The Pension Crisis Is Bigger Than You Think

08/26/2010 10:37 am EST

Focus: MARKETS

John Mauldin

Chairman, Mauldin Economics

John Mauldin, editor of Thoughts from the Frontline, says state and local pensions are underfunded by $3 trillion, and taxpayers are on the hook for most of it.

I first wrote about public pension problems in 2003, suggesting that pensions would soon be underfunded by $2 trillion, as a long-term secular bear market would dampen returns. Turns out that I am once again proven to be a wild-eyed optimist. 

A report just out from the Center for Policy Analysis, by Courtney Collins and Andrew J. Rettenmaier (solid academic types from Mercer University and Texas A&M, respectively), that indicates that state and local pension funds are drastically underfunded.

"Many state and local government pension plans' liabilities are calculated using discount rates that are not commensurate with the risk they may pose to taxpayers,” the report said.

"Due to the use of high discount rates, the liabilities of state and local government pension plans are underestimated. As a result, taxpayers' role as insurer may be much greater than anticipated."

Turns out that, by the authors' calculations, state and local pensions are underfunded by $3 trillion (with a T). Of course, some states are much worse off than others.

You can read the whole report and see how your state is doing at NCPA.

In most states, the law will not allow for adjustment of pensions. Taxpayers are completely on the hook. That money will be found at the expense of either higher taxes or reduced services (such as health care, roads, or police).

Second, the hole is getting deeper each year. Most pensions assume they are going to get an 8% return on their investments—in a time of a slow economy for years ahead, very low bond yields, and a stock market that I think is still in a long-term secular bear market for another [six or seven] years.

[So,] what if instead of getting an 8% return, total returns were 5%? That would mean the hole would be getting deeper by about $75 billion a year. And what if people lived longer, as is clearly the trend?

Why use an 8% assumption? Because if you used more conservative numbers, as the academic studies suggest, you would have to make larger current contributions to the pensions, when state and local governments and schools are already in fiscal trouble. So what do the pension plans do? They hire "consultants" who tell them they can expect 8%, as shown by all the nice models and papers that back up their "advice.”

This is going to end in tears for many states and municipalities. I mean, real tears. Pension funding in some states will be required by law to consume 25% to 30% or more of tax revenues. That is going to mean much higher taxes or reduced services. I would seriously consider checking how your state and locality are funded. You might not want to retire to a place that is on a collision course with serious pain.

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