Originally Published in the Washington Post President Obama has proposed that the federal government provide $35 billion to assist state budgets. It’s a fine idea — provided there’s a carrot. Many states have been hit hard by fast-rising retirement costs for public-sector employees, forcing those states to divert money from services such as education and […]

In their magnificent study about eight centuries of financial folly
("This Time Is Different"), economists Ken Rogoff and Carmen Reinhart
lampoon the low level of accuracy with which governments maintain their
books: ""Think of the implicit guarantees given to the massive mortgage
lenders that ultimately added trillions to the effective size of
national debt, the trillions in dollars in off-balance sheet
transactions engaged in by the Federal Reserve . . . not to mention
unfunded pension and medical liabilities. Lack of transparency . . . is
almost comical."

It’s also expensive. In a recent study, Alicia Munnell, a member of
President Clinton’s Council of Economic Advisors and now director of
the Center for Retirement Research at Boston College cited one example:

"In 1999, the California Public Employees’
Retirement System (CalPERS) reported that assets equaled 128 percent of
liabilities, [after which] the California legislature enhanced the
benefits of both current and future employees. 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 . . .."

In May 2008, Federal Reserve Vice Chairman Donald Kohn
delivered important remarks about an obscure but
consequential issue:

"Public pension benefits are essentially bulletproof promises
to pay. The only appropriate way to
calculate the present value of a very-low-risk liability is to use a
very-low-risk discount rate.  However,
most public pension funds calculate the present value of their liabilities
using the projected rate of return on the portfolio of assets as the discount
rate. This practice makes little sense from an economic perspective [and] pushes
the burden of financing today’s pension benefits onto future taxpayers, who
will be called upon to fund the true cost of existing pension promises."

To the vast
majority of Americans those remarks were hardly understandable, much less relevant.  But not to some public pension fund
officials.  Later, the CEO of the California
State Teachers Retirement System (CalSTRS) labeled as deserving of a "letter
grade of F" a study from Stanford University that adopted the Kohn methodology
for measuring California’s pension liabilities.  

Some politicians must think Californians are fools. Either that or they
must believe the Titanic wouldn’t have sunk had just the tip of the
iceberg been removed while the rest of it stayed hidden below the
surface.

The politicians I’m referring to are those engaged in vigorous
grandstanding about the city of Bell’s compensation abuses.

So far
we’ve heard calls to publish every government employee salary and to
make Bell give its citizens refunds. But we haven’t heard anything that
would actually make a difference in solving our state’s financial woes.

Some public pension funds like to blame the 2008 stock market crash for the pension cost crisis but as the chart below shows, pension costs started rising well before the 2008 stock market crash.

In fact, those pension costs increased sharply through the decade even though CalPERS and other public pension funds earned money for the period including the 2008 crash. This is because public pension costs rise whenever public pension funds earn less than they expect to earn. Put another way, when it comes to pension costs, what matters is the "spread" between expected returns and actual returns.

When pension promises are made, employers and employees make contributions into pension funds.  The size of those contributions is based upon an expected return from investment of those contributions so that, together, the contributions and investment earnings on those contributions are supposed to be enough to pay the pension when it’s due. The higher the expected investment return, the lower the contributions when the promises are made. But if the actual investment return falls short of the expected return, the employer must make up all the difference.

During a recent
public discussion about expected investment returns, the Chief
Investment Officer of a California public pension fund was quoted as
saying that "I would argue, and I have, with people who said it’s going
to be 6 percent or lower that they are basically saying the United
States is going to go in the drain in the next 100 years. I’m not
willing to go there."

By all accounts this CIO is a very smart fellow.  However, in making
that statement he’s up against some tough math because, for the 100
years of the 20th century – not exactly "in the drain" for the USA – an
investor with assets allocated like the typical pension fund would have
earned (you guessed it) around 6 percent.  

Somehow a perfectly good return in the 20th century has become a poor
expected return for the 21st century. How did that happen? As Warren
Buffett explained in a remarkably prescient article
in 1999, sometimes people extrapolate from statistically insignificant
periods to draw invalid inferences about future long-term performance.
For example, many people today came of age during the 17-year
investment boom from 1982 – 1999, but as Buffett pointed out, "The
increase in equity values [from 1982 to 1999] beats anything you can
find in history."

Recently the Wall Street Journal reported that CalPERS, the country’s largest public pension fund, is recruiting executives for seats on poorly performing corporate boards.

Apparently, CalPERS places blame for much of the financial crisis on lax cultures inside corporate boards and a failure to hold directors accountable. As a CalPERS spokesperson put it: "If boards live in a world of no consequences and can let a company go to wrack and ruin, what are we to do?"

CalPERS is right to pursue better governance. Boards sometimes do allow practices that can lead to failure of enterprises and disaster for our economy. As starkly illustrated in the financial crisis, one glaring example took the form of misleading financial reporting.

As
California’s public pension funds consider changes to their investment return
assumptions, it’s helpful to review that assumption’s role and whom it impacts.

The
investment return assumption determines who pays for pension costs. This
is because it determines how much money must be set aside (contributed) by the
generation that got the benefit of the services to which the pension relates.

If the right amount of money is set aside when the promise is made, then the
generation that got the benefit of the services to which the pension relates
rightly bears the full cost, and only that cost. If too little is set aside, a
future generation has to cover some of the cost even though it did not get the
benefit of the employee’s services. If too much is set aside, the generation
that got the benefit of the services bears too much of the cost.

Later this week, CalPERS’s board is expected to approve a staff
recommendation to require more money from the state in order to meet
pension costs, a decision it had earlier postponed.  The board should
be commended for breaking a troubling trend and lowering total pension
costs to boot.

The troubling trend is "cost shifting," a technique by which a
generation issues debt to cover operating expenses and then shifts the
obligation to service that debt to future generations.  

For years, the
state has been doing just that by making promises of lifetime pensions
and healthcare after retirement but then not contributing enough money
to meet those promises.

Reprinted here is David Crane’s testimony yesterday before the Senate Public Employees and Retirement Committee on pension reform, SB 919, (Hollingsworth, R- Murrieta)

Good afternoon, Mr. Chairman, and thank you for allowing me to appear before the committee today on this important matter.

I will divide my remarks into five categories:

• The nature of pension promises
• The rising costs of meeting those promises
• The consequences of those costs
• The causes behind those costs
• What the state can do about it