Public Pensions Fail Simple Math

John Ransom
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Posted: Jul 26, 2012 12:01 AM

There is a dirty secret about state entitlements that liberals don’t want you to know. The collection of a state pension increases the chances that a pensioner will live in poverty. That’s because money put aside for state-guaranteed benefits can not be safely invested at rates that provide for more than a modest retirement unless the state subsidizes retirement benefits through taxes or if retirement savings are invested in riskier, higher yielding investments. Since governments are loath to raise taxes to subsidize a riskless retirement, benefits are eventually reduced. It works that way in London and Moscow as well as Madison and Sacramento.

In Moscow, public pensions and social programs helped bankrupt the Soviet Union in the 1980s while “transfer to pension status greatly increase[d] the likelihood of poverty,” according to Mervyn Matthews’ Poverty in the Soviet Union (Cambridge Press, 1986). In London, the former Labour Minister John Hutton’s Independent Public Services Pension Commission has recommended changes that would calculate pension benefits on lifetime earnings rather than current salary, in line with recommendations for pension reform from the Office for Economic Co-operation and Development (OECD). Trade unions in U.K. say that such changes will lead to “increased pensioner poverty.”  In Madison, WI public retirement applications have risen 73 percent according to the Wall Street Journal as workers try to lock in higher retirement benefits that will likely shrink for those public employees retiring in the future.    

Increasingly state governments in the US are facing budget shortfalls over entitlements paid to public servants and those on the public dole. And like the Social Security program, the shortfalls have been wholly predictable as government makes bigger and bigger promises to a select number of citizens who then take up a bigger share of the public pie.

Behind the rhetoric and the rants about state entitlement programs is one simple question: Who wants to pay for expanded public retirement and health care entitlements?

It’s a question that union organizers, doctors, teachers, state legislators and governors across the country grapple with as inflation takes a bigger bite of fixed incomes, market returns fizzle and the federal government cuts back on Medicaid payments after expanding welfare rolls through the stimulus and Obamacare. And while liberals try to make the case that entitlements play little part in the current state budget battles, simple math says otherwise. Medicaid makes up the second largest part of many state budgets, if not the largest. In fact, if governments used the same math that private pensions are mandated under the law to use to figure their liabilities, experts say the entitlement shortfalls in states’ pension systems is two-to-three times larger than has been widely reported.

Federally mandated Medicaid spending that is busting this year’s budgets in every state is the biggest story today. But fuzzy pension math is potentially the gravest budget killer. The Heritage Foundation points out that while it cost less than $1 trillion to shore up the financial system in the bank crisis of 2008, “The IMF expects that, on net present value basis – that is, the deflated total of all future costs,” the entitlement gap “will amount to about 34% of the US’s GDP.” That’s equal to $5 trillion of today’s GDP.

How did we fall into such a hole?     

Take the average teacher who enters the work force at of 25 years old and who retires at the age of 65. The teacher’s savings, accumulated at ten percent of their salary for 40 years, must enjoy rates of return near 6 percent to ensure a retirement income equal to 70 percent of the salary they first enjoyed when they entered the workforce. From 1925-2004 the safest investments, US Treasuries, have returned only 3.7 percent. Corporate bonds have averaged 5.4 percent. The riskiest investments average near 10 percent but are not suitable for a state managed pension program. Nor are they reliable. Dizzying rates of return in the 1990s, in part, have led to assumptions about market returns that are unsustainable. As a result, politicians have been able to use fuzzy math to hand out bigger benefits to public employees.

It would be nice if everyone could afford to open up a bed and breakfast with their retirement savings, as was depicted in retirement planning commercials of the late 1990s. However, historic rates of return in markets don’t allow for expansive retirement dreams, no matter what Dennis Hopper told us when pitching the brokerage firm Ameriprise. In a way Hopper never imagined, he was right though when he promised us that Baby Boomers were going to “turn retirement on its head.”    

In Florida for example, the state currently assumes that its pension system will return 7.75 percent annually, according a report by Milliman, an actuarial consultancy located in Vienna, Virginia that tracks pension obligations. But private pension plans can only assume at 5-6 percent rate of return currently- approximately the same rate of return that corporate bonds get historically- according to Asset International, a publication for chief investment officers. Safe rates of return are substantially smaller than those projected by the state. Consequently, the pension shortfalls will be that much greater, because states don’t realize those high rates of return. “’It's widely reported to be a $1 trillion problem, but if you dig into the numbers, it’s a $2 to $3 trillion problem,’” says David Kelly, an actuary at Mercer Investment Consulting’s Financial Strategy Group, reports Asset International about unfunded pension liabilities. “’The reported liabilities are understated by using an optimistically high … rate [of return].’”

Equally, this year’s Medicaid spending crisis has been predicated on math that is unsustainable. States, already facing budget woes, were suckered by the federal government into taking stimulus dollars that had expensive strings attached. The stimulus program sponsored by Obama and the Democrats further exacerbated the state budget problems in the future, even if it postponed them for a short while, an outrage that did not go unnoticed by conservatives.  

NPR reported at the time: “Because most states must by law balance their budgets each year, a number of them have no choice except to cut their Medicaid programs, which for many states represents the largest or second-largest budget item.”  T

Then Obama got out the fuzzy math calculator and proposed a cure worse than the disease: In return for the money to bailout their current Medicaid deficit and forgo the painful cuts states needed to balance their budgets back then, Obama and the Democrats proposed a bailout of Medicaid that shipped extra dollars to the state for a limited time. The bailout required states to agree not to trim Medicaid enrollees or cut benefits later on, even though the federal largesse would end in 2011. Essentially, the Democrats played the game both parties have been playing for a decade with entitlements: make more promises, add more entitlements and borrow more money to pay for today. Rather than make the system more solvent, the bailout made it more difficult for states to balance their budget this year by expanding Medicaid.

For two years the federal government shipped “enhanced” Medicaid reimbursements to states as high $2.68 for every dollar the state paid for the healthcare entitlement program designed to help the poor. But, as was laid out in the bailout plan, “enhanced” reimbursements will end in July of this year leaving state budgets worse off then before. Stimulus dollars consequently have expanded Medicaid and the states’ financial commitment to it.

It wasn’t like no one saw this coming, either.

“Budget gaps in fiscal 2012 will likely rival the critical shortfalls that states faced before enactment of the new stimulus package,” said Nelson A. Rockefeller Institute of Government in 2009. “Cuts or reductions in growth of spending on education, health care, and other programs, and/or major tax and other revenue increases, will almost certainly be on the table once again.”          

They are on the table for 2011. As a consequence, states have been forced to take the only recourse they have, which is to cut payments to medical providers in order to balance their budgets. “South Carolina is hoping to trim provider rates by 3% starting April 4 to help it close a $25 million deficit in its Medicaid department this fiscal year,” says CNN. “Managed care organizations would also see a 12.5% cut in their administrative fees. The move should save $7.5 million.” Even the New York Times admits that the program has hurt patients and has helped drive healthcare providers out of the Medicaid market.

The Times says that Dr. Saed Sahouri of Flint Michigan quit the Medicaid practice when Michigan reduced payments to physicians thereby making Medicaid uneconomical for him professionally.   “My office manager was telling me to do this for a long time, and I resisted,” Dr. Sahouri told the Times. “But after a while you realize that we’re really losing money on seeing those patients, not even breaking even. We were starting to lose more and more money, month after month.”

One of the complicating factors of the entitlement crisis is a willful blindness that has government conveniently over-estimating tax revenues during recessions, in addition to over-estimating rates of return at all other times. “During the 1990-92 revenue crisis, 25 percent of all state forecasts fell short by 5 percent or more,” finds the Rockeller Institute report States’ Revenue Estimating: Cracks in the Crystal Ball. “During the 2001-03 downturn, 45 percent of all state forecasts were off by 5 percent or more. In 2009, 70 percent of all forecasts overestimated revenues by 5 percent or more.”  If Bernie Madoff had used such sloppy account methods as state governments do in estimating pension liabilities and revenues, no doubt his house of cards would have collapsed more quickly. If anything, government accounting methods are hurting those people that liberals claim to care so much about, low-income workers, by creating huge entitlement deficits that require cuts in benefits which will hurt those who will have the hardest time retiring.    

Recommendations by the OECD on public pension reform include a private “pillar” for public pensions which could help increase rates of returns, while guaranteeing that the safety net still exists for those who will have the most difficulty making ends meet in retirement. Also recommended are later retirement ages to take into account longer life spans. But as the OECD notes, the length of the average retirement is growing while the working age population is shrinking. That aging population, which peaks in 2050, helps explain rising healthcare costs as well.

One only needs to look at what government math has done to pension liabilities to understand the difficulties the country faces if it does not repeal Obamacare soon. The longer we leave it, the greater temptation politicians from both parties will have to start using it like a checkbook, as they have other entitlement programs. 

Tinkering around the edges of our demographics won’t help that much if politicians aren’t willing to come clean as to the size of the problem that faces us in the future.  Neither party has shown a real willingness to tackle entitlement reform yet, although some on the GOP side of the aisle have shown flashed that they have understand the scope of the problem and the potential difficulties.  

“Is this a political weapon we are handing our adversaries? Of course it is,” GOP budget chair Rep. Paul Ryan said in March of last year. “I think everybody knows that we are walking into I guess what you would call a political trap that arguably we are setting for ourselves ... but we can’t wait. This needs leadership."

That passes the verbal portion of the test. Now it they could just pass the math portion…