The Looming State Pension Disaster

A great piece from Walter Russell Mead on how lax accounting, underfunded promises and the need to reach for yield will likely doom many state pension funds.  Be sure to read the whole thing:

The biggest scam going in American financial life may be the collusive effort by Wall Street, the political class, and public sector unions to use union retirement money to prop up Wall Street speculation.

Step One: state politicians promise big pension and health care benefits to their unionized work forces, but don't set aside enough money to fund those benefits when the bill comes due. This makes union leaders and unions look good, because they can point to the shiny new benefits they have negotiated with the politicians. Meanwhile, it makes the politicians happy because the unions support them with contributions and volunteers at election time, but because the unions don't insist on full funding for the benefits, the politicians don't have to raise costs or otherwise disturb the big majority of voters who don't work for the government.

Step Two: Make aggressive assumptions about the rate of return on pension investment funds. This has two consequences: it covers the gap between promise and reality (for a while), thereby postponing the day when the politicians have to face the voters and the union leaders have to tell their members that those beautiful benefits were bogus from the start. But the other purpose, equally important, is that it forces America's public sector pension funds into the deep end of the financial markets, leading pension funds to be major investors in hedge funds, derivatives and various other not-for-the-widows-and-orphans investments. If these work out, great — the funds hit their investment targets and the benefits, or at least some of them, get paid. If they go awry — as many did in the last few years — then the pension problem turns into a crisis.

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Private sector pension funds "are required by law to use low, risk-adjusted discount rates to calculate the market value of their liabilities, [but] public employee pensions are not." This means that the private pension funds must take into account the chance that their projected rate of return on investment isn't met. The higher the assumed rate of return, the greater the risk that must be taken into account.

This is exactly what public pension plans, backed by the unions, do not want to do. Ignoring the chance that assumed rates won't be achieved disguises a harsh reality for state and municipal pension funds. As a new report from Boston College's Center for Retirement notes: "there is a total of $2.6 trillion of assets on [the 126 public sector pension plans tracked by the study] but current liabilities under today's assumption that they can grow by eight percent annually are $3.6 trillion. If the investment assumption is moved down to four percent (still high when compared to current returns), then the liabilities of those plans jumps to a staggering $6.4 trillion."

Pension funds and union officials like the current lax rules. When Montana needed a new actuary it ignored all applicants who suggested using the same methods private pensions do to assess their future risks. "If the Primary Actuary or the Actuarial Firm supports [market valuation] for public pension plans, their proposal may be disqualified from further consideration," read the job description. Scott Miller, legal counsel of the Montana Public Employees Board, was more blunt: "The point is we aren't interested in bringing in an actuary to pressure the board to adopt market value of liabilities theory."

The new GASB rules allow many pension funds to continue to use these lax risk accounting methods that would be illegal in a private company. And amazingly, once you sprinkle a little pixie dust and some optimistic, undiscounted assumptions onto them, a number of shaky pension systems look strong. For example, New York City: "The current accounting rules make New York City's plans look almost perfectly funded. Using the risk-free [market-based] method, Robert C. North Jr., the chief actuary for New York City, has said, there would be shortfalls running into the billions of dollars."

Even the new rules, weak and watered down as they are, reveal a devastating picture of political irresponsibility and opportunism from one end of the country to the other. When a pension fund can reasonably project having 80 percent of the money needed to meet its obligations, it is considered to be in reasonably good shape. Under the new rules, startling numbers of large state pension funds don't come anywhere close. (Click here for a Wall Street Journal table that shows what the pension situation looks like around the country.) In Illinois, the pension system for teachers is about as well funded as a Bernie Madoff fund: 18.8 percent of what it needs.