2009Dec31 Government Employment

2008Mar States Short in Pension Funding

“Many States are Lax in Funding Their Pension Plans”
New York Times, February 29, 2008

The quote above, reported by the Times, is straight out of a report sent to the US Senate by the Government Accountability Office.  The report’s findings are, to say the least, disturbing.   As a whole, the states have not come close to putting aside enough funds to cover public-sector pension and health plans.  Failing to properly fund these liabilities today only makes the problem worse, and many of the states are likely to eventually face severe financial distress.  It won’t be pretty.

There are essentially two major problems with respect to pension funding.  The amount of money a state owes its pension plan for future retiree benefits depends in part on the rate of return that the plan is expected to enjoy over its life.  Herein lies the first problem.  A state can make its liabilities partially “disappear” by assuming a higher rate of return.  By simply choosing to believe that stocks will return, say, 10% per year instead of 7%, the amount that the state has to set aside today magically shrinks.  (We will spare you the technical details, but the assumed rate of return is closely related to the discount rate, which determines the plan’s present value).   

This has been a major point of contention between the states and the actuaries that advise them, with the states obviously taking a more, shall we say, “optimistic” view of the market’s future prospects and the actuaries taking a sterner view.  Unfortunately, due to the natural slowing of the economy that should happen as a result of the aging of the Baby Boomers, we believe it is highly likely that even the sober actuaries have expectations that are a little too rosy. 

The other major problem, and the focus of the Times article, is that the states are not following their actuaries’ instructions.  Less than half of public pensions are receiving their full annual contribution as calculated by the plans’ own actuaries. 

So what does this mean to us, as citizens, taxpayers, and investors?  As citizens and taxpayers, we can expect higher taxes and reduced government services.  The money to meet the obligations to retirees will likely have to come out of budget items, such as education, roads, and public transportation.  We will likely all be paying more and getting less, and this is something to keep in mind in your own retirement budgeting.

As investors, we should be wary of the bonds of state and local governments with the highest unfunded pension liabilities.  The same is true of retiree health obligations, a murkier subject that is just now becoming a topic for discussion.  Governments can indeed go bankrupt, as residents and creditors of Vallejo, California are rediscovering.  In the years to follow, investors who “do their homework” when choosing their income investments should weather the storm far better than those who do not.