Public Sector Pensions 101: The Hidden Taxpayer ‘Put’

1. “If a taxpayer’s personal portfolio underperforms, he or she can cut back on their expenditures. But if the government’s pension portfolio underperforms, the taxpayer will be asked to pay to the government the difference between what the government promised to public employees and the resources that are left to meet those obligations”.” Professor Joshua Rauh, Northwestern University February 14th, 2011 statement to Subcommittee on Courts, Commercial, and Administrative Law “The Role of Public Employee Pensions in Contributing to State Insolvency and the Possibility of a State Bankruptcy Chapter” Public Sector Pensions 101:The Hidden Taxpayer ‘Put’ NEW JERSEY TEA PARTY COALITION

2. Are We Against Pensions? Of course not; we just don’t want to be lied to about the true cost pensions to taxpayers

3. Public Sector Pension Underfunding:Really, Really Boring but Actually Quite Dangerous • Pension liabilities for states and local governments are 40% understated nationally through near-fraudulent accounting • Real unfunded accrued liabilities are many times higher than reported • This means that total state and local government debt is much higher than bonded debt-- and a pension-muni bond collision is coming • Pension reform efforts to date focus on current employees only and not the accrued liability (Battle of Madison just the beginning) • The accrued pension liability is too large and can’t be paid • Municipal bond ratings are based on faulty data and willful misperception, and are wrong • The municipal bond market is straining to downplay the problem and lull retail investors, and generally in deep denial that a problem exist • The players--pension boards, legislators, financial managers, rating agencies, and state judges--are seriously conflicted

4. Public Sector Pension Underfunding:Really, Really Boring but Actually Quite Dangerous • Pension liabilities for states and local governments are 40% understated nationally through near-fraudulent accounting • Real unfunded accrued liabilities are many times higher than reported • This means that total state and local government debt is much higher than bonded debt-- and a pension-muni bond collision is coming • Pension reform efforts to date focus on current employees only and not the accrued liability (Battle of Madison just the beginning) • The accrued pension liability is too large and can’t be paid • Municipal government bond ratings are based on faulty data and willful misperception, and are wrong • The municipal bond market is straining to downplay the problem and lull retail investors, and generally in deep denial that a problem exists • The players--pension boards, legislators, financial managers, rating agencies, and state judges--are seriously conflicted

5. Why Do We Care? I don’t think of the long-term budget fight as being between Democrats and Republicans or between rich and poor. I look at it as a fight between people with funded retirements and unfunded retirements. If I have saved enough to support my lifestyle in retirement, then I have a funded retirement. If my neighbor who teaches in public school wants to support a similar lifestyle based on her pension, then she has a retirement that is somewhat unfunded. That is, as of now, her pension plan has only about 50¢ for every $1 of promised benefits. Social Security and Medicare also are unfunded. Their trust funds consist of government bonds. If I took care of my own retirement the same way, the drawer where I keep statements from mutual funds that I own would instead be filled with IOUs from myself. More important, the actuarial shortfall in Social Security and Medicare, like that in my neighbor’s pension plan, is very large. Down the road, someone is going to get the shaft. It could be my neighbor, it could be me, or it could be both of us. That is, people who are relying on the unfunded systems--public sector pensions, Social Security, and Medicare--might find their benefits cut. Or people who are relying on personal savings could wind up having those savings taxed away in order to address the shortfalls in the public systems. Or all of us could have our savings eroded by inflation, from which we may not be able to protect ourselves. Arnold Kling, April 2011

6. Why Do We Care, Once Again? • Entitlements: political promises that be taken back • Social Security: $12 trillion? • 1935 benefits began at age 65, vs life expectancy of 58-62 (now 78-81) • Medicaid/Medicare: $80 trillion? • Death panels and rationing • Debt: the rules are decided by the lender • Total US private wealth: $49 trillion • Federal debt: $14.3 trillion as of…what time is it? • Municipal Bonds: $2.6 trillion • Reported unfunded public sector pension liability: $1.3 trillion • Real unfunded liability: $3 trillion or more • Public pensions are not a distant future problem • Pension costs now encroaching on essential services • 20-30% of general budgets in some cases • About ten state pensions are within a decade of going bust • And we still haven’t dealt with OPEB entitlements

7. Does This Look Like a Smoking Gun? (Hint: lying about the true liability) Source: Official Statement, State of Illinois General Obligation Bonds, Taxable Series February 2011

8. How AboutThis? (They also lie about the assets) 17. On June 29, 2001, the State legislature approved legislation (P.L. 2001, c. 133) that, effective November 1, 2001, increased retirement benefits for employees and retirees enrolled in TPAF and PERS by 9.09 percent. In order to fund the enhanced benefits, without increased costs to the State or taxpayers, the legislation revalued TPAF and PERS assets to reflect their full marketvalue as of June 30, 1999, near the height of the bull market.13 Bond offering documents did not disclose the retroactive mark-to-market revaluation of the pension assets under the 2001 legislation until March 2003 or the reason for the reevaluation. More specifically, bond offering documents did not disclose that the State used the market value as of June 30, 1999 in order to make it appear that the State could afford the benefit improvements. 13. In the actuarial valuations as of June 30, 1999 for TPAF and PERS, the actuarial value of assets was replaced with the market value of assets. Subsequent actuarial valuations, including actuarial valuations as of June 30, 2000 and June 30, 2001, applied the five-year smoothing method. Source: Securities and Exchange Commission Administrative Proceeding re State of New Jersey File No. 3-14009 Release No. 9135, August 18, 2010

9. Some Points of Reference • Defined Benefit Plans (vs. 401 k Defined Contribution) • Contractual obligation is at least legally equivalent to bonded debt • Even more protected under some state constitutions (IL, NY, HA) • In past cases of muni bond default, pensions not affected • Dollar-certain future annuity • Obligation to pay much stronger than Social Security or Medicaid/Medicare • OPEBs--health benefits--are a separate category • State and local plans not governed by ERISA (1974) • Same actuaries use different assumed-return standards • Private plans in better shape, though ERISA put taxpayers on the hook via PBGC • Not all public workers covered by Social Security • Most public sector employees covered through 220+ state wide plans • Range in size from $500 mm to over $150 bil • About 19.8 million state and local government employees (2.7 m Fed civ, 153 m total US) • Muni bond market very disaggregated compared to corporate bonds • 50,000 issuers from states to local districts; many security types (GO, revenue, etc) • Illiquid, ‘buy and hold’ market • 30% institutional, but 70% held by individuals directly or through mutual funds • ‘Munis never default’ • Oh yeah?

10. Some Major Conflicts of Interest • Most statewide pensions were 100%+ funded in 2000 • Same poor accounting but risks obscured by dot-com run-up • Instead of building reserves, legislators promptly increased pension benefits • The trading of pension benefits for votes is obvious in retrospect • Who sits on the boards of public pensions and decides investments, discount rates, benefits? • Legislators (pension recipients) • State and local treasurers (pension recipients) • State and local employees and union members (pension recipients) • State judges have their own state pensions • Will they recuse themselves when the inevitable legal fights begin? • Rating agencies paid by advisors, bankers, issuers • Actuaries hired and paid by pension boards • The same actuaries apply more conservative practices for ERISA plans

11. How Does a DB Pension Work? • Defined Benefit pensions are fundamentally simple • Future, dollar-certain benefits are earned during a working career (pension liability) • Employer/employee contributions are made to a pension trust fund (invested assets) • The combination of contributions and trust fund investment earnings should cover the future benefit payments (assets = liability) • The actuarial forecasting of the pension liability can be complex • Actuarial variables include mortality of both retiree and spouse; also • retirement age; • salary growth; • inflation • Another key variable is the assumed rate of return on the invested assets, or the discount rate

12. Future Pension Payments Comprise a Bundle of Many Annuities 2010 2020 2030 2040 2050 2060 2080 retires at 50 Fireman, 25 Teacher, 45 retires at 60 Accountant, 65 already retired Ex-employee, 35 retires at 55 DPW operator, 75 already retired Because retirement systems have been around for decades and are full of baby boomers, the duration or mid-point of future benefit streams for both public and private plans is 12-15 years--not 30! (I.e., the problem is imminent)

13. Present Value, Future Value: The Fundamental Principle of Finance • Time value of money is expressed as an interest rate PV FV 2011 15 years 2026 $100 $31.52 8.00% $100 $56.13 4.25% • Rate of return is correlated to risk • Higher return = higher risk

14. Pension Accounting: Merely Misleading, orMoreInstitutional Fraud? • The actuarial complexities are real, but they can obscure blatantly mismatched risk/return assumptions • The pension liability ismandatory; it must be paid • Therefore, asset investment should be conservative and low in risk • This means contributions should be conservatively ample • Typical 8% ‘discount rate’ creates inappropriate market risk • Asset/liability risk intentionally mismatched to understate current contributions required to fund the pension trust fund • Effectively forces a put on taxpayers to cover the future shortfall • 5-12 year ‘actuarial smoothing’ can overstate asset value and hide recent market declines (NJ SEC) • This accounting allows politicians to buy votes with benefits and hide the real cost

15. Is the Discount Rate Important? Benefits Paid Out in Retirement Benefits Earned During Working Career 25 40 62 80 Employee’s Age Annually Required Contribution (ARC) to Pension Fund Pension Fund Assets Build Over Time

16. Is the Discount Rate Important? Benefits Paid Out in Retirement Benefits Earned During Working Career 25 40 62 80 Employee’s Age Future Value of Benefit Stream Discount Rate Present Value of Future Benefit Stream Annually Required Contribution (ARC) to Pension Fund Pension Fund Assets Build Over Time Discount rate determines how much has to be set aside during working career from employer/ employee contributions for investment to ensure adequate funds to pay future benefits

17. Is the Discount Rate Important? Benefits Paid Out in Retirement Benefits Earned During Working Career 25 40 62 80 Employee’s Age Future Value of Benefit Stream Discount Rate Present Value of Future Benefit Stream High discount rate assumes more investment earnings, requires lower contributions (but more risk!) Annually Required Contribution (ARC) to Pension Fund Pension Fund Assets Build Over Time Low discount rate assumes less investment earnings, requires more contributions (less future risk to taxpayers, politicians restricted) Discount rate determines how much has to be set aside during working career from employer/ employee contributions for investment to ensure adequate funds to pay future benefits

18. Is the Pension Funded or Under-funded? Benefits Paid Out in Retirement Benefits Earned During Working Career PV of future benefits earned to date = Accrued Liability FV of Benefits Discount Rate +$ If at any valuation date invested assets are greater than the Accrued Liability, the plan is fully funded or better If at any valuation date invested assets (past contributions) are less than the Accrued Liability the plan is underfunded -$ Today Use fair market value, not ‘smoothed’ values

19. What if the Assumption is Bad? • The pension plan’s actuarial report shows the funding level based on the assumed discount rate • Most public sector plans now officially funded at 80% or less, even with absurdly high discount rates • Since the discount rate is too high--as it usually is in public sector pensions, where 8.0% is common--the plan’s underfunded situation is actually much worse • Guess who gets stuck covering the shortfall? • Since we know the average duration of the pension liability is 15 years, it’s not hard to calculate a more realistic funded level using a more conservative interest rate--such as the 15 year Treasury (4.25%)

20. And Now for the Really Bad News (remember that taxpayer put?) * *Reported UFPL FV’d 15 years at plan discount rate; PV’d back at 4.25% (15 yr Treasury) Source: State CAFRs, Actuarial reports

21. And Now for the Really Bad News (remember that taxpayer put?) * *Reported UFPL FV’d 15 years at plan discount rate; PV’d back at 4.25% (15 yr Treasury) Source: State CAFRs, Actuarial reports

22. And Now for the Really Bad News (remember that taxpayer put?) * *Reported UFPL FV’d 15 years at plan discount rate; PV’d back at 4.25% (15 yr Treasury) Source: State CAFRs, Actuarial reports

23. How Does This End?(hint: probably not well) • State and local government revenue ‘pie’ can’t increase • Economic activity not growing so revenues stay flat • Tax rates can’t increase given high unemployment, foreclosures • Caterpillar, Sears threatening to leave Illinois • Blue states already losing population • Pension funding claims higher and higher share of annual budgets • Public sector layoffs, service cuts result, but with no cut in taxes • Economic ‘death spiral’ as ranks of unemployed swell • Unions forced to choose between active and retired workers • Government will get increasingly desperate as ‘Kick the Can’ finally runs out of time • Hyper-inflation to pay debt and pension with devalued dollars • personal savings destroyed • IRAs/401ks forced into US Treasuries when no one else wants them • State and local bankruptcies, defaults, as leadership fails