The U.S. Pension Disaster

November 10th, 2011
in econ_news

broke Econintersect:  About two-thirds of pension fund assets are invested in stocks and real estate.  Most are quite aware of how poorly both asset classes have performed over the past five years, and stocks have suffered poor returns over the past twelve years.  Many workers covered by defined benefit pension plans, however, do not realize how these lean years have impacted their own defined benefit pension plans.  According to an article by Jack Hough of Smart Money, not only may private sector pension plans  be unable to pay future retirement income promises, but the shortfall in public pension funds may produce higher tax rates in the future, as well.

Follow up:

Hough summarizes the public pension problem as follows:

Pension accounts for state and local government workers are underfunded by $4 trillion, according to one recent analysis. If America's households were to split that tab today, each would have to kick in $34,000.

Don't have that kind of cash on hand? Another option is to chip away at the shortfall over 30 years starting now. That would cost households $1,400 a year beyond what they pay in taxes today.

So, not only will those in private sector pension funds face the possibility of lower than promised defined benefit pensions, they may also face higher taxes to fund lower than promised pension payments to public sector retirees.

Many corporations have terminated pension plans in the past 10-15 years and transferred to so-called “cash balance plans” which, although company managed as are defined benefit plans, do not promise a future income stream but will make future pay-outs to retirees based on the value of the assets in the plan.  In that regard, the payouts are like those that will come from employee managed retirement accounts such as 401(k)s and IRAs:  Payments will reflect whatever is in the account when the retirement years arrive.

As reported in GEI News yesterday (November 8), the U.S. ranks poorly in the world for pension plan quality.  But the problem is worst in the public sector where plans assume, on average, 8% average annual returns and have fallen far short of that in recent years.  The current report estimates the shortfall (public sector) is as large as $4 trillion).  A CBO (Congressional Budget Office) report report (GEI News, May 2011) estimated $2-$3 trillion.

A year ago John Lounsbury analyzed the public pension shortfall problem.  In that article it was shown that even if public pension plans operated on the low return assumption of 5% (average) for private sector pension plans they still would have significant shortfalls.

What is the solution?  Retrofit public pension plans to reality.  This means pensioners will receive less, more in line with what actual plan asset investment returns actually are.  From the Smart Money article:

Future stock returns shouldn't enter into the math, says Joshua Rauh, a finance professor at Northwestern University. He and Robert Novy-Marx of the University of Rochester have proposed a new treatment for pension benefits. "You'd never say to your bank, 'I'm not going to make my credit card payments because my stock returns will take care of that,'" says Mr. Rauh. "That's what state and local pensions do."

What they should do, say the professors, is to treat pensions like debts that don't allow for default. That would call for math that uses a default-free investment rate, like the rate on U.S. Treasury bonds. Even the longest-maturity Treasury bond pays barely 3% at the moment, or less than half what pensions are assuming for their returns. "The only reason to use a higher rate is if you allow room for future defaults," says Mr. Rauh.

Sources:  Smart Money, GEI News (global pension plans evaluation), GEI News (CBO public pension analysis) and GEI Analysis (Lounsbury article)

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