State finance officials should face the truth on pension promises

Sacramento Bee

In the 17th century the Catholic Church attacked Galileo for advocating Copernicus’ view of the universe. Three centuries later, Pope John Paul II apologized for that persecution.

Hopefully it won’t take California’s finance officials that long to accept some basic financial truths, but based on the venomous reaction of some of those officials to a recent academic study by my Stanford colleague Joe Nation, one can’t be sure.

Nation reached three conclusions:

• The state’s pension debt is greater than the state reports.

• The state is counting on unlikely investment returns to meet that debt.

• Because those returns are unlikely, state pension costs are likely to soar.

The first conclusion – that the state is underreporting the size of pension debt – simply confirms conclusions already reached by other economists such as President Bill Clinton’s economic adviser Alicia Munnell and former Vice Chairman of the Federal Reserve Board Donald Kohn.

The second conclusion – that the state is counting on unrealistic investment returns to meet that debt – simply confirms views already articulated by Warren Buffett and other investors that pension funds are assuming “Alice in Wonderland” returns.

The third conclusion – that pension costs are going to soar – simply confirms an assessment already made by Buffett and others that, because pension funds are assuming unlikely returns, taxpayers should brace for big “pension-cost surprises.”

Even though Nation concluded nothing radical, some state officials issued statements attacking him and his motives. They didn’t address the substance of his conclusions, however, and that substance is what matters to Californians.

The importance of the first item – underreporting the size of debt – was illustrated when Lehman Brothers and AIG used aggressive but legal accounting techniques to underreport debt, thereby encouraging uninformed investors to enter into a web of transactions with them that later threatened the world financial system. A similar occasion took place in 1999, when California’s pension funds used aggressive but legal accounting techniques to underreport pension debt in order to show they were overfunded and thereby coax a huge and unfunded pension benefit increase from an uninformed state Legislature. But as Munnell illustrated in a 2010 report, California’s pension funds were actually underfunded in 1999. The cost of that unfunded pension increase has since diverted billions from education and social services, and bigger diversions are on the way.

The second and third conclusions – that the state is using unrealistic investment return assumptions that will lead to pension-cost surprises down the road – are relevant whenever contribution levels are established and are particularly important to future generations. That’s because when state officials assume that investments will do extremely well, the state can get away with putting away less money upfront, but if the investments fall short, future generations will have to pay far more.

This is why GM and California got hit so hard in the 2000s by pensions promised but underfunded many years before. But Nation’s report explains that much greater increases are in store because our pension funds are still in “Alice in Wonderland” world: By Buffett’s calculation, California’s pension funds are now basing contributions on the expectation that investments will perform eight times better over the next 100 years than in the 20th century.

For example, CalSTRS recently reported that it needs an extra $3.8 billion per year in contributions for the next 30 years, but that contribution assumes “Alice in Wonderland” investment returns. At Buffett’s 20th-century return, the contribution needs to be at least $7 billion per year – and the longer that larger contribution is delayed, the bigger the surprise down the road.

Instead of ad hominem responses, California’s finance officials should explain why they’re basing contributions on the expectation that 21st-century investments will perform so much better than 20th-century investments. For now, whenever they are asked about investment return assumptions, they point to past returns earned over short periods of time (e.g., 20 years) that are not relevant in the context of meeting very long-term pension liabilities that already extend into the 22nd century. If that technique sounds familiar, it’s because the pension fund practice of justifying unrealistic long-term future returns by reference to short-term past investment performances is no different from the mortgage-broker practice of hawking long-term mortgage obligations based upon irrelevant past home-price movement.

Every dollar not contributed today costs many more dollars down the road. The consequences of continued underfunding of pension promises are enormous. California’s finance officials should stand with Buffett, Munnell and Nation for financial truth-telling.