We are just a couple of days past a ten-year anniversary. On July 11th 2000, then-Governor Pataki signed one of the biggest of the recent pension enhancements. Comptroller Carl McCall had pushed for some of the changes, which had passed the legislature several times without any votes against but had previously faced Pataki vetoes, and New York City Mayor Giuliani had pushed other changes as part of a deal he had cut with the public employee unions. Pataki, Giulani and McCall, all looking for support (or neutrality) in runs for higher office at the time, claimed that the pension enhancements (which will be discussed in the next post) would cost absolutely nothing. Because the pension law passed in 2000 asserted that from the high point of the biggest stock market bubble in history, the New York State and New York City pensions funds would earn an additional 8.0% per year on average into the future, not the 7.0% that had previously been assumed. New York State and its local governments, and those throughout the country, had already cut the amount that was being contributed to the pension plans based on high stock prices, to levels below what my model finds would be required to pay for the pensions. So how accurate has that 8.0% rate of return assertion turned out to be, and what are the consequences?
Well, according to Yahoo Finance, the S&P 500 stood at 1,481 on July 11th, 2000. Given that not all pension fund money is invested in stocks, and bond yields tend to be lower, to meet an 8.0% overall annual return stocks would have had to have risen more, say by 9.0%. Which would have brought the S&P 500 to more than 3,500 ten years later. But in fact, the S&P 500 stood at just 1,077 on July 11, 2010, less than one third the predicted value. And according to mutual fund company Vanguard, its S&P 500 index fund averaged a return of minus 1.67% during those ten years, no surprise given how high prices were at the start of the period. Not plus 8.0% or 9.0%. Its bond index fund averaged 6.2% during the past ten years. So how did such a wildly incorrect estimate of future returns work out for those involved in the 2000 pension deal? Splendidly! Because based on that expected return they seized for themselves a huge chunk of our future well being, and hid the cost by putting it off.
To understand how this magic occurred, return to the Excel file attached to this post, and tab to the “underfunded” worksheet. As discussed previously, based on a reasonable expected return of 4.0% more than inflation, New York’s state and local governments would have had to consistently contributed 8.8% of payroll to the pension funds of most public employees, 13.2% for those in physically taxing titles, and 28.7% for police and firefighters, just to pay for the pensions that had been promised when most of those now approaching retirement were hired. Without any subsequent deals such as the one signed into law on July 11th, 2000.
That is based on a 5.8% rate of return. But what if the rate of return were assumed to be 8.0%?
Then for most public employees just 10.25% had to be put into the pension funds, and with the employees having been required to put in 3.0% based on what they were promised when they were hired, that leaves just 7.25% for the taxpayer. Not 8.8%. The taxpayer would be contributing 35.7% less to the pension funds during a worker’s career. For physically taxing titles, just 13.3% would be required to be deposited, leaving 10.3% for the taxpayers, not 13.2%. That is also a 35.7% reduction in the taxpayer contribution. And for police and fire just 23.55% would be required, leaving perhaps 22.8% for the taxpayer, not 28.7%. The taxpayer would be contributing 31.5% less. Lots of tax dollars could then be used for other things. Like special tax breaks and special member item grants. Or pension enhancements.
So does a higher expected rate of return mean that state and local governments have lower pension liabilities, and a lower expected rate of return, which the Government Accounting Standards Board (GASB) has called for, mean higher pension liabilities? Bloomberg News seems to think so. “Pension-forecasting proposals from the rule-making organization, released June 16, would revise methods for projecting liabilities and investment returns. The changes mean estimated investment income likely will be reduced from current assumptions and unfunded liabilities will increase, Moody’s Investors Service said July 6 in a report.” But it isn’t so. The actual liability is the pensions that were promised. What the expected rate of return affects is when the liabilities are paid for, now compared with later. By increasing the expected rate of return, pension contributions experience time travel – from the past when the public services were provided, to the future that no one in the United States seems to care about until it arrives.
What happens when the rate of return turns out to be more like the 5.8% (4.0% over inflation) that I believe is reasonable to assume, not 8.0%? At the time of retirement, the spreadsheet shows, for a Tier IV NYC teacher (or another worker with a similar earning pattern) nearly $80,000 too little would have been set aside to pay for their pension, or 15.0% less than was actually required. That amount would have to be made up later. The deficiency would be $77,000 for an employee in a physically taxing title with a Department of Sanitation salary pattern, 18.0% less than was actually required, and $151,176 for the NYPD, or 22.1% too little.
But the actual deficiencies New York faces are far greater than that. In the years leading up to the year 2000, New York’s state and local governments had been contributing less and less to the pension funds because stock prices went up faster than the 7.0% expected pension investment return in force before 2000. For several years, then-Comptroller Carl McCall did not require any employer contributions to the pension funds on behalf of regular employees of local governments in the rest of the state. Zero is a lot less than 8.8% of payroll. Mayor Giuliani slashed the city’s contributions to its pension funds as part of the 2000 deal to make those pensions richer, a combination that makes absolutely no sense. In 2000, according to the annual report of the police retirement fund, the city’s contribution to the fund was just 10.0% of payroll, not 28.7%.
Putting off costs makes perfect sense to New York’s political class, which represents the sort of people who have been cashing in and moving out, and public employees in particular. By the time the bill comes do they may have died off, or retired to a lower tax state, and/or started collecting retirement income instead of paychecks. Retirement income that is exempt from New York’s state and local income taxes no matter how high that income is, if you are an ex-public employee (or state legislator), no matter how young you have retired. In other words, someone else, someone in a younger generation, would have to pay higher taxes and/or face service cuts to make up for what older generations decided to promise themselves but not pay for. Just like all those government debts that were run up at the same time. Just like Social Security. And that is exactly what is happening. And it is not an accident.
In defense of their de-funding of the pension system, some pols have asserted that legally they can’t contribute more to over-funded pension plans, but that is a flat out lie. There are federal limits on what corporations can contribute to over-funded pension plans, because the contributions reduce their corporate income tax liabilities, but state and local governments pay no corporate income taxes, and are not bound by those rules. (In fact, if state and local governments were required to follow corporate rules, they would be required to kick in to their pension plans based on their actual past investment returns, not the 8.0% fantasy).
Moreover, whether or not a pension plan is overfunded depends on the expected future rate of return. If, in 2000, that expected future rate of return was slashed based on the fact that stocks were overpriced, then the pension funds would not have seemed over-funded. That is exactly what should have been done.
And, of course, the excess returns of the 1982 to 2000 period were followed by extremely weak returns during the past decade. Returns that have been nowhere near the 5.8% per year in the model I created, and may not get there for another decade. Our debt bubble was similar to that of Japan. The Nikkei stock index peaked at nearly 39,000 in early 1990 according to Yahoo Finance, but stands at just 9,550 today – it is down more than 75 percent after 20 years. And Japanese executives are not systematically pillaging their companies through excess executive compensation the way U.S. executives are. (With much of the cost of that compensation deferred so people don’t realize how low future corporate earnings are likely to be, and a growing share of it in the form of massive “supplemental” pensions). The previous downcycle for U.S. stocks, moreover, lasted 18 years from 1966 to 1982, for numerists.
By the way, what assumed rate of return does GASB propose? According to Bloomberg News it “proposes using the expected return on a basket of high-quality municipal bonds, which would produce a deficit somewhere between the high and low estimates. The Bloomberg Fair Market index of AAA-rated municipal bonds ended yesterday yielding 4.38%….Every percentage point drop in the assumed rate of return would increase reported pension underfunding by between 8 percent and 12 percent, according to Moody’s.” Well that’s a little harsh. After all, after the coming wave of municipal defaults I’m sure local governments, almost none of which are high quality, will be paying much higher interest rates on their debts than that.
So past and present underfunding by taxpayers is responsible for a share of the pension catastrophe. In some states, where nothing was put into the pension plans for years, that share is large. But for New York City I was surprised that for a typical employee the pension shortage created by an expected return of 8.0% rather than 5.8%, according to the model in the spreadsheet, was as small as it was. The pension enhancements, the subject of next post, caused far more damage.
Looking back to 2000, it is clear that we had a mania, easily identified as such by those outside it, one that people with power took advantage of. With stock prices having soared for reasons that had little to do with them, a generation of corporate executives, as members of corporate boards, awarded each other a soaring share of U.S. private sector wealth. And public employee union officials and the state and local politicians they kept in office shifted what should have been pension contributions to tax breaks and other deals, while radically enriching their generation’s retirement benefits above what had been promised, claiming higher investment returns would pay for it all.
The executives didn’t admit that their excess compensation would in fact be paid for through lower wages and benefits for other private sector workers and lower returns for investors, often through stock dilution as stock options were exercised. And unions and politicians didn’t admit that the pension enhancements and pension funding reductions back then would be paid for in huge tax increases and drastic reductions in public services and benefits down the road. But that is what is happening.
How does the pension actuary who writes for Governing magazine see the future? He doesn’t’ see bankruptcy, as I do. Instead a “more likely scenario” is a “decade-long reduction of public services, chronic hiring and salary freezes, bigger payroll deductions for employees that reduce their real wages, and withering confidence in state and local government as a result of the ballooning costs of retirement plans and unsustainable benefits” ending with the “ultimate demise of public services to pay for over-promised retirement benefits,” something “we don't need to be melodramatic or hyperbolic about it.” He must not use public transit, seldom go to public parks, expect to be able to pay for his grandchildren to attend private schools, not need the public old-age benefits he is paying for, and live in a gated community, because otherwise he would surely be as “melodramatic or hyperbolic about it” as I am.
And here is what is amazing. Even with the disasters of the past decade, the dot.com crash, the earnings fraud scandals, the huge reductions in interest rates to ward off deflation, the stock price decreases, the government bailouts funded by massive federal debt, the assertion that for younger generations only Social Security and Medicare will have to be cut – they are still doing the same deals! The assumed investment rate of return on public employee pension fund investments is still 8.0%. Executive pay consultants still assert that executive pay should be just as high, as if justified by the wealth the executives create. And new pension enhancements continue to pass the New York State legislators, allowing public employees to walk out the door to a life of leisure years earlier. Each and every year.
The rationalization is long gone. And yet they kept grabbing, and mouthing the same nonsense, or trying to hide and defer the costs. Are they really delusional enough to lie to themselves about what they are doing, and what the consequences for other people are? Or do they just not give a damn?