I have been trying to understand our pension mess for years now, and I will tell you that the numbers and acronyms are at times baffling. But help is here.
Two of the nation’s Federal Reserve Banks (the Cleveland and the Atlanta Federal Reserve Banks) have joined together to form a “Financial Monitoring Team to study pension funds and municipal finance with an eye toward implications for the wider economy and financial system.” In other words, these two banks are seeking to shine a light on the dark and difficult to understand corners of municipal finance. Chiefly, the banks are interested in learning about Municipal Pensions.
The Cleveland Fed publishes a newsletter, “Forefront”, and the latest issue contains a number of incredibly helpful articles about the state of municipal pensions. The main article is: Public Finances: Shining Light on a Dark Corner. This is a clear and helpful article, with a glossary and helpful sidebars. It also comes with a video primer on the pension crisis that is sober, clear, and helpful.
One question the article addresses is just how big the pension shortfall actually is. According to government numbers, the shortfall is $800 billion. The government estimates are based on assumptions of an 8% rate of return, which inflates the assumptions about the present value of pensions. In all likelihood, the return will be somewhere between the 8% historic average and the painfully low return offered by persistently low interest rates. Thus, many private economists estimate the shortfall at around $4 Trillion. Here is what the Cleveland and Atlanta Feds say:
Some economists, however, have come up with a $4 trillion shortfall. They have pointed out that for most state and local plans, promised pension benefits are protected by constitutional, statutory, or common law guarantees. (See related article, “Navigating the Legal Landscape for Public Pension Reform.”) By definition, this ought to make them riskless obligations to the pensioners. Thus, the appropriate valuation methodology should discount promised benefits using the risk-free interest rate, usually calculated as the yield on long-term U.S. Treasuries. This method, argued cogently by Jeffrey Brown and David Wilcox in “Discounting State and Local Pension Liabilities” (2009), has the virtue of being supported by both economic and legal principles. It also produces substantially higher estimates of the present value of pension liabilities. Given the currently low yields on Treasury bonds, this approach implies a present value of accrued obligations as high as $6.7 trillion, leaving an unfunded liability of $4 trillion.
In other words, the actual size of the pension shortfall is probably somewhere between $800 Billion (the size of the 2009 stimulus package) and $4 Trillion. The likely shortfall, as the Fed says in its video on the site, is in the $3-$4 Trillion range.
So what does this mean? The Cleveland and Atlanta Feds offer a few conclusions:
1. At this point, it seems unlikely that any major pension fund will run out of cash in the next few years, barring a general worsening of economic and financial condition.
2. But we are not out of the woods yet. Many funds will require significant reforms to reduce underfunding levels, with painful new contributions from employers and employees.
3. Another concern is that some states’ legal protections may be too strong to give reforms enough time and flexibility to put plans on sustainable paths. In that case, states would ultimately be on the hook for covering pension benefits out of general revenues. This scenario, by creating crisis conditions in those states, could stress economic conditions more generally.
The real problem is the combination of #2 and #3. For if state laws make it too difficult to cut or reduce pensions, the only option is “painful new contributions from employers or employees.” It may be that we cut the guaranteed pensions of pensioners, making them less well off in retirement. That would hurt the workers. Or, if legal protections prevent that option, we the taxpayers will have to dig deep to pay their pensions, probably as we at the same time cut other essential services. And that will not be pretty. Either way, the state and local government crisis is shaping up to be one of the most important challenges of our generation.
For more on the pension crisis, you can revisit our other posts on the subject here.