Chicago Tribune recently wrote about how the decision to reduce expected return assumption from 7.5% to 7.0% for the Illinois Teachers Retirement System resulted in the governor calling for approximately $400 million in additional taxes.

While the political positioning behind this small move of 0.5% is fascinating, it more importantly brings to the forefront the issue of how large future obligations are, and why there is a lot of fear and an incentive to hide.

If reducing the expected return assumption from 7.5% to 7.0% results in an additional $400 – 500 million a year of taxes, then moving the liability discount rate to something closer to a risk-free rate of 3% may imply additional $5 billion in additional contributions (Note: the actual number is likely several times higher than this – see the Illustration below for some simplified math).

The dilemma we face is that we have made future promises and do not have enough money set aside today to pay them. Therefore someone has to make up the shortfall. Instead of trying to determine who makes up the shortfall, we try to bury our heads in the actuarial sand of high expected returns.

 

But where can Illinois get the additional $5 billion a year from? And where can America get the additional $6 trillion from?

 

Investment returns aren’t going to help:

 

The Teachers Retirement System assumes that investment returns over the long-term will average 7 percent. With liabilities of $108 billion, and assets of $41 billion, even if investments return 7 percent per annum, the hole will only continue to grow (see Illustration below). This is why using investment return expectations to discount liabilities isn’t appropriate.

But investments don’t return 7 percent year-in, year-out. For simplicity, lets assume the long-term horizon to be ten years. Even if there is one year where returns are -20 percent, this results in an asset value that is over $20 billion lower (see illustration below).

When risk-free rates were around 6-7%, generating 8-10% expected returns required minimal risk and complexity. However, with risk-free rates at 2-3%, generating even 7% is a lot harder. While investment teams at pension funds such as Teachers are extremely capable, high expected returns are forcing them to take on additional risk, either in the form of increased leverage or complex investments.

The Rockefeller Institute of Government points out that “taxpayers and citizens may or not want this risk taken on their behalf, but they have little say in the matter. And they have no easy way out: If they want pension funds to take less risk, they’ll have to increase government contributions by even more than contributions have gone up already”.

 

Inflation may not help either:

 

Arguments in favor of using higher discount rates tend to revolve around the “artificially low” level of interest rates fueled by Central Bank actions, and a belief that discount rates would return to a more “normal” level in the future. However, a return to “normal” is likely to be accompanied by an increase in inflation. For public plans, higher inflation could actually be a problem, as benefits tend to be linked to inflation, and therefore liabilities would likely get larger, not smaller, with inflation.

 

Therefore, by not putting in the money today, we are effectively making a leveraged bet on the stock market, and hoping it pays off, and praying that inflation stays low. 

 

And if the bet doesn’t work then who will pick up the pieces?

 

In 2010, Josh Rauh at Stanford estimated that if state pension funds earned an average return of 8% on their assets, then states would in aggregate run out of funds in 2028. If average returns are only 6%, then state funds in aggregate will run out in 2024 – thats only eight years from now.

 

According to Rauh, funds would need to earn at least 10% per annum out to 2045 in order to sufficiently meet their obligations.

 

Higher inflation and lower investment returns would only make this situation worse. Current tax payers and law makers are either unwilling or unable to shoulder the burden, as recent events in Illinois have highlighted.

 

This then shifts the burden to future tax payers. As this burden becomes more apparent, Josh Rauh speculates that tax payers may choose to relocate from states with high unfunded pension liabilities. This would, in his opinion, increase the likelihood of a federal tax payer bailout. Failing which, states would have to resort to what has so far been unthinkable – cutting benefits. In the absence of a federal bailout or a cut in benefits, its likely that muni-bond holders would have to take a hit, as tax dollars get used to fund pension benefits.

 

Quantifying the true extent of liabilities is the first step in recognizing the magnitude of the problem – the amounts involved are too large to ignore, and it impacts almost everyone. Hopefully policy makers can make informed decisions before its too late.

 

If decisions aren’t made, then our only hope is that we earn over 10% investment returns each year. Would you take that bet with your future?

Sources:

• Behavioral implication of high expected returns
• Rauner loses $400 million vote on teacher pension fund issue
• Why your states public pension plan is in a much bigger hole than you already fear
• Rockefeller Institute Reports Highlight Public Pension Risk
• Are State Public Pensions Sustainable? Why the Federal Government Should Worry About State Pension Liabilities

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Disclaimer: All views expressed in this article are that of the author and do not necessarily reflect the views of his employer or any of its affiliates.