What’s an “unfunded pension liability”?
As part of the efforts of conservatives who are desperate to cut government spending (particularly on any kind of employee or social benefit spending), we are being treated to an unending drumbeat of “unfunded pension liabilities” are killing state and local government budgets. Since it’s all couched in accountant-type talk and delivered with serious faces and ominous tones, the message received by people is it must be because public employees are being compensated with overly-rich pension schemes. Usually there are a few anecdotes about some police officer, teacher, or city official somewhere that’s retired with a six-digit annual pension. Of course, the fact that a few anecdotes don’t establish anything when we’re dealing with millions of workers doesn’t stop the media. Scare tactics make good politics and TV.
So let’s blow away some of the fog about “unfunded pension liabilities” and public employees. First, the concept of “unfunded liabilities” is a very, very murky, fuzzy area. The way a pension plan works (an old-fashioned defined-benefit plan) is that in the present the employer makes a promise to the worker to pay a pension of a certain fixed amount in the future when the worker retires. Let’s say the worker is making $50,000 a year now and the pension promise is to pay $20,000 per year in 20 years (these numbers are much more common than the inflated 6-digit anecdotes talk-radio hosts cite as “proof”). The employer is obligated by accounting rules to both pay cash right now for the salary to the worker and to also make payments right now into a fund (the pension fund) which is invested. Then in 20 years when the employee retires, the pension fund pays the money back to the employee by paying the $20,000 pension each year. The trick is in the “investment” part. The employer only needs to put just enough into the pension fund now so that when the money sits there for 20 years accumulating interest and dividends there will be enough in the fund to pay the pension for the worker’s remaining life after retirement. We want to know if the employer is putting enough into the pension fund now and whether or not the pension fund has enough money in it now. “Enough” all depends on things that will happen in the future, and the future, of course is unknowable. But we can make assumptions about it. The critical missing pieces of information are: What rate of return or interest rate will the invested pension fund earn from now until the employee retires? How many years will be until the employee retires? and How many years will the employee live after they start receiving the pension. If you know these things, then the rest is just math. But we can’t know this stuff for sure. We have to make assumptions.
If we make these assumptions on future rate of return and life of the worker then we can determine if the fund has enough in it right now that will grow to be enough in the future. If the amount in the fund is greater than what we calculate/assume will be needed, then it is overfunded. If the fund actually has less in it right now than we estimate it should to pay the promised benefit in the future, then we call the difference between the actual and the projected “ought to have” is called an unfunded liability. Technically, even if the pension fund is underfunded at the time the worker retires, there is still no problem as long as the employer is able to make up the difference so that the worker gets the full pension that they were promised (and gave good labor for years earlier).
The existence of an unfunded pension liability is a very serious issue for a private business or corporation. The reason is because a private corporation stands an high chance of not even existing when it comes time to pay the pension. To make it worse, without rules that limit how much unfunded pension liability a private company can have, an incentive exists for the private business to intentionally defraud the worker. They could make promises now, receive labor in return now, and then never deliver the payment for that labor in the form of the pension. Even with rules against unfunded pension liabilities there are still large numbers of firms that go bankrupt and default on their pension obligations and stick the federal government with the bill (see Pension Benefit Guaranty Corp.). When the entity in question is a goverment, the seriousness of an unfunded pension liability is lessened, although not entirely absent. This is because the government entity is much, much less likely to disappear or not be able to raise funds in the future – they have the power to tax. And, just how many government entities, states or cities, have disappeared in our history – pretty close to none.
But the state and local government “unfunded pension liability” boogie man is even less threatening than it has been made out to be. The really, really scary numbers are largely the result of the assumptions made. As it turns out the nature of compound interest means that even very, very small differences in assumptions (future investment rate of return, lifespan of retirees) will change the unfunded pension liability estimate dramatically. Further, what’s a “realistic” assumption of rate of return is strongly influenced by stock market crashes. So for example, many state and local governments (and many private companies also) actually had fully-funded pension funds in 2007. But then the financial world world collapsed due to the unregulated speculation of the big banks. Those pension funds lost literally billions and billions (some estimate in the trillions) of dollars worth of investments in the crash. Rate of return likewise dropped as The Federal Reserve has kept interest rates very low. So now the new “realistic” assumptions on those funds future performance make them look like they are seriously unfunded.
Dean Baker at Center for Economic and Policy Research has a new paper out available that explains the crisis isn’t what it’s made out to be and that the cause is most certainly not “overly generous pensions for public employees”. The primary cause is the financial collapse created by Wall Street and our government’s inept and failed attempts to fully stimulate the economy back to recovery. The abstract:
There has been considerable attention given in recent months to the shortfalls faced by state and local pension funds. Using the current methodology of assessing pension obligations, the shortfalls sum to nearly $1 trillion. Some analysts have argued that by using what they consider to be a more accurate methodology, the shortfalls could be more than three times this size. Based on these projections, many political figures have argued the need to drastically reduce the generosity of public sector pensions, and possibly to default on pension obligations already incurred.
This paper shows:
- Most of the pension shortfall using the current methodology is attributable to the plunge in the stock market in the years 2007-2009.
- The argument that pension funds should only assume a risk-free rate of return in assessing pension fund adequacy ignores the distinction between governmental units, which need be little concerned over the timing of market fluctuations, and individual investors, who must be very sensitive to market timing.
- The size of the projected state and local government shortfalls measured as a share of future gross state products appear manageable.
EconProph 