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Public Pensions: Why there looks to be a problem brewing.

ubetchaiam just posted a diary titled “The attack on pensions is bogus.” I had a rather lengthy response so I decided to make it a diary.

The reason I think there is a problem is the fact that most pension plans expect an average return of 8%. Most of us have 401k’s or some may have pension plans. Assuming 8% is a little crazy even in my optimistic mind. The hard hitting part is that if you miss your 8% number for one year it has far reaching consequences. Especially when you are planning over very long time horizons due to compounding returns. Most of us also realize that the markets are not exactly stabilized yet. I expect a roller coaster of a ride over the coming years. Nothing is stable right now.

Most government pension plans assume they will earn about 8 percent a year on their investments. Some have achieved those returns over certain periods, but critics think that the assumption is too optimistic.

Warren Buffet thinks there is a problem.

Public pension promises are huge and, in many cases, funding is woefully inadequate,” he wrote. “In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep.

Some states are better off that others.

Already, in Illinois, for example, pension payments amount to nearly 13 percent of the general budget. The state has had to borrow money to make the payments for two years in a row. Even under the current rules, less than 40 percent of the pension costs are funded.

It also seems that the accounting methods that are currently used are quite controversial.

These critics say the current method of calculating pensions is wrong not only because many doubt that the pension investments will return 8 percent but also because it understates the risks of investing, as pensions do, in the stock market.

Although the issue of pensions often divides Democrats and Republicans, the group of economists who support revising the pension calculations includes members of both parties.

Economist David W. Wilcox, who co-wrote a paper calling the current method of estimating pension liabilities an idea “foreign to most economists who have studied the issue,” served as an assistant secretary of the Treasury during the Clinton administration. His co-author on that paper was Brown, the University of Illinois professor and a former George W. Bush appointee.

A politician who is advocating reporting the worst number and has drawn in the GAO.

On Capitol Hill, Rep. Devin Nunes (R-Calif.) is pushing a bill that would require state and local pension funds to report pension liabilities using the method that yields the higher figure. And the body that oversees government accounting practices, the Government Accounting Standards Board, has taken up the issue and proposed a compromise.

“If it was just an accounting argument, it would be hard to get exercised about this,” Brown said. “But accounting drives the information available to people, which drives decisions. And there is a lot of money at stake.”

Link to above quotes

Another article

By their own assessment, state and local governments acknowledge that their funds for retiree benefits are increasingly falling behind, with the number that are severely underfunded soaring to 40 percent in 2006, a five-fold increase from 2000, according to the U.S. Government Accountability Office.

But even these grim calculations are based on assumptions that some analysts consider too aggressive, including projections about how the investments of pension funds will fare and how long retirees will live.

“Very small shifts in actuarial assumptions can generate huge changes over time,” said Susan Urahn of the Pew Center on the States, which has studied the issue. “It is not very transparent, and even where it is transparent not many people understand it.”

Map of the Crisis with an alternative accounting function.

More from Buffet.

Most public pension funds limit their contributions by assuming their investments will grow between 7.5 percent and 8.5 percent a year.

“While anything is possible, does anyone really believe this is the most likely outcome?” Buffett wrote in the most recent annual report his firm, Berkshire Hathaway. Buffett is also a Washington Post Co. director.

A growing number of leading investors are warning that the return rates used by state and local governments are unreasonably optimistic. Buffett, for one, has pointed out that over the 20th century — when the Dow Jones Industrial Average soared from 60 points to 13,000 — the stock market produced a 5.3 percent annual return for investors. Over the next century, the Dow would have to explode to 2.4 million to produce a similar rate of return.

Yet even that would be less than the rate of return commonly projected by public pension funds.

More bad news for pensions

Another concern for public funds is demographic: We are living longer and more of us are getting old. By 2015, life expectancy is expected to reach 79.2 in the United States. By 2030, one out of five people will be over 65.

In addition, retiree costs are soaring. A study by California predicted its retiree health care costs would jump from $4 billion today to $27 billion by 2019.

Nor has the crisis in the housing and debt markets helped matters. Investment returns for most pension funds across the nation turned negative for the first part of this year. State and local governments are also facing budget deficits that are expected to top $30 billion next year, according to Standard & Poor’s, making it tough for officials to find more funding for pensions.

Urahn, of the Pew Center, called the current environment “a perfect storm” and expressed a concern over whether governments may be tempted to cut their pension contributions. Yet most are loath to revise the benefits employees have traditionally been promised.

“The age of retirement was set when people did not live that long. It’s very hard to change that now,” she said. “People feel these pension obligations were a promise. And changing them feels like you are breaking a contractual promise, that you are changing the rules of the game. But the game has changed.”

The good thing is that more and more states are starting to realize this and contribute more towards their pension plan budgets. This has the adverse effect though of pulling resources from other areas like services and infrastructure. My grandfather complains of his dental and vision insurance getting cut when GM went into bankruptcy. I think he was lucky to still have his pension. I think that in many states over the coming years these benefits are going to be cut drastically. i would love to have a pension to draw on. If I were to council someone on a career choice, I would advise that these pensions may not be what they are today 30 years from now.

Link to a report titled: The Trillion Dollar Gap This report has a lot of useful information for your particular state and the overall problem with some solutions.

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