Key to pension costs is realistic assumptions

Sacramento Bee

Recently I wrote that culpability for rising pension costs lies with pension fund officials and politicians, not public employees or Wall Street. That conclusion surprised some because conventional wisdom is that pension problems started only after pensions were increased and the stock market crashed in 2008.

But pension costs started rising before 2008 and would have risen even without those increases.

Here’s why.

For pensions to work right, enough money must be set aside when the promises are made so that the combination of those set-asides and investment earnings on those set-asides will yield enough money when the promises come due. The key is to set aside enough. If too little is set aside, there will be make-up payments.

Establishing the level of set-asides is the responsibility of pension funds and politicians and is a function of how well they expect investments to perform over the extremely long period between promise and payment. The higher the expected return, the lower the set-aside. This is where the pension problem is created.

In order to keep set-asides artificially low in the short term, pension funds have been basing set-asides on the assumption that equity markets in the 21st century will grow 40 percent faster than equity markets grew in the 20th century. That means pension funds are assuming that the stock market, which grew 175 times in a very successful 20th century, will grow more than 1,750 times in the 21st century, or 10 times as much. That’s not a typo – that’s the power of compounding.

By making that assumption, pension funds enable employers to save cash upfront but at big costs down the road when the assumption isn’t met. This is because a penny saved in set-asides today costs several pennies in make-up payments down the road. Again, compounding.

Some corporations such as General Motors also used unrealistically high assumptions to keep pension costs artificially low in the short term but at great cost down the road. As a result, company pension costs rose sharply even though their pension funds earned money. In that case, the downstream victims were retirees, employees and shareholders. In the case of governments, the downstream victims are general funds.

The numbers illustrate that outcome. Costs rose before 2008 because the unrealistic assumption required the Dow Jones industrial average to reach 20,000 by then, but even before the crash the Dow never rose above 14,000. Currently the unrealistic assumption requires the Dow to be at 25,000, but it’s at 12,000.

The use of unrealistic pension investment return assumptions to keep short-term costs low is really no different than the destructive “teaser rate” home loans of a few years ago. There, the “pay rate” on a mortgage was set at a fraction of the real rate in order to keep payments artificially low in the short term but at great expense in the long term. Likewise, artificially low pay rates disguise real pension costs at great expense.

In fact, even the large make-up payments in the chart will be eclipsed by larger make-up payments down the road. That’s because they too are based on the unrealistic assumption. Recently New York state disclosed that its pension contribution this year of $3 billion, based on the unrealistic assumption, would be $8 billion if based on 20th-century returns. By using the unrealistic assumption, the state is saving $5 billion today but at multiples of that cost down the road. Using that math, the pension costs that take up about 4 percent of California’s general fund this year would take up 10 percent if a 20th-century return was assumed. That is, 10 percent is the real cost of pensions this year, with 4 percent being the pay rate and the balance, plus interest, being deferred to future general funds.

This is why Warren Buffett, a critic of inflated pension investment return assumptions, has written that “whatever pension-cost surprises are in store for shareholders down the road, these jolts will be surpassed many times over by those experienced by taxpayers.”

The same holds true for retiree health care, for which the pay rate is 1.5 percent of the general fund this year but for which, according to the state controller, the real cost is 4.5 percent. The difference, plus interest, is being deferred.

Public employees and Wall Street are not responsible for unrealistic assumptions and artificially low pay rates. To lower total retirement costs and to protect future general funds and taxpayers, politicians and pension funds must require adequate set-asides.