shifting in strategy, with many of the public pension proponents laying low for right now. State budgets are being cut, and you don’t want to be the group representing the ever-increasing pension contributions that are “required”.

But these “myths” and their “refutations” will be back, don’t worry.

I will just have to update my data… I’m sure I will be getting the same results. I wonder if they will.

STUMP - Meep on public finance, pensions, mortality and more

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