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June 2, 2010

Inside the State Pension Crisis

Throughout the last decade or more, Social Security has been increasingly discussed as a huge “time bomb” in our society’s fiscal and retirement planning.  Now, however, a tsunami of equal magnitude may be arising in state public pension funds.  How did this happen?

The pension payouts that state employees get when they retire are not investments, they are promises.  Basically, state legislatures decided to promise a certain percentage of return (varies from state to state) without having an actual strategy on how to get the money.  Public pension funds invest in stocks and bonds, but they usually return much less than the seven to ten percent that state legislators promise.  Over the past several decades, these funds were increasingly supplied with taxpayer dollars.  Now, state governments employ so many people and money is so hard to come by (a la recession) that funding shortages have started.
“Public pension promises are huge and, in many cases, funding is woefully inadequate.” From a 2008 Letter to shareholders by Warren Buffet.
A Bloomberg article recently pointed out that public pension funds (from state and local governments) could cause the federal government to pass another $1 trillion bailout.  The article added that retirement fund administrators are writing up the amount of pension funding that is actually available.  Most estimates have the nation’s public pensions with about $2 trillion in assets and $2.9 trillion in liabilities, however the asset valuation could be bloated while the liability estimates could be low.  As an example, some claims have a $500 billion shortfall in California’s pension system alone.
Therefore, the scale of the problem could actually be larger than the $1 trillion estimated.  Unfortunately, there appears to be other problems related to the size of these funds.  The biggest of these problems are unnecessary waste.  Waste, in this case, is defined as paying people six figure pensions when they retire at ages 45, 50, etc.  These people are still alive and collecting massive pensions when the next generation retires.  The growing group of retirees and the shrinking group of the workforce is increasing the pressure on the workforce to fund the public pensions through their tax dollars.
Examples of outrageous public pension plans:
Some states are turning to bond sales to fund pensions, however, this causes a new long-term problem.  As we have learned from debt management, heavy bond borrowing leads to high interest payments.  If states borrow money only to spend it immediately in funding their pension plans, the taxpayers will be left to pay back the entire bond issuance plus the interest rate.  The taxpayers are actually better off paying off the shortfall (through a one-time tax increase) up front.
States need to stop promising rosy retirements.  The state needs to fund pensions as part of the benefits package of hiring individual state employees.  State employees should be required to make their own contributions to their retirement.  Then, a minimum age (between 62 and 67) needs to be set to collect on retirement accounts. 
Whatever the market returns is what your retirement fund ends up being, not what some state legislator promises 20, 30, or 40 years down the road.  If you eliminate the promises, you eliminate the short-funded possibilities.  When the fund shrinks, people get less.  When the fund grows, people get more.  If state employees don’t like it, they are more than welcome to start their own 401k or IRA in order to offset the state’s problems.  This is what the rest of the real world does.

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