Government Pension Plans Are Headed for Disaster
The combined debt held by U.S. public pension plans will top $1.7 trillion next year, according to a just-released report from Moody’s Investors Services.
This “pension tsunami” has already forced towns like Stockton, California and Detroit, Michigan into bankruptcy. Perhaps no government mismanaged their pension as badly as Puerto Rico, where a $43 billion pension debt forced the commonwealth to seek protection from the federal government after having defaulted on its obligations to bondholders — a default which is expected to spread to retirees in the form of benefit cuts.
While the disastrous outcome of Puerto Rico’s pension plan — which is projected to completely run out of assets by 2019 — represents the worst-case scenario, the same series of events that led to its demise can be found in most public pension plans nationwide.
There are three primary culprits that can be found in nearly every state suffering from a public pension crisis:
- The use of accounting gimmicks that are designed to shift costs onto future generations — an approach outlawed for private pension plans and rejected by both public and private plans in Canada and Europe.
- Lawmakers, acting in their political self-interest, who have catered to the past demands of government unions to enrich their members’ benefits while passing the costs onto future generations.
- A broken governance structure where public pension board members are actually penalized in tangible ways for acting responsibly, and are rewarded by choosing to delay the day of reckoning.
Perhaps the most concise assessment of public pensions came from the former chief actuary for the nation’s largest public pension fund — CalPERS — who noted simply that: “Politics and pensions just don’t mix.”
And it’s not just "liberal" states like California who have succumbed to the siren call of public pensions. My home state of Nevada — historically thought to be a bastion of limited government thought — is in a proportionally deeper hole than our California neighbors!
The Trouble in Nevada
While most financial experts are warning of future teacher shortages, decaying roads, higher taxes and cuts to public safety, the Public Employees’ Retirement System of Nevada (PERS) is confident they can avoid all that by doing one simple thing: produce investment returns higher than what even Warren Buffett expects to get!
Because PERS has failed to hit its investment targets over the past 5-, 10-, 15-, 20- and 25-year periods, government workers’ retirement costs have soared to today’s record-high 28 percent of pay (40.5 percent for police and fire officers) — which now consumes more than 12 percent of all Nevada state and local government tax revenue combined.
And as more money is sent to PERS, less is available for salaries, like the only $34,684 offered to new Clark County school teachers last year — almost certainly a driving factor behind the district’s perennial teacher shortages.
What’s worse, over 40 percent of what all government workers — excluding police and fire officers — pay towards PERS is spent on the system’s previously accrued debt, rather than on financing the employee’s future benefits.
Consequently, all new hires are expected to be net losers under PERS — receiving a benefit worth less than its total cost — which, unsurprisingly, will “negatively affect current teacher quality and retention,” according to scholars at the Bureau of Labor and Statistics.
Retirement costs for police and fire officers are even higher: Paying PERS an amount equal to 40.5 percent of their salary means fewer cops on the street.
The Las Vegas Metropolitan Police Department, for example, has sat on roughly $100 million in funds explicitly designated for hiring new cops for over a decade now — likely anticipating the future explosion in retirement costs to come. In fact, despite the surplus, Metro is pushing for yet another tax hike, citing their ever-increasing personnel costs.
But that was just the tip of the iceberg.
PERS debt is projected to explode over the next decade, rising from roughly $11.4 billion to over $38 billion if the average 5.85 percent annual investment return forecast of the consultant hired by PERS — Wilshire Associates — is accurate:
To put that in perspective, in 2013 Nevada spent less than $3 billion on police, highways, and fire protection combined.
Servicing a debt of this size would require similarly massive increases in contribution rates, inevitably requiring lower wages for government workers, cuts to vital services, and higher taxes.
At that point, it’s likely that there would simply not be enough taxes to hike and services to cut to make PERS solvent — leaving no other choice but to cut the benefits promised to retirees.
In order to avoid that fate, and save PERS, Nevada lawmakers must act with the urgency that this situation demands.
How We Got Here
PERS is different from retirement accounts in the private sector, where workers’ contributions are deposited directly into individually owned accounts.
In PERS, workers’ retirement contributions are all pooled together in one large fund, with members promised a fixed future benefit based on salary and work experience — similar to how Social Security works.
Consequently, PERS must make a series of projections to determine how much workers must contribute in order to ensure their promised, future benefit is fully funded. One of the most significant projections PERS makes is its assumed 8 percent annual investment return.
In other words, PERS would consider a $10 payment due in 30 years as fully funded with only $1 today — as the expected gains from investing that $1 would bridge that $9 gap over time.
Unfortunately, if PERS investments underperform that target, taxpayers and government workers must bail them out via higher contribution rates.
But using expected investment returns to discount guaranteed future benefits amounts to serious malpractice, which is why such an approach is rejected by private US pension plans, public and private plans in Canada and Europe, and 98 percent of financial economists. US public pension plans are the only dissenters from this consensus.
The easiest way to see why this is wrong is to look at what happens by raising that rate. Imagine if the governor and the legislature uniformly demanded the PERS board must immediately pay down the approximately $11 billion unfunded liability it currently reports.
That sounds like an impossible task, right?
But because of the flawed PERS accounting methodology, the board could appear to pay off that entire amount in an instant. All that would be needed is for the PERS investment advisor to claim that instead of an 8 percent annual return, he now believes PERS can return 10.5 percent.
Presto! PERS would have eliminated their entire $11 billion debt, and would actually enjoy a slight surplus to boot!
Of course, their actual unfunded liability — over $50 billion using correct accounting — hasn’t changed.
If that approach sounds fishy to you, you’re in good company.
But given that this is the approach PERS board members employ, they should be extremely vigilant in ensuring their assumed investment return is one that they can confidently expect to hit.
Instead, they ignore both their poor past performance, as well as the projections of their own, hand-picked consultants who are warning that the board’s assumed annual rate of return is far too high.
After a careful selection process, PERS last year commissioned a second-opinion review by Wilshire Associates, which, on August 20, 2015, informed the Board that it was most likely to realize only an average annual return of 5.85 percent over the next decade — not the 8 percent minimum PERS must hit to avoid falling further into debt.
Wilshire’s assessment of lower expected future returns is shared by virtually all major industry experts.
The McKinsey Global Institute, for example, warned that, “After an era of stellar performance, investment returns are likely to come back down to earth over the next 20 years.” Based on McKinsey’s projections, PERS can expect a 20-year return ranging from as low as 4.6 percent under a “slow-growth” recovery to as high as 7.4 percent under a “growth-recovery” scenario.
Even investing guru Warren Buffett uses a mere 6.5 percent assumed long-term rate of return for Berkshire Hathaway’s pension plan.
Because of this, most US public pension plans are now lowering their investment targets. For example, the nation’s largest public pension plan — CalPERS — implemented a plan last year to gradually drop their 7.5 target to 6.5 percent over the next several years.
A Broken Governance Structure
So why does PERS — in defiance of its peers, experts, and its own consultants — continue to employ an 8 percent assumed rate of return?
After PERS investment advisor Ken Lambert offered a few half-hearted reasons to justify dismissing the Wilshire report — the Board asked for a precise calculation of what lowering its rate to 7 percent would entail.
Such a move would increase the non-safety contribution rate from 28 to 38 percent of pay, at which point, according to Lambert, “We’ll all go home” — apparently predicting massive rebellion by public employees that would drive the current board and its staff out of office.
PERS here illustrates the core error built into the governance structure of US public pension plans: Short-term board members, with no skin in the game, face a set of incentives where they are actually punished for doing the right thing, and benefit from pushing costs off onto future generations.
Given that understanding, it’s easy to see why PERS characterized the Wilshire report as meriting “no rush, no real urgency” and containing “nothing [that] is actionable,” when Nevada State Education Association president Ruben Murillo repeatedly, and correctly, pressed the board for answers.
PERS now finds itself in a Catch-22 situation: Because board members have for so long failed to face reality, costs will skyrocket if they should now adopt correct assumptions. Yet, failing to do so will only compound their initial mistake — and the resultant carnage — when the day of reckoning finally arrives.
Significantly, because PERS only has about 72 cents of every dollar of promised benefits on hand, the system actually needs to outperform its 8 percent investment target. Only then would the system have enough money to make good on its promises.
Making matters worse is the fact that PERS is now cash-flow negative — paying out more in benefits than it collects in taxpayer and employee contributions.
If this trend persists and Wilshire’s projected investment returns are realized, PERS could easily find itself approaching a funded ratio of only 50 percent — which is considered a “crisis-point” that is “very difficult to climb out of,” by CalPERS Chief Investment Officer Ted Eliopoulos.
Even though the call for reform enjoys widespread, bipartisan support and includes at least one former PERS board member, Warren Buffett’s assessment of public pensions still rings sadly true in Nevada:
There probably is more managerial ignorance on pension costs than any other cost item of remotely similar magnitude. And, as will become so expensively clear to citizens in future decades, there has been even greater electorate ignorance of governmental pension costs.
Thankfully, there is still time left to save PERS, but the particulars of reform are much less important than acknowledging the fundamental problems. As officials with Oregon’s pension plan stated of their similar crisis: “This is becoming a moral issue. We can’t just talk about numbers anymore.”
In theory, government is ostensibly designed to override the allegedly short-sighted, greedy nature of individual actors with policies that are long-term oriented and designed to maximize the general welfare.
Yet, as the case of public pensions (not to mention infrastructure spending, the national debt, entitlements, etc.) reveals, the political process actually does the exact opposite: it rewards those who underfund the present and defray costs onto future generations.
Thus, asking for lawmakers to “be more responsible” or “think about the future” misses the point. We are all self-interested actors. Instead of wishing this wasn’t so, it would be vastly more effective to embrace this reality and restrict the role of government to only those areas that it is well-equipped to provide.
As Ron Seeling said, “Politics and pensions just don’t mix. That’s all there is to it.”