Clarifying the View of Retirement Debt
An insightful report from Barclay's Capital sheds new light on pension obligations.
One of the burning issues in public finance, following last December's notorious 60 Minutes interview with bond analyst Meredith Whitney, is the true size of state and local governments' retirement benefits obligations and public employers' future ability to pay those bills. On one side we have the financial economists and some vocal doomsayers who use "risk free" discount rates to trump up the size of the "true" pension liabilities to levels that will crush taxpayers and frighten away bond investors. On the other side, many pension advocates claim that governmental pension contributions are now only a little more than 3 percent of state and local spending -- so gee-whiz, it can't really be that big of a problem even if costs go up. As you might expect, the truth lies somewhere in the middle.
Perhaps the best single objective data source on this issue now is last month's municipal bond research report by Barclay's Capital, entitled State's Pensions: A Manageable Long-term Challenge. As the title suggests, the Barclay's team concluded that the world will not come to an end but that some serious headwinds lie ahead. My recent column on pension reform outlines the steps that states and localities must take in order to grapple with these serious funding issues. Where the Barclay's research team contributes the most value to this debate is their insightful approach on page 18, in which they put the unfunded pension obligations into perspective using tools from the municipal bond market. Barclay's calculates the debt service costs of funding all the presently unfunded public pension obligations using municipal bonds trading at current taxable market levels. They estimate that the annual costs to defease these pension obligations would consume approximately 7 to 8 percent of state revenues and 4 to 5 percent of state and local tax revenues. That would be on top of normal pension contributions for current service.(I have not independently verified their data and invite professionally qualified readers to do so -- and comment below if they obtain different results.)
And then there's OPEB. Barclay's did not include the unfunded liabilities of state and local retiree health coverage obligations (OPEB or "other post-employment benefits") which are at least double and likely triple the size of the unfunded pension obligations reported by the public funds using conventional actuarial methods. If you add the OPEB obligations, then "we have a problem, Houston" as the percentage of revenues required to defease retirement promises this way would then jump to 15 to 20 percent of an average employer's annual tax revenues. Barclay's made only passing reference to the OPEB costs and was careful to note that some states have very little pension or OPEB debt while others have more, so averages can be deceptive.
Without getting into the pros and cons of funding pension and OPEB liabilities through the issuance of "benefits bonds" (see my landmark research and analysis on that subject), Barclay's approach provides the single best estimator of the true cost of future benefits obligation relative to budgetary capacity. Their approach is even better than the proposed method to calculate pension liabilities now under consideration by the Governmental Accounting Standards Board (GASB), which would use a tax-exempt discount rate. GASB's anticipated methodology slightly exaggerates the pension liabilities and fails to reflect an issuer's true borrowing costs to defease these obligations, but it shares the same line of thinking by using a borrowing rate to measure the unfunded liability and project future costs.
Better numbers provide better perspective. The public pension coalition has been touting national economic statistics based on current (underfunded) contributions. That sweeps the problem of unfunded liabilities under the rug. They also ignore nearly $2 trillion of unfunded OPEB obligations (almost three times the pension deficits) as if those somehow don't count.
I appreciate the efforts of pension advocates to downplay their plan costs as a percentage of budgets. It's important to dispel the notion that pensions alone are causing municipal layoffs (and bond defaults in the future). I also agree that over time most states will ultimately be able to manage the imminent cost increases required to amortize properly the unfunded liabilities. That means austerity and downsizing in many states and localities.
That said, the "3-percent-of-budget" numbers are deceptively light and can't be taken seriously in an honest appraisal of the size of our fiscal funding problem. The pro-forma costs of a pension obligation bond are mathematically less than a normal actuarial amortization because of their projected arbitrage advantage. Thus, Barclay's more-realistic estimate actually sheds a more favorable light on costs than a fair conventional actuarial analysis would provide. Also, Barclay's focus on tax revenue as the denominator in these ratios is the proper measure as that is the marginal funding source -- not intergovernmental expenditures, federal revenues and other inelastic funding sources built into these budgets, which underlie the 3 percent calculation.
As with GASB, Barclay's analysts avoid overstating the liabilities with a "risk free" discount rate that fails to reflect reasonable diversified investment practices over long periods. Further, their POB-proxy methodology does not suggest that such bonds be issued, but simply that when we seek to estimate the future drag on operating budgets, these annual costs as a percentage of relevant revenues would be a far better measure than anybody else has provided so far in these debates.
Public policymakers need better measures of the magnitude of this problem, and the Barclay's methodology offers a helpful new tool that analysts on both sides of this debate can reference as a neutral standard. It should be refined further to reflect amortization over the remaining lives of employees and not the obsolete 30-year amortization practice now permitted by GASB (which is expected to change in their forthcoming pension accounting standards). Of course, that would raise the annual projected costs of defeasing retirement obligations. In that light, it would not surprise me to see total retirement plan defeasance costs closer to 20 percent of state and local tax revenues on a national basis. That's a huge number and a major drag on the national economy as states and localities continue to lag the private sector in this economic recovery. Although pension and benefits reforms along with higher employee contributions will reduce those numbers, we still face huge challenges in coming years that cannot be swept under the rug.
I stand by my previous projection that absent major reforms -- including material benefits and contributions changes for current employees -- the state and local workforce must be reduced by a million workers over this decade because of remedial retirement plan funding costs. That's 5 to 10 percent of the payroll in many states -- and a commensurate reduction in public services. Hardly a trivial consequence, even if it's a "manageable challenge." As my companion column explains, there are clear solutions that can mitigate this impact, but they require concentrated and prompt action to stem the tide.
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