States and cities face scrutiny for optimistic investment assumptions as stock market dips, Stanford scholar says

By Clifton B. Parker

Public policy scholar David Crane says overly hopeful assumptions by state and local governments about returns on pension investments make those pensions appear healthier than they actually are. (Photo: docstockmedia / Shutterstock)

State and local governments have made optimistic retirement promises to employees without setting aside sufficient funding to meet those assurances, a Stanford researcher warns.

David Crane, a lecturer on public policy at the Stanford Institute for Economic Policy Research, said overly hopeful assumptions about returns on pension investments make those pensions appear healthier than they actually are. Stanford News Service recently interviewed Crane on the issue:

What are the key problems with state and local funding of public pensions?

Cities, states and public school systems have promised trillions of dollars of pension and other retirement benefits to government employees without setting aside enough money to satisfy those commitments. As a result, tax revenue is being diverted from current services to pay off those promises.

For example, five years ago the state of California allocated the same amount, $6 billion, to the state's public universities as it did to pensions and other retirement costs. But this year the state will have to spend $9 billion on pensions and other retirement costs, up 50 percent, while universities will receive no increase even though state revenues will be more than $40 billion higher. As a result, the share of the state budget allocated to the state's universities will decline by more than 20 percent. Courts, social services, parks and the Department of Transportation suffer even greater cuts.

Even tax increases haven't helped. In 2012, California imposed a seven-year temporary tax increase that was advertised as being for education, but education's share of the 2015-16 budget will be lower than it was in 2010-11. That's because more than 40 percent of the tax increase this year is needed to cover increased spending on pensions and other retirement costs and the rest is going to boosts in other non-education-related spending. Worse, more money within those education systems is being diverted to increased pension and other retirement costs. For example, California school districts are scheduled to boost their pension spending a minimum of $170 billion over the next 30 years, which will divert money from classrooms and constrain salary increases for current and future teachers.

The same is true at the University of California, which has more than $20 billion of unfunded retirement obligations. The combination of UC's growing spending on retirement costs and reduced state support for UC has contributed to upward pressure on student tuition. Unfortunately, for the reason described below, the worst is yet to come.

Is there a problem of high assumptions on returns by public agencies?

Yes. When governments make pension promises they are supposed to set aside enough money so that the combination of those set-asides, usually referred to as "contributions," plus investment earnings on those set-asides may reasonably be expected to fund the pension promises as they fall due. That system is designed to protect future budgets from being invaded to pay for past promises. The size of the set-aside is based on an assumed rate of return on investment, which is selected by pension plan trustees. The higher the assumed rate, the lower the set-aside.

By choosing an unreasonably high assumed rate of return, trustees both reduce the set-aside and artificially suppress the reported size of pension promises, making the liabilities associated with the pension promises appear smaller than they really are. But eventually that choice cuts the other way. In fact, the more liabilities were artificially suppressed upfront, the greater the rebound effect in the future.

That's in large part why pension costs keep galloping ahead even though the stock market has more than doubled since 2009.

What should states and cities do to efficiently solve their pension issues?

First, pension fund trustees should be truthful about the accounting. New pension promises are being made every day that still are not being properly disclosed. Second, elected officials should inform citizens of what the future holds should nothing change. In California, pension and other retirement costs are just starting their rise but they've already caused substantial damage to essential public services and forced tax increases to be diverted from productive services. If not reformed, future service cuts and tax increases will be far greater. Third, leaders should ask government employees to share in the burden.

To date, the weight of swelling retirement costs has largely fallen on citizens – who are receiving reduced services while paying higher fees, tuition and fines – and taxpayers, who are paying more for less. Current employees could help by agreeing to share in the funding of unfunded liabilities and/or to reduce liabilities by accepting lower benefits for years not yet worked.

How has the recent stock market plunge affected public pension outlooks?

Not much. When it comes to public pension costs, it's long-term investment returns that matter. For example, from 1993 to 2013, the stock market quintupled and California's pension funds earned a very healthy 7.5 percent compounded annual return, but within that period there were several ups and downs, including a market crash in 2008-09 and a steep decline in 2001-02.

Far more important is an inadequate set-aside when the promise is made. For example, despite the quintupling of the stock market from 1993 to 2013, California's unfunded pension liabilities grew 30 times over. That was due in large part to inadequate set-asides when the promises were made, which was caused by pension plan trustees employing unrealistic investment return assumptions when establishing those set-asides.

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