The fix for all underfunded pension liabilities (Scial Security included) is to use a realistic assumption for return on investment. Thomas DeMarco, CFA, FCM Market Strategist in a Market Note today discusses this in some detail.
His analysis is to the point and a must read for all citizens concerned about their financial future and that of their children:
"In a recent Market Note I highlighted the abysmal condition of State pensions and the inappropriate (my opinion) discount rate used to measure those liabilities. At the risk of being overly repetitive I thought I would highlight a few items from another report on the topic, this one titled ‘Valuing Liabilities in State and Local Plans’ from the Center for Retirement Research (CFRR; Boston College).
1. The author agrees that the generic 8% assumed rate of return on investments is inappropriate to PV pension liabilities and instead argue for use of a risk free rate. The paper succinctly raised the following points: “…adopting a riskless rate has clear advantages: it would accurately reflect the guaranteed nature of public sector benefits; it would increase the credibility of public sector accounting with private sector analysts; and it could well forestall unwise benefit increaseswhen
the stock market soars” . I can’t stress the last two points enough.
2. Furthermore, “Benefits promised under a public plan are accorded a higher degree of protection than those under a private sector plan because, under the laws of most states, the sponsor cannot close down the plan for current participants”. Investors should pay attention to this as a recent issue of The Economist bluntly points out that several state constitutions (including Illinois and NY) make state pensions senior to bond debt.
3. In my prior note I mentioned that pension benefit obligations were no longer a distant worry – that a peak in obligations was coming around 2020 (only 10yrs from now).
4. To hammer the point about accurately measuring liabilities and forestalling unwise benefit increases the author points to CalPERS as a poster child: “in 1999, the California Public Employees’ Retirement System (CalPERS) reported that assets equaled 128 percent of liabilities, and the California legislature enhanced the benefits of both current and future employees. It reduced the retirement age, increased benefit accrual rates, and shortened the salary base for benefits to the final year’s salary. If CalPERS liabilities had been valued at the riskless rate,the
plan would have been only 88 percent funded. An accurate reporting of benefits to liabilities would avoid this type of expansion for current employees” (emphasis mine).
5. The author also brings up the point that the discipline of making state and local governments pay the annual costs discourages governments from awarding “excessively generous pensions in lieu of current wages”. I agree in theory, but the problem is a number of states/localities do not make the required annual payments and some even use the most brazen gimmickry to make said “payments” that bondholders should be insulted, repulsed, and afraid (I am thinking of a recent New York proposal to allow the state and municipalities to borrow about $6B from the state pension fund to, wait for it, make their payments to the same fund!).
6. The authors did point out one system that appears to be run more conservatively (outside of the discount rate question): Florida. “Despite being more than fully funded from 1998 through 2006, Florida succeeded in restraining benefit increases through statutory stabilization methods. Article X of the Florida constitution, passed in 1976, requires that any proposed benefit increase must be accompanied by actuarially sound funding provisions. The subsequent addition of Part VII of
Chapter 112 of the Florida statutes stipulates that total contributions must cover both the normal cost and an amount sufficient to amortize the unfunded liability over no more than 40 years. What is more, the combination of an employee’s pension and Social Security benefits cannot exceed 100 percent of final salary. As a result of this legislation, Florida has not increased benefits substantially since the late 1970s”.
Its far past the time for State Legislatures and the Congress to take the obvious lessons from this and reform all Government pension practises.