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Commentary By Steven Malanga

Scary Pension Math: Even After Bull Market, Governments Still Owe $1 Trillion

Governance Pensions

Wall Street has only recently ended the third-longest bull market in history. But in July, when stocks were still near their 2015 high, the Pew Charitable Trusts reported that state and local pension debt nationally had barely fallen since 2009, despite years of market gains.

“When pension funds did well in the market, politicians often gave away the gains as new benefits, rather than banking the surpluses. Officials should have known better.”

Now, with markets down more than 12% since summer, new pension debt is piling up rapidly again, putting fresh pressure on budgets. Facing a bleaker outlook, some pension officials are admitting they've underestimated how hard it is to bounce back from volatile market declines like 2008.

Absent some startling development — like an even bigger runaway bull market, which few market watchers anticipate — the crisis will worsen.

At the root of the problem is a change in the financial structure of public pension funds. Whereas in the early days of government pensions governments expected more than half the money to pay benefits would come from taxpayer and worker contributions, pension systems increasingly came to rely on risky investments to pay retirees.

Since 1984, investment earnings have accounted for 62% of the money pensions need, according to a study by the National Association of State Retirement Administrators.

Another problem: When funds did well in the market, politicians often gave away the gains as new benefits, rather than banking the surpluses. Officials should have known better.

After five consecutive years — from 1995 through 1999 — when the S&P 500 advanced by at least 21% annually, many pension funds were fully funded and handing out new benefits. But the bursting of the dot-com bubble in 2000 and subsequent broader market declines proved devastating. By 2003, government pensions had accumulated $233 billion in debt.

Where'd The Money Go?

Governments have made little progress since, especially after the 2008 financial crisis hammered stocks again. Even though investment gains averaged double digits for eight of the years since 2003, including increases in the S&P 500 of 29% (2003), 27% (2009) and 32% (2013), debt has now swollen to at least $1 trillion.

Many state systems have higher unfunded liabilities today than in 2003. Now pension funds must contend with the steep market slide that began last August.

All this points to a future where pension funds can't climb fully back from market declines before another one hits — a version of one step forward, two steps backward.

Part of the problem is missing money. Government pensions lack, on average, 25% to 30% of the money they're supposed to have invested - devastating for systems designed to pay most benefits from returns.

Even when fully funded, government pensions must earn on average 7.7% annually just to stop the accrual of new debt as today's employs accumulate additional benefits. But few systems are fully funded, meaning the pressure on returns is even greater.

In July the Maryland pension announced it had averaged 9.4% returns over five years — well above its projections. Yet Maryland pension debt — $18.6 billion in 2009 — now stands at about $21 billion. The problem: About 30% of the money that should be invested in the market is missing.

Pension officials say they're trying to address the pressure by requiring more contributions, mostly from taxpayers. But total pension debt across the U.S. grew by $670 billion between 2003 and 2013, and in many pension systems debt is substantially greater than a government's entire annual tax haul.

Governments have resorted to pension-repayment plans that stretch 30 and even 40 years - paying off the debt from a single bad year like 2008 over decades. These long amortization plans make it likely that pension funds will experience other major market drops before they've paid off the damage from previous ones.

No Real Improvement

Though more than 40 states report they've reformed their pension systems, many of the changes have been superficial — such as lowering benefits for new workers, which doesn't reduce today's debt. Courts have overturned other reforms.

“Total pension debt across the U.S. grew by $670 billion between 2003 and 2013, and in many pension systems debt is substantially greater than a government's entire annual tax haul.”

Admitting they've overshot their estimations, some pension funds are lowering their horizons. CalPERS staff have told the fund's board they want to gradually reduce the system's return rate, now 7.5%, to 6.5%.

But such reductions to projections do little to slash the $1 trillion or more in current debt. Instead, retirement systems will have to ask taxpayers to ante up even more to pay for lower investment earnings in the future.

That's one reason why in California, for instance, government unions are lobbying to make Gov. Jerry Brown's temporary 2012 tax hike, expiring in 2018, permanent. Much of his tax increase has gone to pensions, and an even bigger bill is coming. Other tax hikes aimed at sending more money to pensions have passed elsewhere.

Facing bleak numbers, taxpayers should demand greater reform. One priority should be eliminating the open-ended liability that defined-benefit pension plans generate, where taxpayers must make up market shortfalls.

Utah, to take one example, has reformed pensions so the state caps its contribution to pensions at a generous 10% of salaries. If more is needed, workers must contribute.

Taxpayers should also seek laws that bar politicians from being able to make key decisions that impact pensions, including manipulating accounting standards to make systems seem better funded than they are.

The biggest impediment to real reform has been the notion that a few good years of investment returns, combined with some additional contributions, will solve most pension underfunding. That's turning out not to be true.

This piece originally appeared in Investor's Business Daily

This piece originally appeared in Investor's Business Daily