Is the Underfunding of Our Pensions 3 Times More Than Advertised?
As I pointed out in the previous post, the required contributions to Illinois’ 5 pension funds will increase by $291 million in the next fiscal year, and will comprise fully 24% of the state’s general revenue outlays. That’s being done to satisfy the requirements of the Illinois pension law that requires all 5 funds to achieve a funding level of 90% by 2045.
That’s based on an assumption that the plans are underfunded by the $111 billion as stated in the November, 2015 report issued by the Commission on Government Forecasting and Accountability (COGFA). But what happens if the underfunding is 2 or 3 times greater than is reported?
Contributions for the past 3 years have increased dramatically from the previous years. From Doug Finke’s Springfield Journal-Register article:
“Dan Long, the commission’s executive director, said a reason is that the pension systems lowered their expected rates of return on investments last year, resulting in the state having to make a somewhat larger contribution. That lowered rates of return are now built into projections for state contributions.” (Emphasis mine)
I want to concentrate on Dan Long’s comment above about how lowered expected rates of return resulted in larger annual contributions. That’s going to require a bit of math.
Simply put, to achieve a particular return on an investment, the greater the investment return you demand, the less you’re willing to pay for it. Conversely, the lower the investment return you will accept, the more you have to pay for it. That’s because investors aren’t willing to pay a higher return-adjusted price for an investment than they could get if they put their money into a risk-free investment, which is generally defined as the rate on U.S. government securities. (Now, that wasn’t so bad, was it?)
According to the 2013 Illinois State Actuary’s Report:
“The interest rate assumption (also called the investment return or discount rate) is the most impactful assumption affecting the required State contribution amount. This assumption is used to value liabilities for funding purposes.”
This goes to the very heart of the discussion as to how underfunded Illinois’ pension funds truly are. According to the COGFA report, the plans are underfunded to the tune of $111 billion. That number is derived by using a lower assumed investment rate of return than had been used in previous years. This chart shows the reduction in investment returns for the 5 funds over the past several years:
In 2013, Andy Kessler wrote an article in the Wall Street Journal which discussed the unrealistic assumptions that pension funds use regarding expected rates of return:
“Pension math is more art than science. Actuaries guess, er, compute how much money is needed today based on life expectancies of retirees as well as the expected investment return on the pension portfolio. Shortfalls, or “underfunded pension liabilities,” need to be made up by employers or…taxpayers.
Public-pension funds in Illinois use an average of 8.18% expected returns (since lowered as noted above)…Who wouldn’t want 7.5%-8% returns these days? Ten-year U.S. Treasury bonds are paying 1.74%.
The right number is probably 3%. Fixed income has negative real rates right now and will be a drag on returns. The math is not this easy, but in general, the expected return for equities is the inflation rate plus productivity improvements plus the expansion of the price/earnings multiple…[I]n our new environment, inflation is +2%, productivity is +2% and given that interest rates are zero, multiple expansion should be, and I’m being generous, -1%.”
Closer to home, University of Chicago economist and Nobel laureate Eugene Fama was asked in a 2013 Chicago Magazine article how he felt about buying State of Illinois bonds. He replied:
“Well, in the short term, they’re OK. In the long term, I wouldn’t touch them. The [state’s] pension liability is much worse than [the reported $100 billion that] people think.”
When asked why, he replied:
“States discount their liabilities—I think Illinois uses a discount of 7.5 percent, arguing that’s the expected [annual] return on their portfolio. But the expected return on a portfolio is totally irrelevant. What counts is: How risky are the claims that you have to meet? You’ve made a promise to your employees that you’ll pay them a certain fraction of their income that is usually indexed. Which means it’s a risk-free real outcome. What’s the risk-free real rate? Is it anywhere near 7.5 percent? It isn’t. Historically, it’s like 2 percent. A 2 percent discount rate would approximately triple Illinois’s pension liabilities.” (Emphasis mine)
So there you have it. People who’ve got a lot more economic chops than I have are saying that the underfunding of Illinois’ pension plans isn’t just cavernous, it’s dire to the point of hopeless. But since the State can’t file bankruptcy, what’s to be done? Tune in to the next installment.