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COMMENTARY: WI: Pension systems sickened by bloated assumptions

By   /   June 19, 2012  /   No Comments

By M.D. Kittle Wisconsin Reporter

MADISON – I’m going to lose 40 pounds by eating the same kind of high-caloric, fat-laden crap I’ve always eaten, while doing very little but typing on this laptop and watching TV.

That’s an assumption.

It’s a bad assumption, but it’s an assumption.

The same, arguably, can be said about most public-sector pension systems in America today.

They’re fat and bloated on obligations, frighteningly unhealthy, unwilling to cut out the junk and slim down, but laboring under the delusion that, given some time, they’ll be lean and mean.

Bad assumption.

These deeply indebted systems (see the state of Illinois and its woefully unfunded liabilities), rely on smoke and mirrors, accounting tricks and projected returns on investments that bear little resemblance to reality.

The secret to their delusion is Governmental Accounting Standards Board Statement 25, which in part stipulates that benefit promises are to be discounted at an assumed return on pension plan assets.

It governs the actuarial recommendation for the annual amount that state and local governments set aside to fund newly promised benefits, according to “The Crisis in Local Government Pensions in the United States,” a fantastic study detailing the sickness in the public pension system.

“The higher the assumed return, the lower the present value of recognized benefit cash flows and the less money the government entity sets aside on a flow basis to cover a given benefit stream,” notes the 2010 study by Joshua Rauh of Northwestern University and Robert Novy-Marx of the University of Rochester.

And public pension systems have jacked up those rates over the years. That’s perhaps understandable when the markets and the hedge funds on which they rely are humming. Not such a good idea when they’re collapsing.

The Illinois Teachers Retirement System, the largest state-run pension system, assumes a rate of return of 8.5 percent, for instance.

TRS has an unfunded liability of $44 billion, or 55 percent unfunded, meaning it has only enough assets on hand to cover 45 percent of the cost of current and future pensions.

System officials have been trying to calculate their way out of an oncoming freight train – If their investment yield comes in lower than expectations — and when you’re betting on an 8.5 percent return, that’s likely — the system’s unfunded liability will go up.

“It’s stupid. Are the liabilities any cheaper” in the future? Asked Andrew Biggs, of the American Enterprise Institute for Public Policy Research. “No. They are what they are.”

Biggs and AEI, a free-market think tank, have extensively studied the chasm between projected return rates and reality. Biggs, joining a chorus of other economists, has come to the conclusion that the system of accounting used by public pension systems is a joke, and return rates, particularly in such economically distressed times, should be more in line with long-term Treasury Bonds – about 3 percent.

Put it this way, as the Rauh/Novy-Marx study aptly did:

“If households could use the GASB accounting system, then they could write down the value of their mortgages by simply reallocating their savings from a money market account to the stock market,” the report’s authors wrote. “By doing so, they would increase the expected rate of return on their assets and get to use that higher rate to discount their debts. If state and local governments took further advantage of this system, they could make their liabilities essentially disappear by taking on risky investments with high average returns and high risk.”

Even good old Wisconsin, lauded as the strongest state pension system in the land and “fully funded” to boot, uses what has proved to be an unrealistic discount rate in recent years.

The Wisconsin Retirement System historically has exceeded its projected rate of return, as my colleague Ryan Ekvall pointed out his examination of the system.

Actuaries at the Wisconsin Department of Employee Trust Funds, have stood by a 7.2 percent rate of return.

The Great Recession did a lot of damage to old expectations.

WRS returned 6.8 percent on its core fund during the past decade, and just 3.3 percent during the past five years — both of which are actuarial losses. The crash in 2008 wiped out $23.6 billion from WRS’ assets.

Wisconsin, too, uses the GASB standards.

A new Pew Center on the States study notes that it used Wisconsin’s own numbers to conclude the pension system is holding or will easily earn the $80.75 billion it needs to fund retiree pensions.

But if you use the standard market valuations, from 7.2 percent to a more conservative Treasury bill rate, suddenly Wisconsin’s pension system is underfunded by about $70 billion.

Using that assumption, the state pension plan is just 60 percent funded.

Still, Wisconsin’s discount rate is much lower and, Biggs argues, much more realistic than the city of Milwaukee’s pension discount rates, which have topped 8 percent. The Rauh/Novy-Marx study rated Milwaukee’s pension system as having the 10th largest unfunded liability among major U.S. cities in 2010.

City officials, like government officials in most municipalities, chastised the study, with budget director Mark Nicolini telling the Milwaukee Journal Sentinel the report was a “work of fiction.”

Here’s some nonfiction: the reckoning is coming, and, as has been the clarion call by the clear minded, this problem isn’t about politics, it’s about math.

Biggs said there’s little political will to fix it. Public employees have no incentive to change a system that benefits them; politicians have no motivation to remind taxpayers how much they’re paying for extremely generous benefits, and how much they may be on the hook down the road.

“The future doesn’t like it,” he said, “but they can’t vote. Nobody who is a player in this wants to deal with it.”

You don’t lose weight by eating Cheetos and watching hours of “Keeping Up with the Kardashians.”

You don’t tackle the toughest problem governments face by hiding behind false assumptions.