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The Inevitable Failure of Public Pensions

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Tags Taxes and Spending

10/25/2018

Unless your primary news feed is Facebook, you’ve probably been exposed to the fact that public pensions are in pretty big trouble with funding. Being a liberty-bent community with Austrian economics as a core focus, the immediate reaction is to think that the underlying is the fact that these public pension systems are run by the public sector and that the private sector would do a better job managing such plans. However, being a State-run institution is only a problem in just one aspect, which will be discussed later. First, it is important to recognize that the reason the public sector pension systems around the country are failing is more fundamentally a problem of mathematics than it is a problem of being run by the State.

Pension Primer

Before we get into the meat, a brief primer on what a pension system is. In the common lexicon, when the word pension is mentioned, what we’re discussing is what’s called the defined benefit pension. Under this form of pension, the pension provider promises a guaranteed fixed return, usually index to cost of living adjustments, after retirement. To accommodate this, the provider will fund an investment portfolio in which to cover the future costs and build the contribution into the wages of the employee — either explicitly with a formal contribution or implicitly with a lower base salary. Any shortfall is later covered by the provider while gains are kept by the provider in the pension system, which is a form of risk transfer. The pension plan takes on all the risk to shield the recipient from volatility in the market — which means the recipient neither loses money in a down year nor reaps the windfall in an up year. Further, in this plan the recipient doesn’t own the assets and benefits typically cease upon death and benefits are fixed whether the recipient wants or needs it withdrawn or not.

The other form of pension is called the defined contribution pension; this is more commonly referred to as a 401k. The provider agrees to deposit an agreed upon sum, usually on a matching basis up to a certain percent of salary, into an account for the recipient to manage. All risk is assumed by the recipient — the provider neither deposits extra in case of a shortfall nor benefits from any higher return. Further, the recipient owns all the assets and can will any remainder to heirs after death and has flexibility in withdrawals, so recipients can adjust how much is withdrawn to take advantage of market fluctuations.

The Instability of Defined Benefit

Where the problem arises in the defined benefit pension is the notion of risk transfer. Because the future is unknowable, pension plans have to make assumptions on rate of return and typically fall back on long-term averages. While it’s true that over a long period of time, equity markets tend to average 7% return, these returns are couched in the assumption of the “buy and hold” method of investing. Unlike an individual 401k, defined benefit pensions are pooled funds — current workers are paying into the same pool while current retirees are drawing from it. Where the 401k holder spends a few decades doing nothing more than contributing to his retirement fund, the pension is both paying out and receiving new contributions every pay cycle. Further, mature pension plans always pay out more benefits than are received in contributions and utilize market returns to cover the difference.

What this does is create a timing cycle concern that the 401k recipient doesn’t have to worry about. Whether the market is up or down, the amount that is paid out and contributed in is relatively fixed. Worse, because pensions are typically planned out on an average market return rate, the plan can’t shift to a more predictable but lower return form of investment as the recipient nears retirement, which is something a 401k facilitates. Defined benefit pensions find themselves unable to do this since it would require higher contributions and/or lower payouts to cover the lower returns assumptions, particularly in an era of artificially suppressed interest rates.

Because of this mismatch, over time, the pension plan will deviate from the 7% assets on hand assumption that is typically made since payments are made when the market is down just the same as when the market is up. To maintain the 7% plan assumption, the market average must exceed 7% to reverse losses in weak years.

An Example

To demonstrate, I’ll use the CALPERS financial details from the 2016-17 fiscal year. In that year, CALPERS received $16.5 in contributions and spent $22 billion in benefits and administration expenses. The difference was funded by $326 billion in investment assets. Using this and past market performance, I’ll simulate two hypothetical portfolios. If we assume a 3% annual growth for contributions and expenses, when we compare a hypothetical fixed 7% annual return portfolio to the performance of the Dow Jones over the past 20 years , we see why defined benefit pensions tend to be problematic (numbers in millions):

 7% Fixed AssumptionActual Result 
YearEnding BalanceEnding BalanceSurplus/Deficit
1$ 343,059$ 372,235$29,176
2$ 361,012$ 459,019$98,007
3$ 380,039$ 425,177$45,138
4$ 400,211$ 389,406($10,805)
5$ 421,602$ 318,989($102,613)
6$ 444,292$ 391,767($52,525)
7$ 468,366$ 397,334($71,032)
8$ 493,914$ 388,188($105,726)
9$ 521,033$ 443,322($77,711)
10$ 549,827$ 464,190($85,637)
11$ 580,407$ 302,218($278,189)
12$ 612,890$ 350,050($262,840)
13$ 647,401$ 379,919($267,482)
14$ 684,077$ 392,405($291,672)
15$ 723,061$ 411,971($311,090)
16$ 764,508$ 510,305($254,203)
17$ 808,581$ 539,191($269,390)
18$ 855,455$ 518,280($337,175)
19$ 905,318$ 577,214($328,104)
20$ 958,371$ 709,917($248,454)

 

Year 1 corresponds to 1998 and 20 to 2017. As we see, when the market is hot, the plan runs a surplus. Eventually, however, the weaker years begin to compound with the payout gap and we start to generate an underfunded scenario. By year 20, even though the market averaged 7% return over the 20 year period, the pension plan is now under-funded by $248 billion, which is the same as assuming a fixed 5.5% return as opposed to the 7% market average. In essence, running a defined benefit pension is a form of gambler’s ruin .

This under-funded scenario eventually needs to be closed by topping up the account with additional funds, funds not contributed by the retirees now drawing on them.

Where the Public Part is the Problem

If this were a private company, this wouldn’t be much of a concern as a private company has many options — primarily phasing out defined benefit and converting employees to defined contribution. And this mathematical problem is exactly why the defined benefit pension has effectively vanished from the private sector with only larger, legacy employers that trace their roots to the early or mid 1900s or foreign companies in jurisdictions mandating such pensions retaining them.

Where the “State” element of State Run Pension runs into a problem is that the public pensions have entrenched themselves as Constitutional rights to public employees and court systems have systematically rejected any attempt to alter contributions, payments or even convert them wholesale to a defined contribution plan, not that many politicians wish to alter this agreement as the public sector employee unions are a major source of campaign funding and votes. Any attempts to close the funding gap will be extracted through involuntary taxation. A private company that does this has to hope the market is willing to bear a price hike to cover funding deficits or explain to investors that returns are going to be lower for the period and hope this doesn’t result in lost market share or bankruptcy. The State, which has no investors or customers, will just take it from the public, either through higher taxes or an additional debt burden as States borrow to cover the difference, shifting the unfunded burden elsewhere.

The Social Security Elephant

The big elephant in the room is Social Security, the nation’s largest pension system. The claim is that it, along with other entities like Medicare, has around $210 trillion of unfunded liabilities; though estimates differ wildly given the size and scope of the programs. What this means is that the Social Security needs to have this absurd number in investment assets to avoid increasing contributions (taxes) or cutting benefits.

However, this is a false assertion given the nature of Social Security. If this were a traditional, or even State run, pension plan, this would be a fair assessment of future liabilities to remain solvent, assuming the fixed returns hold. The problem with this claim, however, is that Social Security isn’t a pension but a convoluted Ponzi scheme that the administration dresses up with cute language . Since Social Security is required to purchase US Treasuries with the excess, the fund doesn’t really invest in anything. This is little more than a system that promises current contributors that some different set of taxpayers in the future will cover their retirement as all the contributions they made were paid out to existing retirees or use to fund the welfare/warfare State at the time. US Treasuries aren’t based on any productive asset and are honored only to the limits the US Government can reliably extract those resources in the future from some other group of taxpayers. You, too, can create a Social Security pension trust by writing “I Owe Me $3 trillion” on a sticky note and putting it in a jar.

In other words, if the government so wanted, they could easily “fund” Social Security by handing over a $210 trillion special Treasury Note that only the Social Security Administration can own and can even be kept off formal national debt metrics since it’s untradeable, similar to how the $100,000 bill was created exclusively to transfer funds between the various Federal Reserve banks before electronic commerce and didn’t get counted in the money supply. This is just a convoluted process on top of the existing convoluted process used to fool people into thinking they’ve “paid into” some pension system when the investment vehicle is just a way to disguise the fact the government has been using the excess OASDI taxes to bomb the Middle East and buy votes with welfare programs. Converting the status of Social Security from “unfunded” to “IOU” is trivial semantics.

At the end of the day, the funding problems with the public pension system were an inevitable result of trying to use averages to plan volatile future returns. This kind of pension, no matter who runs it, is destined to fail. The public part is only a problem because the pension won’t ever go away and any shortfall is forcibly closed through taxation.

Justin Murray received his MBA in 2014 from the University of St. Gallen in Switzerland.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
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