The 'Pension Ponzi' Rap

Many still use Ponzi-like accounting, but pension funds are not Ponzi schemes.
by | March 17, 2011
 

Almost every week nowadays we can find a new article written somewhere that blasts public pension funds as "Ponzi schemes" that siphon money for some evil purpose at the expense of taxpayers. The term is also often used to describe the nation's Social Security system, which taxes current workers to provide retirement benefits for the prior generation. So, it is perhaps natural that pension abolitionists would apply the term to public pension funds. However, it's a misnomer in several ways, and I'd like to set the record straight.

For those unfamiliar with the history, Charles Ponzi was a notorious, nefarious character in the 1920s who created a scam involving foreign stamps, paying fictitious profits to the original investors from funds received from subsequent investors — until the money ran out.

Public pension funds are almost universally prefunded. This means they systematically collect money each year from employers and employees to invest for the future in an effort to fully fund the retirement benefits of qualifying employees upon their retirement. This actuarial method is anything but a Ponzi scheme, as long as the money is held securely in a trust fund for the participants' exclusive benefit, and the investment and actuarial assumptions all work out. Obviously it is the latter qualification that has plagued many pension funds: They failed to earn their expected rate of return and now face unfunded liabilities that must be restored to the pension fund before the retirees deplete the fund.

So it is not the pension fund itself that is a Ponzi scheme. It is the plan's accumulation of unfunded liabilities that are not fully prepaid before current workers retire that constitutes a Ponzi account within the pension fund. (I realize some cynics would call that a distinction without a difference, but it's an important technical point and a $3 trillion difference, because that's how much has already been set aside in legitimate state and local retirement plan trusts to prefund the benefits.)

As to retiree medical plans (known in the trade as OPEB for "other post-employment benefits plans"), very few now prefund. They are the real Ponzi schemes in the public sector: Almost all their accrued liabilities are completely unfunded, and they are not even trying to amortize their accumulated deficits. They just pay the minimum amount necessary, charging today's taxpayers for the retiree medical benefits of their parents' teachers and police officers.

Here are the numbers: Public pension funds presently have about $800 billion of unfunded liabilities on their books, or about 25 percent of their total accrued liabilities according to the latest Wilshire survey for 2010. Of that, about half will be properly amortized over the remaining service lives of today's employees, under normal actuarial practices. Unfortunately, the balance will be recaptured from employers and taxpayers after today's employees retire. That's because current accounting and funding practices allow public plans to amortize their liabilities over 25 to 30 years. So I would estimate that the "Ponzi portion" of public pension funds is about $400 billion based on today's financial market levels. That works out to about $2,000 for every American man, woman and child now under the age of 40. It's about 10 or 12 percent of the public plans' total liabilities, which is certainly a cause for concern and a civil injustice, but it's not going to bankrupt the system or the public employers on its own.

OPEB is often the real Ponzi. In the OPEB world, unfunded liabilities today are somewhere between $1.5 and $2 trillion. Except for about 5 to 10 percent of plans now invested in prefunding trusts, taxpayers will be stuck with the entire bill for retiree health benefits payable to retirees. That's outright intergenerational theft, and deserves the Ponzi label. The numbers start to get really ugly when we include these OPEB deficits, which bring the total size of the public retirement deficit being kicked to those under 35 to $13,000 per capita or $50,000 per family of four.

Again, it is important to avoid over-generalization. About a third of public-sector employers provide no or negligible retiree medical benefits, so they don't have a Ponzi problem. Another group is paying its bills on time. But over half of the public sector can clearly be characterized as Ponzi-funding their OPEB plans.

GASB has the right approach. All together, state and local pension and OPEB plans have accumulated more than $2 trillion of Ponzi deficits. Clearly that is a serious matter which requires immediate action to begin proper amortization of these accumulated liabilities. One hopeful sign is the prospect that the Governmental Accounting Standards Board (GASB) will adopt its latest published preliminary view that these unfunded liabilities must be recorded as expenses over the remaining lives of today's employees, and not deferred to the next generation.

Now if we can just get the actuaries, pension administrators and trustees to adopt the prospective GASB approach in their funding policies. They don't need to wait for GASB to promulgate standards on this issue. Trustees can implement this policy reform immediately and not wait until the next recession to increase the employers' and employees' contributions at the worst possible time, which is the end result. They are playing a stall game right now, praying for rain in the form of a stock market bailout of their unfunded liabilities that is highly improbable, as I've explained in a prior column.

Secondly, we have to convince public employers to begin funding the OPEB plans on an actuarial basis, even if they start with small increments and work their way up to full actuarial funding and proper amortization of liabilities over the next five or six years. That is the only way we will ever get out of this hole.

So let's not smear every pension fund and every public employer with the Ponzi label. If they are funding their liabilities properly over the next 15 years* they should not be tarred with the same brush that applies to half of the OPEB plans and several of the giant pension funds. Those are the people who continue to kick the can to the next generation by amortizing substantial liabilities over two generations instead of one — or ignoring them altogether.

*Unfortunately, few public plans presently meet this test, but the pending GASB changes should spur more into meeting this intergenerational standard and should become a best practice for funding policies.

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