State And Local Government Financial Data Are Also A Problem

The series over the past week on fraudulent government economic data focused on data published by the Federal government, the reason being that most of the economic data for the U.S. come from the Federal government.  But the state and local governments put out substantial amounts of data too, mostly about their own financial condition.  What is the level of trustworthiness there?  Not good.

Thankfully state and local governments have much less ability to practice financial fraud than the Feds, in part because they have restrictions on the incurring of debt, in part because they have statutory or even constitutional balanced budget requirements, and in part because they can't print their own currency to pay their debts.  But like all politicians, state and local pols have powerful incentives to use the public fisc to pay off favored constituencies today while hiding what they are doing from the voters, thus allowing obligations to accumulate out of view to spring upon the next generation after those who took on the obligations are long gone.

If your goal is to pay off your political supporters while not revealing for many years the obligations you are incurring, then probably the perfect vehicle for you is the defined benefit pension plan.  In a state or local government defined benefit pension plan, the sponsoring entity takes on obligations that are not due to be paid for 10, 20 or even up to 80 years.  It is perfectly appropriate that the obligations due many years out are valued today based on a discount rate, the idea being that you can put money aside today against the discounted value, and the money will then earn the assumed rate of return over the years, resulting in sufficient funds to pay the obligations when they come due.  Nothing wrong so far. 

Now just think like a politician for a moment.  The higher the discount/return rate that you assume, the lower today's liabilities will appear to be.  If you assume an aggressive rate of return today, then you can promise generous pensions while putting aside little money to fund them.  However, when the markets fail to produce the assumed rate of return, required contributions will gradually accelerate, but over many years.  With any luck, you will be long gone.

The states with the worst pension problems today are probably Illinois, California and New Jersey, in that order.  New York is not far behind.  (Does anyone notice that these states have in common their deep blue politics?)  Anyway, I'll use New York City as an example, because I live here and I follow it closely.

New York City has five main pension funds for its workers:  New York City Employees' Retirement System (ERS), New York City Teachers' Retirement System (TRS), New York City Police Pension Fund (Police), New York City Fire Department Pension Fund (Fire), and New York City Board of Education Retirement System (BERS).  All have long assumed an 8% discount/return rate for valuation purposes.  Such returns can only be had in the stock market or even riskier investments like hedge funds, and any such investments can go down as well as up.  In fact, the stock market, after recent large gains, is only now approaching the records achieved in early 2000 -- that's 13 years with no gains whatsoever, against the 8% assumption.

What's the result?  In fiscal 2002, when the contributions were set based on the stock market values in 2000, New York City made required pension contributions of right around $1 billion, which was about 2.5% of a budget of then about $40 billion per year.  By 2012, with the stock market flat for a decade, required contributions had soared to $8.4 billion out of a budget now at $70 billion -- 12% of the total. 

In 2012 Richard North, chief City actuary, issued a report recommending lowering the assumed discount/return rate all the way to 7%.  Believe it or not, it takes an act of the state legislature to make that change!  A bill was presented in the 2012 session of the legislature, and it never came to a vote.  I guess the legislators understand where their interest is on this matter, namely continuing to keep the public in the dark.

In his actuarial valuations for the funds that came out in October 2012, North went ahead and used the rogue 7% rate.  The result was to reveal dramatically lower funding levels than previously advertised using the 8% rate:  ERS funding went from 78.6% funding to 64.2%; TRS from 64.1% to 58.9%; Police from 71.3% to 60.1%; Fire from 56.8% to 48.2%; BERS from 68.7% to 57.8%. 

But isn't even 7% rather aggressive for a public pension fund?  In a very valuable blog, John Murphy, the long time (1990 - 2005) Executive Director of ERS, commenting on the dramatic declines in funding resulting from use of the 7% rate, wrote on January 9, 2013 as follows:

The historical rate of return on stocks is 6.8% and for bonds it's 3.5%. Actuaries should not be playing with these rates. A standard prudent pension plan should operate within a 50/50 range of stocks and bonds depending on the level of annual benefit payments that the plan is required to make. A 5.15% interest rate should be almost a mandatory upper limit for interest rate assumptions.

We outsiders don't have the data available to make a precise calculation, but based on average funding declines of close to 10% resulting from a 1% drop in assumed discount/return, it would be a good bet that taking the assumed return rate down to 5% would cause further declines in the funding ratio in the range of 15-20%, dropping funding ratios into the mid-30s to low 40s.  Or to put it in dollar terms, the five funds have total assets of around $105 billion.  Valued at 7%, the actuary put their liabilities at around $171 billion.  Valued at 5%, those liabilities are likely to be more like $250 - 300 billion.  In short, there are huge, huge increases coming in the required pension contributions.  While the data to figure this out are publicly available, they can be quite hard to fine.  Few people know about it.

PS.  I have submitted an op ed to the New York Times on this subject.  They say they are going to run it, but they have been sitting on it for months.