One of the major public pension funds' spin-meisters recently wrote a letter to The Wall Street Journal, seeking to counter the claims that taxpayers bear the brunt of costs of public pension funds. The argument, which has made the rounds through the public pension community, is that public employers — and hence the taxpayers — only contribute about 20 percent of the cost of public pensions. The rest, she claimed, is paid for by the employees and investment income. It's as if investment income grew from some kind of magic beans that are peculiar only to public pension funds, and simply wouldn't exist if we didn't have pension funds to create money out of thin air.
This idea started circulating several years ago, and it has oddly gained a life of its own despite its intellectual dishonesty. Following the old adage that repeating the same lie enough times will make people believe it, labor union and pension plan spin-doctors have taken long-term accounting information and added up the numbers using second-grade math. But they completely ignored the time value of money as well as the fiduciary concept that interest (and investment income) follows principal.
Time value of money. The second-grade math works like this: Take all the contributions made by public employers since their pension plans were started 100 years ago, then ignore inflation, discount rates and the time value of money. Add up the historical employee contributions in nominal dollars. Add up the cumulative investment income. Voila! It turns out that Einstein's "miracle of compound interest" works: That darned investment income grew in value. My gosh! It would seem that the magic beans are what pay for pensions, and apparently this has no relationship to who bought the beans and who planted, watered and cultivated them — and most importantly, who insured the crop.
The logical corollary of this line of thinking is that today's dollar of employer contributions is worth no more and no less than yesterday's. If that is the case, then the rational approach of all public employers would be to revert to pay-as-you-go financing so that they can optimize the value of their tax receipts which can be put to better work almost anywhere else but in a pension fund where they apparently get no credit for the employer.
Interest follows principal. Third-graders know that principal (their money) earns interest. That's why we take them to the bank to open a savings account, right? That's why we open 529 college savings plans for them, right? So it follows that interest is directly related to the contributions made by the respective donors, the employer and the employees.
Employers could invest elsewhere. It’s not as if pension funds are the only place a public employer could invest its money. Although the investment returns of pension funds should earn more over time than a state or municipal general fund that invests only in government bonds, a risk-free rate in U.S. treasuries (just like their bond sinking funds and debt service reserves) would earn over half the investment yield of a diversified pension fund, so the idea that employer contributions earn zero is ludicrous.
If pension funds want to take credit for their contribution to investment income, it would be fair and informative for them to separate out and analyze the portion of their cumulative earnings that exceeds the risk-free rate. Over the past 20, 30 and 84 years, this would be a substantial accumulation that exceeds what most government employers would have earned otherwise. Since 2000, however, the risk-adjusted returns from the public pension portfolios have been negative, which accounts for much of today's unfunded liabilities for irrevocable benefits awarded in that era.
Dual discount rates are hypocritical. Pension advocates lobby the Governmental Accounting Standards Board to use the expected return on investments to discount liabilities for reporting employers' liabilities. How can they then turn around and suggest that we discount previous contributions by employers at zero when calculating the share of costs paid by employers? These are the same people who scream loudly when academic financial economists suggest a lower discount rate of 4 or 5 percent rather than today's 7 or 8 percent actuarial conventions. Try discounting tomorrow's pension costs using a zero percent discount rate! You'll see national unfunded liabilities that make the "risk-free" projections look like small change.
Unfunded liabilities don't lie. To see how flimsy this line of logic is, ask yourself who will pay for the unfunded liabilities now that the investment returns of the pension funds failed to meet their actuarial expectations? Will the investment portfolio managers write checks to the retirees? Will the current employees? Has the pension fund asserting this claim sent bills for its unfunded liabilities to these parties? No, it will be the public employers and ultimately the taxpayers who will either face higher taxes or reduced services. Today, taxpayers nationwide are on the hook for around $700 billion, and that's just for unfunded pension liabilities of state and local pension plans, if my calculations using today's prevailing pension portfolio valuations and conventional discount rates are reasonably accurate.
The 20 percent VEBA solution. If unions want to start a plan in which public employers can limit their contributions and obligations to 20 percent of the total cost, that can easily be done through a VEBA (voluntary employee beneficiary association) that adjusts benefits downward when markets underperform and funding ratios are substandard. Every public employer and taxpayer group in America would jump at the chance to limit their financial exposure to that level, and the pension crisis would end tomorrow. That's just what happened when General Motors declared bankruptcy and left employees holding the investment and retirement risks in their VEBA plan.
The honest approach. Public pension plans should differentiate themselves from the private sector by calling attention to the much-higher share of real costs that public employees bear. On average, public employees pay a significant share of the "normal cost" of their pensions, unlike their counterparts in the private sector whose plans are "non-contributory" for employees. They don't pay much if anything toward the unfunded liabilities which remain the taxpayers' obligation, but that may change quickly as the bills come due and financially stretched public employers begin to demand cost-sharing of the unfunded liabilities. Instead of stretching their facts, the pension proponents should work harder to require public employees to bear one half of the total costs of their pensions and retiree medical benefits. That would put an end to the debate about who foots the bills.