Thursday, 04 March 2010 23:41

Fraud in the Inducement: The Trillion Dollar Gap

by Manuel Rodriguez
A trillion dollar gap exists between states' pension and health care promises to their current and future retirees and the funds on hand to pay for these liabilities.

Taxpayers have, for decades, been induced into believing that unfunded pension plan increases were painless methods of increasing employee pay, especially pay for unionized workers.  Deferring the pain has left state and local governments with a massive, unfunded liability, though, and could bankrupt many state governments.

The report published by the Pew Center on the States highlights the chasm between the promises made to government employees throughout the last three decades and the stark choices that will have to be made to pay for these benefits in the coming decades. These choices will exacerbate tensions between state government stakeholders, their citizens and employees.

The gap is roughly divided into two benefit components, pension costs and health care benefits. These benefits will increase steeply over the next few decades and will burden states and local governments with very difficult choices, namely, whether to dramatically raise new revenue by increasing the tax burden or slash services to their constituents, or a combination of both.

The Pew report starkly highlights these important facts:

  1. The gap is likely to be much higher, as the measurement date for this study and the pension assets was June 2008, well before the financial implosion and collapse of the financial markets.
  2. Accounting gimmickry called “smoothing” allows investment managers to report their gains and losses over time, easing the pain of any losses by deferring their recognition. This accounting gimmick allows funds to understate losses temporarily, but will accentuate those losses in later years if fund valuations or contributions fail to keep pace.
  3. Up until 2000, states had combined surpluses of $56 billion in their retirement plans. From 2000-2008, “growth in pension liabilities had outstripped growth in assets by more than $500 billion.”  This fact is amazing, because the period of 2000-2008 roughly coincides with the most dramatic asset valuation bubble in history, leading to equally large pension asset bubbles. The deflation of asset valuations could collapse pension asset valuations and lead to significantly higher contributions or cuts in these programs,to the extent permitted by law.
  4. Retiree health care and other non-pension benefits represent an even gloomier statistic: only $32 billion in assets fund a projected $587 billion liability. Only two states have more than 50 percent of the assets needed to meet their liabilities for retiree medical or non-pension benefits, Alaska and Arizona, meaning that the largest states are  significantly underfunded.
  5. Unlike pensions, states “generally continue to fund retiree health and other non-pension benefits on a pay-as-you-go basis – paying health care costs or premiums as they are incurred by current retirees.” As “both medical costs and the numbers of retirees grow substantially each year, these costs will escalate far more quickly than average expenditures.”
  6. As the number of retirees grows over time, “extremely underfunded systems confront an additional problem: their assets need to be kept more liquid to pay benefit As a result, investment opportunities that can prove advantageous to a large investor with a long horizon are closed off.”
  7. Returns on pension plan assets are extremely volatile, with median annual losses approaching 26 percent in 2008.
  8. Pension plans typically invested in conservative assets in the 1970’s, but have begun shifting their assets to equity investments. By 2007, “equity investments accounted for 70 percent of all state pension plan assets”, increasing plan volatility exponentially and placing the assets at risk.
  9. States have given themselves “funding holidays” as favorable investment returns masked the deficits in actual contributions. Now that that the market has stumbled badly, the folly of these funding decisions has been revealed.
  10. States have promised a slew of unfunded benefit increases in lieu of salary increases, which are extremely difficult to remove or rescind. These unfunded benefit increases include early retirement incentives, sharing of excess returns, and spiking of final salaries. In general, pension benefits are constitutionally protected and become a political time bomb for any politician attempting to retract them.

The pincer-like effect of severely depressed asset valuations, which will ultimately result in significantly decreased tax revenues, and lower pension asset valuations, will cripple local governments. This will necessitate increased pension contributions, which will severely test the ability of local and state governments to maintain balanced budgets. The true test will be whether these state and local governments can uphold the insane promises they made to their employees, over many decades, and raise taxes significantly, or whether they will be forced to abrogate those promises and services in favor of fiscal sanity and discipline.

Either way, the future looks increasingly bleak for these municipal entities, who made promises they knew they could not keep, and saddled future generations with these obligations. Beginning soon, local governments will either have to renege on the promises made to employees decades ago, tax current and future generations for benefits never received, or curtail services to their stakeholders and citizens. These choices are all poor, and will create significant pain for everyone.

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