Why the Illinois Pension Funding Hole is Even Deeper than You Think

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Oct 13, 2009

It is well-known that Illinois has one of the worst track records of funding its public pension plans of any state in the nation.  What is less well-known is that the problem is far, far worse than the official statistics would indicate: indeed, the extent of under-funding may be 2.5 times larger than what is typically reported!

 

To be clear, this is not because anyone in Illinois state government is doing anything unethical – those responsible for calculating the pension liabilities are presumably doing so in accordance with Government Accounting Standards Board (GASB) procedures.  Even so, there is near unanimity among economists (and yes, unanimity among economists is rare) that GASB rules themselves are deeply misguided. 

This is a complex topic, but I am going to over-simplify for brevity’s sake.  As noted in at least two prior posts, the Illinois state constitution provides a rock-solid guarantee that pension benefits will not be reduced or impaired in any way.  That makes the benefits that participants have accrued virtually risk-free.  It also means that it makes the liability to the State of Illinois risk-free.

 

Simple (and also advanced) finance theory is unambiguously clear that the appropriate way to discount a risk-free stream of cash flows is to use a risk-free interest rate.  While there is not a perfect risk-free asset available for this purpose, municipal bonds and U.S. treasury securities offer reasonable proxies.  (I have written on this subject in more depth in a paper with David Wilcox published in the American Economic Review, and I will simply refer readers there for a more in-depth discussion).

 

Instead of using this clear and rigorously grounded approach, GASB allows public pension plans to discount their liabilities using the expected rate of return on plan assets. There is not a shred of logic to this as an approach for valuing liabilities unless one believes that the liabilities share the exact same risk characteristics as the portfolio in which one is investing (and that is certainly not the case in Illinois.  We have riskless liabilities but invest in diversified portfolios of risky assets).

 

How big of a difference does this make?  A relatively new paper by Robert Novy-Marx (University of Chicago) and Joshua Rauh (Northwestern University) estimates the size of the liabilities when calculated using appropriate discount rates.  (Read their paper here) What do they find?

 

In 2008, the four large public pension plans in Illinois had combined assets of $65.7 billion.  The combined liabilities of these four plans (calculated under flawed GASB rules) were $151.1 billion, for a shortfall of $85.4 billion.  

If one uses a more theoretically appropriate rate on treasury yields, the present value of the liabilities is $284.8 billion, for a shortfall of $219.1 billion!  That is more than 2.5 times greater than the official statistics indicate!

 

What do these numbers really mean?  If the state of Illinois wanted to be certain it had enough money set aside today so that it could meet all public pension benefit obligations that have already been accrued, it would need to set aside an additional $219.1 billion.  For perspective, that is about 1/3 of Illinois GDP, about 1/3 of state revenues, and about four times the outstanding state debt.   

Any amount less than this means that the state would have invest in riskier assets in order to fund the benefits, a strategy that might work … or might make the problem worse. 

We’ve all heard to old adage that the first thing to do when you find yourself in a deep hole is to stop digging.  In this case, we also need to stop denying just how deep the hole is. 

The Case Against Funding Relief for Private Pensions

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Aug 20, 2009

Given the hundreds of billions of taxpayer dollars that have been handed out to financial services companies, automakers and other companies over the past year, it should not come as a surprise that corporate sponsors of Defined Benefit (DB) pension plans are also coming to Washington looking for a handout.  Admittedly, this issue has not been at the top of the news lately, but given the increasing number of calls I am receiving from policymakers in our nation’s capitol on the issue, it is pretty clear that this issue is on the political horizon.  

 

The basic story goes as follows: Despite the decline of DB pensions in the U.S. over the past several decades, millions of employees are still covered by these plans.  DB pension plans are essentially promises to workers that they will receive a monthly check for life after retirement, and this promise is supposed to be “made good on” even if the firm that sponsors the plan disappears in the interim.  The way Congress decided to ensure this back in 1974 was to require that companies sponsoring DB plans fund them (that is, set aside assets in a trust fund that would be dedicated to paying future benefits), and then provide participants with a government guarantee (through the PBGC) that their benefits will be paid even if the employer goes bankrupt with an underfunded plan.

 

For a variety of reasons that I won’t go into here (I’ll leave that for future posts about pension accounting rules and the flaws of the PBGC – the agency that insures the benefits), most DB plan sponsors invest their pension trusts heavily in stocks.  Thus, when the stock market declined precipitously over the past year, many plans sponsors found themselves facing substantial funding shortfalls. This increases their required contributions at precisely the moment when the economy is sagging.  Earlier this year, Watson Wyatt released a study showing that in 2009, plan sponsors would be required to contribute over $100 billion to their plans, up from just $38 billion in 2008, so the numbers involved are quite large.

 

Thus, the call for “relief.”  Essentially, plan sponsors are asking Congress to allow them to take a pass on meeting their funding obligations (and basically kicking the can down the road to another year).  Doing so, they say, will free up much needed cash to meet other obligations.  The two other uses for the cash most frequently mentioned are to avoid layoffs and to promote investment.  It is therefore argued that funding relief will be an effective economic stimulus.  (Isn’t it interesting how everything looks like a nail when you are holding a hammer?)

 

On the first question, I am unaware of any empirical evidence showing a link between mandatory pension contributions and employment.  On the second point, there is a very nice paper by my friend Josh Rauh (now at Northwestern University) showing that when firms are required to make contributions to their pension funds, they reduce investment (as measured by capital expenditures).

 

Despite these rationale, I remain highly skeptical of the wisdom of funding relief.  My skepticism arises for 4 primary reasons.

 

  1. While I accept the notion that freeing up internal cash may be useful during a period in which external financial markets are frozen, it is not at all clear that funding relief is a useful way to go about it. First, there is no guarantee that Rauh’s results will hold up in a period in which “cash is king.”  Instead, firms may just sit on the cash to provide a safety cushion.  Second, DB plan sponsors strike me as precisely the *wrong* set of firms to target for relief.  Why?  Because they almost surely have lower growth opportunities than other sectors (keep in mind these plans are concentrated in “old economy” firms).  And because these are precisely the firms where assets are most tangible (and thus less susceptible to the information problems that are often used to explain the advantage of internal over external financing).  If we think firms are being prevented from taking on good investments due to problems in the credit market, I’d much rather see us take steps to provide access to credit directly, rather than directing towards an arbitrary subset of firms.
  2. Even if the firms that are granted funding relief use it to increase investment, this will not necessarily increase the aggregate level of investment.  Why?  Because the money used to fund pensions is not thrown in the ocean.  Rather, it is redistributed by financial markets to those projects with the highest present value.  It is quite possible that funding relief will do little more than redirect funds away from the highest value projects in the overall economy and towards the highest value projects within a small subset of firms.  In short, I am not sure there will really be any stimulus to this stimulus.  
  3. This will further increase the risk to taxpayers.  If an underfunded plan sponsor goes bankrupt with an underfunded plan, the benefits are guaranteed by the PBGC.  But guess what?  The PBGC is already underfunded by at least $11 billion (and possibly much higher) and is expected to grow substantially in the coming decade.  At some point, taxpayer money will be needed to fill this gap.
  4. Most importantly, this simply treats the symptom, and not the cause, of the funding problems.  What we really need is a major overhaul of the funding rules – more on this in a future post.