Our Growing Pension Crisis

Our Growing Pension Crisis

By Peter H. Lester

There are certain words and phrases that can be over-used.  One such word may be “crisis”. Having said this, our states are facing a growing financial crisis and very little is being written about it.

The pension benefit obligations facing our states and local governments has grown over the last few decades and, unfortunately, the improving economy and market performance is not providing the hoped-for relief.

During the recession, revenues fell and they have yet to recover to pre-recession levels. While revenue has improved in recent years, it has not been enough to allow governments to address their pensions. In a recent report by the Pew Foundation, 23 states report having less revenue today than they did prior to the recession. For states relying on sales tax revenue, this is not surprising as many consumers constricted their spending during the recession.  Additionally, as internet purchases become more prevalent, states are losing revenue as many of these purchases are not subject to state sales taxes.

Another reason for this drop in revenue is due to the fact that while unemployment rates have declined, many people who have found employment are working for less. One would hope that as the economy improves, wages will increase. Additionally, people who are “under employed” or have accepted a job for less play will have an opportunity to migrate to higher paying jobs. As this happens, states should see revenues improve.  But at this point, state budgets are still lagging.

State Pension Managers however own the crisis associated with pension funding, or more clearly stated: they are responsible for the LACK of funding to pay state employee retirement benefits. They have been hoping that an improving economy would bail them out – but the funds have not arrived to do so.

More importantly, encouraged by actuaries, they continue to use discount rates (one of the key assumptions in calculating the liability) that defy logic.

The National Association of State Retirement Administrators (NASRA.org – see the issue brief dated February 2016) reported that 127 pension plans report using an average annual investment return of 7.6%.  It has been difficult for managers to select a reasonable basket of assets to keep pace. As performance lagged, pension managers increasingly took more risky positions investing in hedge funds and real estate. 

Currently (assuming they can earn 7% year-over-year) the underfunded status of these obligations totals over $1 Trillion.  If conservative actuaries got their way and a more achievable rate of return of 3% is used, this underfunded obligation grows to $3 Trillion. Frankly, the target rate should probably be somewhere in the middle. 4.5% - 5% seems about right.

It is noteworthy that of the 127 funds participating in the NASRA survey, over half have reduced their discount rate (which is to be applauded), but that rate has been reduced to an average of 7.62%.

Government officials have been slow to address this problem.  The issue is most likely to be ignored until the pain becomes chronic. At which point, it will be interesting to see what our government does – as these state governmental plans are not covered by federal pension law. For this reason, there is no central authority pressing government administrators to adjust the funding assumptions that they use.

For now, the high discount rates make the problem seem large by any measure, but one that an improving economy and more tax receipts might fix. Higher discount rates seem to be a license to seek higher returns – which also increases the risks to us all.