As Milton Friedman famously noted, there are four ways to spend money; the fourth being spending somebody else’s money on somebody else. And, when people spend money this way, they tend to disregard both the costs and the outcomes. Simply put, people spend such money unwisely.
Not only, as Milton Friedman noted, does this describe how the government spends money, it also describes how public pensions invest money.
In the case of public pensions, elected legislators and public investment managers are investing taxpayers’ money on behalf of public employees. Due to their blatant disregard of the costs they are incurring and likely outcomes they are enabling, both taxpayers and future pensioners are now in a precarious position.
Meeting the public pension obligations requires state and local governments to allocate tax dollars toward the public pension fund every year. The investment managers then invest these dollars, along with all past contributions and earnings on those contributions. Unfortunately, state legislatures are not allocating enough tax dollars to the pension funds based on current government accounting practices.
Between 2001 and 2015, state and local governments only contributed 88 percent of the required contributions. In total, according to the Pew Charitable Trusts, the state public pension plans are underfunded by $1.1 trillion. And, this shortfall does not even include the shortfalls associated with local pension funds. Worse, even these estimates likely understate the necessary contributions, so the actual funding shortfalls are possibly even greater.
Due to the funding shortfalls: either promised pensions must be cut; large future tax increases must be levied; large future spending reductions must be made; or, (and perhaps most likely) some combination of all three policies must be implemented. The likelihood, and severity, of this bleak outcome is worsened due to the investment strategies of the pension funds.
Public pension funds currently assume an unrealistic return on their investments. Back in 2000 both public and private retirement systems assumed they would earn, on average, 8 percent annually on their assets. Such returns were also consistent with the returns on a well-diversified investment portfolio.
The return assumptions are important because the higher the actual return earned, the less money the plan’s sponsor (the government in the case of public pension funds) needs to contribute into the fund. For example, if a fund needed $110 next year, but can earn 10 percent this year, the plan sponsor only needs to contribute $100 this year. If, however, the fund can only earn 5 percent this year, then the plan sponsor needs to contribute a bit under $105 this year.
Since 2000, and the end of the dot com stock market bubble, financial returns have been smaller than the historical average. Private sector plans have, consequently, reduced their assumed annual return to a bit over 4 percent. Public sector pension funds have not adjusted their assumed returns to reflect this lower return environment – public sector funds are, on average, assuming they can annually earn around 7.5 percent.
It is unlikely that many public pension plans will meet such a high annual return. Therefore, even if the states were making their required contributions, which they are not, the unrealistic return expectations almost guarantee that there will not be sufficient assets for the pension funds to meet the promised retiree benefits.
It gets even worse, unfortunately. Perhaps in response to the unrealistic investment assumptions and the insufficient annual contributions, public pension funds are carrying too much risk in their investment portfolios. For example, during the 1970s, public pensions used to invest one-quarter of their assets in riskier “equity-like” investments such as stocks, real estate, hedge funds, and other assets subject to substantial investment risk. That figure has now increased to two-thirds of their assets.
One path forward is to continue rolling the dice. Should the risky bets of the public pension funds payoff, then perhaps they will be able to pay future pensioners their promised benefits. The more likely outcome is that the public pension systems are going to come up short. Just like in gambling, betting against the odds tends to be a losing strategy; and, without change, the likely outcome is a future financial crisis.
The more prudent path is to follow the first rule of holes: When you find yourself in a hole, stop digging! The sooner the precarious financial circumstances are recognized, and sound financial practices implemented, the smaller the ultimate costs will be.