I always find it surprising that the people who really believe that state employees should get very generous pensions from state governments aren’t the ones who are sounding the alarm about the upcoming pension crisis. I would assume that they understand that reforming the pension system today is key to preventing some rather dramatic consequences in the near future when states run out of money on their pension plans — which 8 states are scheduled to do by 2020. No matter what data you look at, you can see that many state pensions — led by Illinois and New Jersey — have underfunded their liabilities for years, which means that when their pension plans run out of money, these states will have to either raise taxes dramatically, cut non-pension spending massively, or alter their pension formula for current employees. The question of whether states will be allowed to change the benefits for current retirees will depend on the courts, but the reality is that when there is no more money, there is no more money.
That being said, I found it even more surprising to read this piece in the Weekly Standard by Eli Lehrer, the vice president of the Heartland Institute in Illinois (a state among the most likely candidates for a pension collapse in the very near future). It argues that all is peachy in the state pension world — an especially odd argument given that Lehrer’s previous writings (here and here) seemed to argue that there really is a pension crisis coming and that it is not just a product of the recent recession.
In the Weekly Standard piece, Lehrer makes the case that pension benefits and contributions today are a small share of states’ budgets and may not be their biggest problem in the future, and that reforming pensions is politically difficult. In other words, let’s not bang our heads against the wall for something that’s hard to do.
Finally, he argues that governments don’t go out of business, unlike private firms, and that makes governments better at running pension plans. I am assuming he has changed his mind since this interview last year:
MuniNet: High compensation costs, including pensions, were a huge factor leading to Vallejo, California bankruptcy filing. Do you think the situation could reach similar proportions – and cause similar problems – for other governments, whether state or local?
Lehrer: Unless there’s a particularly strong economic recovery, more and more local governments will run into serious problems. Without widespread reform, it’s quite likely that we’ll see a fair number of cities and counties file for bankruptcy protection over the next decade.
Lehrer repeats many of the flawed arguments that economists who have been working in this field for years have proven wrong over and over again. Among other things, he argues that states are in the red by only $1 trillion and we shouldn’t worry about it. I personally find that $1 trillion figure quite scary. However, many economists, joined by a growing number of actuaries, have been very vocal about the fact that this is a gross underestimation of the problem. For instance, economists like AEI’s Andrew Biggs, the Mercatus Center’s Eileen Norcross, the Kellogg School of Management’s Joshua Rauh, and Simmons University’s Robert Nova Marx have noted that unfunded liabilities could be as high as $3 trillion. Where does the difference come from? It is the product of the difference between how private-sector firms measure liabilities and how governments do. That question is of great importance, as it has serious implications for what the size of the unfunded liabilities really is.
It boils down to a debate over the value of the discount rate. As Douglas Elliott of the Brookings Institution explains in this excellent study:
A dollar today is worth more than the promise of a dollar a year from now, even if you are sure the promise will be kept. A dollar today could be invested and would therefore be worth more in a year. Alternatively, a dollar today could allow you to avoid borrowing a dollar from someone else, on which you would have to pay interest. If the promise is less than certain of being kept, then receiving the money up-front becomes even more valuable in comparison to the promise. Economists and other experts dealing with long-term promises use a “present value” approach to reckoning the value in today’s dollars of future payments. This involves estimating the future payments and then reducing the payments in each year by a discount factor based on: (1) the number of years from now until the The discount rate is absolutely crucial to measuring the cost in today’s dollars, since the pension payments are spread over so many years, with the average payment typically occurring decades into the future4. The compound effect of a discount rate being applied over so many years means that, for example, one dollar received 20 years from now would be worth 46 cents if discounted at a 4% rate or 21 cents at an 8% rate.
In short, economists argue that the discount rate should be 4 percent, yet in most cases states use an 8 percent rate. As Elliott notes, “Virtually all economists, many actuaries, and the author, take issue with this approach to choosing a discount rate [based on the assets set aside to meet the liability, which is what states are doing], an approach inconsistent with standard practice in finance, economics, and accounting for private sector firms.”
It is important to note that a higher discount rate would be warranted if a state or locality could legally and practically choose to let a pension plan it sponsored default on its pension obligations. In general, however, state and local governments are legally committed to support these pension payments and therefore pension liabilities should have a discount rate no higher than the interest rate the market requires on municipal bonds to compensate for the risk of default on general obligations of these entities. In fact, these pension payouts are in a privileged position in many states that make them virtually risk-free, implying a considerably lower discount rate. There is considerable discussion later in the primer on the degree of legal commitment to pension obligations. In addition to the conceptual problems with using asset composition to determine the right discount rate for a liability, such an approach encourages funding levels that leave future taxpayers with large exposures to overly optimistic return expectations or sub-par investment performance. For example, most states and localities report expected annual returns on their portfolios fairly tightly clustered around 8%. Many observers consider this an unreasonably high expectation. Even if it is a reasonable expectation, it leaves states and localities exposed to decades like the last one in which returns are much lower. Even worse, this approach can create perverse incentives stemming from effectively treating uncertain future investment returns as certain.
And that’s where Lehrer is inconsistent. If he (now) believes that governments can’t go out of businesses and can’t reform their pension plans because it is too politically difficult, and also believes that states have a legal obligations to pay these benefits, then he should understand that the unfunded liability is likely closer to $3 trillion than to $1 trillion, because the states should use a 4 percent rather than an 8 percent discount rate. Then, if the unfunded liability is closer to $3 trillion, he really shouldn’t be using the current cost of pension contributions in state budgets as evidence that states pensions aren’t in crisis, because this low figure is part of the gigantic problem. He can’t have it both ways.
I would really recommend reading Douglas Elliott’s paper here. Norcross and Biggs responded to Lehrer’s article directly here.