Imagine your children go out trick or treating tonight. Your daughter is the world’s cutest cupcake and your son is Iron Man. They canvas the neighborhood, diligently and strategically hitting every house (except the one that gives out toothbrushes). However, upon returning home, they are horrified to find their bags, once bursting at the seams with candy, are nowhere near full. It turns out there was a hole in the bottom, and all the work they put in filling their bags with treats was wasted.
That is Connecticut’s public pension system.
State administered pension systems across the United States are short on funds and piling up debt. According to a recent report from State Budget Solutions, the total amount of unfunded pension obligations accumulated across the country is approximately $5.6 trillion dollars. Connecticut’s share of that total is, staggeringly, more than $99,000,000,000. Even more alarmingly, State Budget Solutions’ methodology pegs the state’s pension system to be a mere 22.8 percent funded, which is the worst funding ratio among the 50 states. The sheer amount of debt, as well as the poor funding ratio, means that every resident of Connecticut is on the hook for $27,653. Only three states have higher levels of pension debt per capita.
The report, titled Unaccountable and Unaffordable 2016, examines one of the key drivers of pension debt: overly ambitious discount rates. Put in the most general terms, public pension systems are funded through some combination of state contributions, employee contributions and investing existing assets for a return.
The state’s necessary level of contribution is determined partially by what employees (public sector workers) contribute, but also what returns on investment the state can expect from the pension fund’s assets. The expected rate of return on current cashflow allows the future debts to be discounted. This is a common practice for all pension systems, public and private.
There is nothing wrong with assuming contributions from the state can be invested for a reasonable rate of return. In fact, not investing the money would bloat a state’s necessary contributions, burdening taxpayers. However, the expected rate of return must not be unrealistically high or the pension plan will be in a perpetual state of underfunding. After all, if performance fails to match expectation, the future debts are not really discounted at all. When investments come up short, individuals managing the funds are incentivized to chase higher returns with riskier investments. If those flop, the process starts again, rinse and repeat.
For example, the State Employees Retirement Fund currently anticipates an 8 percent return on its actuarial assets. The plan met this mark in 2014, but 2013 and 2012 yielded returns of 3.11 percent and 0.39 percent, respectively. This is how pension systems dig themselves into a hole, yet the 8 percent return level is lower than it once was. In 2011 and 2010, when the plan assumed 8.25 percent returns, it got 3.74 percent and 2.57 percent, respectively.
Just like the children filling their candy bags, Connecticut has been meeting its payments for the past few years. This is commendable and responsible behavior. Too many states, fearing the immediate implications of budget crowd-out, choose to pay less than 100 percent of their required contributions. However, the Connecticut pensions systems’ structural problems make even 100 percent payments woefully insufficient. Debt levels are going up, in part because of inflated discount rates.
State Budget Solutions’ methodology is based on achievable returns, as explained in the study.
Given that many plans’ assumed rates of return are too high and invite risk, State Budget Solutions uses a more prudent rate of return, rather than the loftiest goals of money managers. This study uses a rate of return based on the equivalent of a hypothetical 15-year U.S. Treasury bond yield…This year’s number is averaged from March 2015 to March 2016. The resulting rate is 2.344 percent, which is considered a “risk-free” rate. As the Society of Actuaries’ Blue Ribbon Panel recommends, “the rate of return assumption should be based primarily on the current risk-free rate plus explicit risk premia or on other similar forward-looking techniques.”
Since most public pension systems are structured as defined-benefit systems, the state is obligated to guarantee the benefits provided. That is why the methodology requires a risk-free rate of return.
Connecticut has numerous structural issues with its state pension systems, all of which must be examined and likely reformed. Pension rescue has to start somewhere, and budget tricks like inflated discount rates are as good a place as any. If the state’s systems continue to pile on debt, neither pensioners nor taxpayers will be in for a treat.