The pot is half full

By Buttonwood

PROMISES are easy to make, but difficult to keep. This is especially the case with pensions, where a 18 year old worker can be promised a benefit that still might be paying out 80 years later. Many states have offered pensions to workers who can retire at 50 or 55 and who might spend longer as a retiree than as a worker; it was recently reported that New York has more retired than working policemen and spends more on police pensions than on pay.

States have been allowed to account for these promises by assuming a high return on their assets - 7.5% or 8%. In effect, they are guaranteeing such returns to their workers, since it is very hard (legally) to reduce pension benefits for existing employees. But they cannot earn such a guaranteed return on this planet - they must buy risky assets. In effect, they are acting like a hedge fund; making a bet on equities with borrowed money, leaving future taxpayers* to foot the bill if things go wrong.

This paper has argued that pensions are debt-like and future liabilities should be accounted for with a bond yield. Moody's shifted in April to this method, using a high-grade taxable bond index. This ends up with yields of 5-6%, which look a little high to me, but the point is moot; it makes the figures look bad enough. Instead of being 74% funded, state schemes are only 48% funded; they are less than half full. We may have had a good run in the markets in early 2013, but this won't occur every year; sooner or later the shortfall will weigh on taxpayers and will require higher contributions.

For credit purposes, Moody's compares this adjusted net liability (the shortfall) with state revenues. Here are the worst ten.

Net liabilities as %

of revenues

1. Illinois 241.1

2. Connecticut 187.7

3. Kentucky 140.9

4. New Jersey 137.2

5. Hawaii 132.5

6. Louisiana 130.2

7. Colorado 117.5

8. Pennsylvania 105

9. Massachusetts 100.4

10. Maryland 99.5

It is a fairly wide geographic range, albeit with an east-coast bias. As Moody's points out, what tends to unite the troubled states is a past failure to fully fund their pension plans. Taking a pension holiday is a way of getting temporary budget relief. But of course, it stores up trouble for the future. Six of the states in the top 10 have seen their debt downgraded over the last 3 years, in large part because of their pension position.

* Current taxpayers benefit to the extent that the state makes lower than prudent contributions today.