State Pensions Built on Rosy Expectations

February 8, 2010

For release noon Tuesday Feb. 9 and thereafter (754 words)

Each time Indiana promises future payments to a state employee, it creates a liability for taxpayers. If total monies in state pension funds, accumulated each year by employer and employee contributions, are insufficient to meet promised benefits, state constitutions generally provide explicit guarantees that public pension commitments will be paid in full. Also, state employees could make it difficult for politicians if promised benefits are impaired. If promised benefits become a hardship, Indiana could apply to the federal government for assistance, as California has done recently.

Before evaluating Indiana state-wide pension commitments, let’s look at pensions from an individual’s point of view. 

No doubt, most of our parents holding jobs outside the home were offered “defined benefit pensions.” This means each year after retirement they receive some dollar amount, generally based on some percentage of their working salaries loosely adjusted for inflation. Most private and government employees now are offered “defined contribution pensions.”  This means that the total amount accumulated at retirement, including employer and personal contributions, has to last us through our final years.

Let’s assume that it takes about $40,000 to keep our household operating each year, and that we can count, please God, on approximately $15,000 in Social Security benefits. Therefore, in retirement, we will need to withdraw about $25,000 each year out of our accumulated pension funds to supplement Social Security.  Assuming that we will live about 20 years beyond retirement, a very crude estimate would be to simply divide the total balance we have in our pension fund at retirement by 20 and hope the amount exceeds $25,000. But this ignores the fact that in retirement we will continue to earn interest on the fund balance. How much would we need in order to meet our $25,000 goal? 

The mathematics of this problem is quite messy, but my software package comes to the rescue.  

Most of us, including Ben Bernacke, chairman of the U.S. Federal Reserve, are clueless about the yearly return we can expect to earn on accumulated pension funds. It could be 5 percent, or 3 percent, or 1 percent a year, or whatever. Let us know immediately if you can guarantee us an 8 percent return. If fact, during the past two years, most of us with “defined contribution pensions” saw not an increase but a decrease in our balances.

But let’s maintain optimism. Using the present value formula in my software, if the expected interest rate were 5 percent, we would need to have $312,000 at retirement to withdraw $25,000 from our pension each year for 20 years. We would need $372,000 at 3 percent, and $451,000 at 1 percent. (This is getting complicated.) And, what if the cost-of-living increases due to inflation? And, what if our taxes increase?

Now we return to guaranteed state pensions. Those state employees with “defined benefit” pensions, indexed for inflation, can concentrate on living a long life and need not worry about interest rates or fund balances. Admittedly, the state could default or lower the formula for benefits, but most of us do not expect or wish this to occur. However, the ordinary taxpayer does have to be concerned if Indiana’s state employment funds are not accumulating assets sufficient to meet defined benefit commitments. 

Two economists, Robert Novy-Marx and Joshua Rauh, calculated the present value of “defined payment pensions” for each state and compared them with pensions assets accumulated. They then ranked states, all of which had significantly underestimated, according to this study, the present value of promised payments to those enrolled in their “defined benefit pensions.” This is one ranking in which you want to be near the bottom. Indiana, with two “defined pension plans,” is ranked 36 out of 50 states. At the end of 2008, Indiana held 15.5 billion dollars in two pension funds. The state of Indiana estimated the present value of these future commitments at 36.4 billion dollars; the researchers estimated them  at 62.4 billion dollars; the gap between the value of the pension fund and the higher estimated commitments exceeds three times the amount of Indiana’s tax revenue collected each year.   

Why would states underestimate future commitments to certain groups of state employees? Part of the reason is that current pension-fund accounting rules permit the states to focus on returns from the expected value of future earnings rather than on current balances. The states’ estimations are approximately correct if accumulated state pension funds were to be invested in assets expected to earn on average 8 percent in yearly returns. On the other hand, the Novy-Marx and Rauh study estimates calculate the present value of future a state’s commitments by using the interest rate on U.S. Treasury notes, a rate considerably lower than 8 percent but one considered risk free. 

At a minimum, we should expect Indiana to be sensitive to risk and different rates of return.

Now, how does all this affect the ordinary Indiana taxpayer approaching retirement? First, given the uncertainly of state pension plans to meet future benefit payments, a resident could compensate for the uncertainty of his or her future tax obligations and balance total risk by placing personal funds in low-risk assets earning lower returns. Second, a resident could save more to enable him or her to pay the needed tax increases to better fund or rescue state pension funds.  Finally, if Indiana in the future limits commitments, he or she can count on a good number of Hoosier neighbors working long enough to assist them in bearing the burden.

Maryann O. Keating, Ph.D., an adjunct scholar of the Indiana Policy Review Foundation, is co-author of Microeconomics for Public Managers, Wiley/Blackwell, 2009.


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