According to the Center on Budget and Policy Priorities, many of us are exaggerating the financial situation in the states. In a new report, the Center argues that the budget gaps states are facing, $130 billion in 2011, are the product of the recession only. Never mind that as my colleague Dan Rothschild reminded me, “State and local per capita spending grew at almost twice the rate of per capita GDP over the past decade, and at about 50% over the clip of growth the decade before that. Marginal gains from growth are already being disproportionately taken by state and local governments to finance new spending. States have already “grown their way” into larger budgets – while not making the necessary contributions to pension funds. What’s more, governments, particularly states, have a very poor track record of using increased revenues to shore up liabilities. Increased revenues almost always lead to more spending, usually at a rate above the rate of revenue increase.”
Another argument used in that piece is the idea that pensions are funded appropriately but the recession put a cramp on their investment plans. While the states were expecting that the assets invested in the pension plans would return 8 percent each year, they haven’t. Interestingly, this is an admission that the states are very poorly managing their pension plans if they keep, year after year, making these unbelievably unrealistic assumptions.
Here is how it works and why their pensions are so underfunded: Pension funds need to assume a certain rate of return on their current assets in order to gauge whether or not the assets held today will be enough tomorrow to pay future benefits. The assumed interest rate or rate of return has a major impact on whether or not a pension plan is adequately funded. For example, if a pension fund has $1,000,000 in assets today, but promised to pay benefits worth $3,000,000 15 years from now – do they have enough in assets today to cover tomorrow’s liabilities? At an 8.5% annual rate of return, the answer is yes. In 15 years, at 8.5% rate of return, the assets would grow to approximately $3.4 million. But, what happens if they market doesn’t return 8.5%? What if it only returns 3.5%? Then, the assets today will only be worth $1.675 million tomorrow and the pension plan is underfunded and faces a significant shortfall. Most pension plans would rather play it conservatively and assume a lower rate of return, so that they ensure that the assets they have today will be enough to cover tomorrow’s promised benefits. In this scenario, assuming a 3.5% rate of return would require $1.8 million today to cover $3 million in promised benefits 15 years from now or 80% more than the $1 million previously assumed to be enough under an 8.5% assumed growth rate. But, that’s not what the state pension plans are doing. So that the states can put less money up front today, they are pinning all of their hopes of being able to pay future benefits tomorrow on an 8.5% annual growth rate. If that 8.5% growth rate doesn’t come to fruition, either tomorrow’s beneficiaries will see a cut in their benefits or taxpayers will be ask to pick up the tab! What would be more prudent is for the states to assume an adequate risk-adjusted rate of return closer to the rate offered on 15-year Treasury bonds (3.5%?) and fund their plan accordingly.
But this is only part of the problem. An unrealistically high discount rate also means that states are highly discounting the likelihood of future payments. In other words, is they are essentially a statement that the states think it a low probability that they will have to actually pay pensioners. That is silly.
4) Going forward, states have to get out of the Defined Benefit game altogether. Unless they recommend that, or at least a move to a Utah-style hybrid system, they’re whistling past the graveyard.
5) Given what we know about the flypaper effect and the dynamics of intergovernmental transfers, it’s unlikely that any federal aid (don’t know if CBPP will recommend this or not) will fix the problem; it’s fungible so it will go to other spending (the kind that gets votes). Go growing federal revenues cannot be credibly earmarked to state bailouts or loans in a way that fixes underfunded pensions.