The Public Pension Crisis

1. The Public Pension Crisis Josh Rauh Kellogg School of Management October 2011

2. A State and Local Fiscal Crisis in the US? • Pensions represent large off-balance-sheet debts for state and local governments • Government accounting standards board (GASB) procedures understate liabilities • Allowing circumvention of balanced budget requirements • Threatens solvency of many state and local governmental entities

3. Outline of Questions • What are the cash flows that have been and are being promised? • What is the present value of these promises? • GASB accounting for liabilities: $3.8 trillion • Assets are around $2.7 trillion • Suggests ~$1 trillion gap… is this right? • What would be the impact of different policy reforms?

4. 1. What are the Cash Flows? • For each entity, starting point should be annual cash benefit outflow • Unfortunately not disclosed • Plans only disclose a (present value) liability and the discount rate they used • Actuarial reports contain demographic data and detailed description of plan rules • With much work, can approximately reverse engineer cash flows

5. Benefit Payments: 50 States $ billion (nominal) Our model ensures that discounting this stream at state-chosen rates (usually 8%) yields stated liability and first-year benefit flow Source: Novy-Marx, Robert and Joshua Rauh, 2011, “Public Pension Liabilities: How Big Are They and What Are They Worth,” Journal of Finance, forthcoming. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1352608.

6. Benefit Payments: 77 Cities and Counties $ billion (nominal) Our model ensures that discounting this stream at state-chosen rates (usually 8%) yields stated liability and first-year benefit flow Source: Novy-Marx, Robert and Joshua Rauh, 2011, “The Crisis in Local Government Pensions in the United States,” in Growing Old: Paying for Retirement and Institutional Money Management after the Financial Crisis, Robert Litan and Richard Herring, eds., Brookings Institution. http://www.kellogg.northwestern.edu/faculty/rauh/research/NMRLocal20101011.pdf

7. 2. The Financial Value of Liabilities • Need to discount these payouts, translate into a present value number • What do the plans themselves use? • GASB: long-term average expected return of plan assets is used as discount rate • Most plans aim for 8% • Major GA state plans use 7.5%, low end of spectrum • Is this a logical approach?

8. Is GASB Approach Appropriate? • Actuaries say… • Yes! • With long horizons stocks have high average returns • Asset income will (may) pay for lots of benefits • Economists say… • No! • Need to discount liabilities accounting for the nature of the liabilities (not the asset) • A dollar of stock is worth same as a dollar of bonds • Whom should you believe?

9. Example #1: Why Expected Return is Wrong • Consider the following example • You have promised to make a lump-sum payment of $100,000, due 10 years from now • That is your only debt • You have $35,000 in cash and no other assets • You want to take out a loan from a bank • Bank will assess your net worth • Suppose you move the $35,000 from cash into stocks. Does that change your net worth? • Common sense: No • GASB Implication: You can discount your debts at an (11%) expected equity return  no debt, since $35,000 will grow in 10 years to repay $100,000

10. Example #2: Two Identical Workers • To each, you have promised a lump sum of $200,000 in 30 years • Plan A set up for Worker #1 Liabilities: $200,000 in 30 years Assets: $10,000 invested in stock market • Plan B set up for Worker #2 Liabilities: $200,000 in 30 years Assets: $10,000 invested in stock market PLUS $10,000 in bonds • Question: Which plan is better funded?

11. GASB’s Answer • According to GASB • Suppose stock targeted return = 11%, bonds = 3% • Plan A PV of liability = $200,000 / (1.11)30 = $8,737Net position is $10,000 - $8,737 = $1,263 [surplus] • Plan B PV of liability = $200,000 / (1.07)30 = $26,273Net position is $20,000 - $26,273 = -$6,273 [deficit] • Plan A is better funded! • Absolutely defies all common sense • Identical liabilities • Identical stock holdings • Plan with additional assets is “less funded” • So how underfunded are the plans really?

12. Appropriate Discount Rates • Focus on already-promised benefits (ABO) • Consider liability from taxpayer perspective • Right discount rate depends on assumptions about default and recovery • If assuming that benefits are default-free, need a default-free discount rate • Only justification for higher rate is if states are to be credited for option to default

13. ABO Liabilities in 2009 were ~$3T • Taking state accounting as given as of June 2009 • $1.0T unfunded at state level + $0.3T unfunded local = $1.3T unfunded in total • Using Treasury yield curve on ABO as of June 2009 • $2.5T unfunded at state level + $0.6T unfunded local = $3.1T unfunded in total • As of October 2011 it is even larger • Assets: up by around 15%, adds around $0.4 trillion • Stated liabilities grew at 5.5% per year from 2007-2009… at that rate would fully offset asset growth • Some policy changes since then, but only a few have affected current employees or retirees • Yield curves lower  liabilities higher

14. Zero Coupon Treasury Yield Curves 10/11/2011 30yr 10/11/2011 10yr 10/11/2011 5yr Bottom line: Unfunded ABO liability as of Oct-2011 likely over $4 trillion.

15. Georgia’s Liabilities: Current Workers * Also includes subsidiary plans of the Employees’ Retirement System of Georgia: ERS, PSERS, GJRS, LRS, and MGPF. ** Estimate for all systems within Georgia in the U.S. Census of State and Local Government Retirement Systems: GA ERS (and subsidiaries), GA TRS, GA Firemen, GA Peace Officers, DeKalb County, Fulton County, Atlanta General, Atlanta Police, Atlanta Fire, Columbus ERS, Savannah, Chatham, Albany ERS plus 9 smaller municipal systems.

16. 3. Policy Options • Most policy changes that have been put in place have hardly dented the unfunded liabilities • If GASB rules are in place, new DB promises continue to be underfunded, debt grows • Even if extent of new benefit promises is less than it was before • True service cost with a benefit factor of 2% of pay is typically around 28-30% of pay, double what is typically recognized • Georgia: fewer unfunded liabilities for new workers under 2009 reform (DC + reduced DB), but still have only slowed growth of debt

17. List of Possible Measures • Employee contribution increases • Make early retirement actuarially fair • Retirement age increases • Cost of living adjustment reductions • Tax increases or spending cuts to devote more resources to pensions • Soft freeze (or partial soft-freeze) • Hard freeze None of these is politically easy

18. Conclusions • Absolutely no basis for expected return discounting • Bad question: “what is a reasonable return to expect?” • Good question: “since pension cash flows are like a bond, how should they be valued?” • No easy solutions to large pension debts • Only two ways to stop the borrowing • rewrite GASB, start paying PV of new benefits; OR • stop promising new DB benefits through (hard) freeze