STUMP » Articles » Are Public Pensions in a Crisis? Part 1: My Opinion » 18 August 2019, 14:19

I generally don’t like putting questions as headlines, but here we go.

Some of this is being stirred up by various white papers coming out this summer, one piece being a paper from someone who has already angered me greatly: Tom Sgouros, who wrote the paper that inspired my Never Fully Funded List of Evil.

First, I will state my opinion in this post. In future posts, I will post links to the reports, articles, and research papers I’m reacting to.

WHAT I THINK ABOUT THE STATE OF PUBLIC PENSIONS

I had a post similar to this one back in 2015: Are Public Pensions Actually in a Crisis? Or Is It Just a “Mathematical Issue”?

My conclusion:

Here’s the problem: it’s a very slow-moving crisis, until it’s no longer slow.

The Detroit pensions were supposedly well-funded, and pensions of current retirees got hit anyway. That’s being allowed a formal bankruptcy process, of course.

When one isn’t allowed formal bankruptcy, you end up with a situation like Prichard, Alabama, where the pension fund actually goes to zero. And you try to pay for pensions for services rendered possibly 50+ years ago with current taxes. From people who weren’t around 50+ years ago, and they are fewer than the population from back then, so it’s not clear they can even sustain such payments even as new liabilities aren’t being taken on.

When you have a less-than-fully-funded pension, things can go really, really bad.

If you have the people running the pensions, some of which are okay, but many of which are extremely underfunded, trying to pawn it off as “just math”, look at what inevitably occurs.

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The main target to get this crisis taken seriously are the public employees themselves. They need to know: if your plan is being deliberately underfunded, year-by-year, you have a non-zero probability of getting less (and maybe a lot less) in your pension than you were counting on. If public employees understand that they may not get what was promised, and the fix isn’t lawsuits against reform but actually demanding their pensions be funded.
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Public employees: Demand full funding and prudent practices in your pensions.

Underfunding and too-risky investments will take their bite.

Don’t expect politicians, taxpayers, or lawyers to save you.

Politicians, taxpayers, and lawyers have thrown in with respect to various attempts to reduce pension benefits, or just close off accruing more (but, in general, pensions in trouble are in trouble for benefits already accrued, and not future benefits. I will revisit this in a future post.)

Those who claim there’s no crisis think that, well, we don’t have to worry about the bonded debt. We’ll just default. We can also increase taxes….or maybe we can be really clever re: investments. Let’s do anything but adjust the pension benefits that we already can’t afford.

WHAT EXACTLY IS A PENSION CRISIS? WHAT IS AN INSOLVENT PENSION?

I will be quoting various people and pieces in subsequent posts, claiming it’s not really a crisis, and going into what they would consider a crisis. We can play word games and quote a dictionary definition:

1. a stage in a sequence of events at which the trend of all future events, especially for better or for worse, is determined; turning point.

2. a condition of instability or danger, as in social, economic, political, or international affairs, leading to a decisive change.

I could go with definition #1 and note that several public pension plans are in a situation where there is no reasonable expectation that they’ll ever be 100% funded, and that even if the plans allowed no new entrants, they would be hard-pressed to cover retiree costs. This is not true of all public plans, or necessarily most public plans. But it is true of several very large and important public pension plans.

Many seem to be going with definition #2, and would consider public plans in crisis if and only if a polity could not make the cash flow demands of current retirees (such as happened in Prichard, Alabama.) And only when that actually happened (again, Prichard)

Some do not think pay-as-you-go pensions are a crisis… they consider it to be a crisis the first year the entities cannot actually fully pay the benefits.

I don’t want to quibble over definitions. Fine, don’t call it a crisis.

But you can say: if it continues this way, pensions become more vulnerable in terms of the benefits actually getting paid in full.

I think the public employees and retirees would consider that a crisis. The policy wonks may not.

ARE THEY ALL IN CRISIS? NO, BUT MOST ARE IN A NOT-SO-GOOD POSITION

Some pension plans are in a very bad way, and some have funding plans that almost definitely will not be met, because they’re assuming an acceleration in contribution rates. I am skeptical that Chicago, Illinois, New Jersey, or Kentucky are going to be able to meet their current promises — to people who already accrued, aka already earned, the benefits. I’m not even including future accruals.

For these (and many other) plans, trouble can be foreseen in terms of funds running out, by projecting cash flows and considering a variety of scenarios. Some will be in trouble even with a 7% constant annual return on assets. That these plans run out of cash should not be treated as if it were a surprise.

I need to update the info in my cash flow tool, to check out a few scenarios, but there are some funds which really are in danger of running out of cash, and will not be able to sustain paying the pensions as pay-as-they-go.

The vast bulk of public pensions are limping along, with funded ratios barely rising after a decade of market recovery, with them very likely to dip below their prior low when we have another market drop. Their problem is more long-term…though a 2008-like market drop will make their trouble more short-term.

Let’s just look at a national snapshot from the Public Plans Database.

Here’s the funded ratio:

I want to note two things: even before the drop in 2008 (which usually was fiscal year 2009 for many plans, and many also do asset smoothing so the full impact wasn’t felt in one year), there was a decrease of funded ratio from over 100% to 87% in FY 2007.

Post-market drop, the funded ratio went further down to about 72% in 2012… and has been at about that level since then.

What about required contributions?

Ignore the specific rates – whether percent of payroll or revenue. Essentially, the required contributions tripled over 2001-2018.

We’ve seen that so many of the public pension funds making “full” contributions find themselves with decreasing funded ratios. There are reasons for this, part of it being that the practice to determine the “full” contribution assumes that more will be paid in future years… and if that tax base doesn’t show up?

Oooops.

A few public pensions are highly funded, and have benefits that are responsive to the fund results. I’m looking at you, Wisconsin. Okay, there are a few others that are also highly-funded (like New York State Teachers), but they’re more traditional plans in terms of both benefits and assets, so they will run into trouble when we have another large market drop.

PUBLIC PENSION PLANS NEED ADJUSTMENT TO BE SUSTAINABLE

So many old-age programs assume a growing tax base — it’s not only public pensions running into trouble, but other programs such as Social Security and Medicare.

When I say something is in “crisis”, I mean that there is unavoidable disaster unless something changes.

This does not mean it’s panic time.

Having to, for example, get a lower COLA on one’s pension in order to be sustainable should not require anybody to panic.

But sitting there, as your pension plan slips into an asset death spiral with a “THIS IS FINE” reaction…

Well.

ON STABLE AND UNSTABLE SYSTEMS

For many pensions with warning signs of deteriorating status, very little has been done to change the dynamic, because there is no “crisis”. Benefits still get paid. Contributions are being made…though they’re accelerating in amount needed just to stay at the same funded ratio. Many of these deficient plans still can’t make “full payments” and some that are making those “required” payments are negatively amortizing their unfunded liabilities.

For these particular plans, the assets will keep petering away, then they’re on a pay-as-you-go basis, then they’re looking at issuing more bonds to cover cash flows earned from service done decades ago, and then they’re looking at defaulting on your bonds as taxpayers flee the ever-increasing taxes trying to cover these very old operating expenses and current operating expenses.

The farther one slides down that spiral, the more severe the actions required to try to keep the system going.

In many ways, traditional public pensions are in a positive feedback loop, which is not a good thing. Positive feedback loops mean that when one gets shoved from a stable point, one does more an more activity that gets you farther away from the stable point. Positive feedback loops are inherently unstable.

In public pensions, one may overpromise benefits, undercontribute to them due to valuation and funding methods that make pension promises look less valuable than they are and that assumes escalating payments will occur in the future. When neither of those pans out, and contributions and promises cannot keep up, then there are incentives to add extra risk to the system in the form of leverage (pension obligation bonds) and riskier assets, instead of adjusting benefits and contributions based on more realistic assumptions.

Mind you, it’s not a perfect analogy – many plans have made some adjustments, at least with regards to increasing contributions and adjusting valuation assumptions. But many times you hear that the valuation rate can’t be dropped to 7% or 6%, as the required contributions would be much too large! We can’t shorten the amortization of the unfunded liability to the average working time til retirement for the population! The payments will be too high!

A negative feedback loop — where getting pushed away from a stable position has you taking actions that get you back towards that stable position — would be something that would reduce leverage and asset risk, adjust promised benefits, and always point towards being 100% funded.

Getting away from 100% funded is a “crisis” in public pensions because so many do not have good mechanisms to get back to that full funded level. So many plans were at 100% fundedness in 2001… and so many drifted away from that, even before the market drop in 2008.

Since 2008, many plans have failed to improve their situation. They’ve been going more into alternative assets. Some have learned the danger of pension obligation bonds, but others have issued new ones. Many have reduced their discount rates to value the pensions. Some have closed off old plans, and made smaller promises to new entrants.

But many, like Illinois and California, have barely adjusted their behavior.

NOT ACTING NOW WILL LEAD TO PANIC SITUATIONS LATER

If another large market drop occurs in the next decade (forget about next year), many public pension plans are going to be in an awful situation if they cannot adjust pension benefits downward for current retirees and participants. We’ve not had an official recession in over a decade, and not had much of a market “correction” yet.

The alternative assets in many of these plans — there may be questions as to the true values in the case of a public equity drop. This happened with the Dallas Police and Fire pension. The usually very illiquid and hard-to-value alternative assets are being expected to support a fairly steady and predictable set of cash flows.

I’m not saying that it’s time to panic (or that panicking will at all help) — but there will be panic if there’s a large market drop. It may make some feel good to blame Trump (or whatever politician is the target at the time), but it will not make pension plan participants whole.

A federal bailout will also not make the public plan participants whole, though it’s unlikely they’ll end up with nothing. They’ll just have a lot less than originally promised.

There are lots of reasons that it is difficult to adjust public pensions, the biggest element being the political risk. Taxpayers are a diffuse group. The public employees seeing the threat to their benefits are a very interested group.

On top of the political problem, there are legal problems in making these adjustments — many states would require state constitutions be amended to allow for these changes.

I’m not saying making the change from a current system to a new, more stable and sustainable system would be easy. Or even simple.

I am saying that many public pensions will not be able to continue as they are, and the ones that are failing will likely not be able to continue on a pay-as-they-go basis. And there will not be a full bailout (but perhaps a partial one).

You can call that a crisis if you wish.

PUBLIC PENSIONS IN CRISIS SERIES

• Part 1: My opinion
• Part 2: Is pay-as-you-go sustainable?
• Part 3: Is it just an accounting problem?
• Part 4: On closing DB plans and replacing with DC plans
• Part 5: On Bonds and Bailouts