July has been a tough month for public-sector pension apologists who have denied, and continue to deny, that there is a nationwide pension crisis. Ratings agencies, bond buyers, academics, journalists, legislators and taxpayers alike are finally beginning to grasp the magnitude of the public pension debt tsunami that will, over the next several years, swamp state and local governments. For those of us who have been actively involved in the pension reform movement — including the tireless publishers of www.pensiontsunami.com — this awakening to the very real perils we collectively face is both a welcome and a sobering development.
Traditional defined benefit pension plans make long-term, guaranteed commitments to public employees and then fund those commitments through a combination of annual contributions and investment returns. The higher the assumed investment return, the less money is required upfront to pay for the benefits. And there’s the rub.
Pension plans around the country are counting on an average annual investment return of 7.6 percent to fund existing pension benefits. The problem is that in this low interest-rate environment, according to the Wall Street Journal, long-term returns for pension plans “are expected to drop to the lowest levels ever recorded."
While we will not know the full impact of lower long-term investment returns until they actually occur, if public-sector pension liabilities were discounted the same way corporate pensions are required to be discounted, nationwide unfunded pension liabilities are not $1.4 trillion (an already impossibly large amount that has required pension contributions to nearly triple over the last several years) but are $5.2 trillion, as explained by Andrew Biggs of the American Enterprise Institute in Forbes last month.
So what does this all mean? According to a paper by Dr. Alicia Munnell and Dr. Jean-Pierre Aubry, published last month by the Brookings Institution, if state and municipal pension investment returns are 6 percent, rather than 7.6 percent, already historically high required pension contributions will skyrocket further. For some jurisdictions, including Chicago, Detroit and Houston, required pension contributions would nearly double.
But even 6 percent returns are optimistic. Munnell and Aubry list “Expected Nominal Returns for U.S. Equities from Selected Financial Firms, 2015-16” on page 14 of their paper. If the experts at Goldman Sachs, Charles Schwab and Research Affiliates, among others, are right, U.S. equities will yield between 3.2 percent and 7 percent in returns over the next 10 years. According to a recent analysis by Deloitte, the average pension plan invests around 50 percent of its assets in equities, 35 percent in bonds and 15 percent spread among cash, real estate and alternative investments. Since equities generally yield higher returns than the rest of the portfolio, blended returns across all of a plan’s assets will almost certainly pull pension plan returns well below 6 percent. They could be as low as 4 percent if interest rates remain depressed for the foreseeable future.
Last week, Moody’s warned, “the ability of U.S. state and local governments to absorb adverse market performance by their pension funds has been constrained by rising costs associated with past unfunded liabilities”. Moody’s also warned that pension plans are taking on more and more risk as they try to chase higher returns.
The pension tsunami is upon us. At this point, there is no way to escape it. All of us will be impacted by this compounding problem, through higher taxes, reduced government services and, in some of the worst cases, reductions in promised benefits. But there is at least one thing we can do, and that is to create new retirement plans for new public employees that don’t exacerbate an already bad situation.
Dan Liljenquist is a former Republican state senator from Utah and former U.S. Senate candidate. He is nationally recognized for work on entitlement reform.