Friends tell me that my pride in St. Paul borders on chauvinism, so I usually am pleased when the city is ranked along with Boston, New York, Philadelphia or Chicago. But when a reader sent a scholarly paper by two finance professors that placed St. Paul among the top six cities in the nation with the shakiest pension financing, I was not pleased.
On further investigation, I found the facts were a bit different. The city of St. Paul does not manage its own pension plan. The data used by the finance professors actually was for the St. Paul Teachers’ Retirement Fund. And when officials for the fund were contacted by a reporter when the report first came out in October, they issued comforting, if not entirely convincing, rejoinders to the charge that St. Paul teachers’ pensions are among the worst-funded in the nation.
Regardless of the details, several lessons can be drawn from this brouhaha. First, when academics pull together comparative data on a lot of different entities, whether corporations or units of municipal government, they can be sloppy and make errors. And any time they make such errors, they undermine the credibility of their own study, even if the essentials are correct.
Second, the paper adds knowledge about something we already know, that state and local government pension plans are seriously underfunded and thus the retirement benefits promised constitute a large, in some cases enormous, claim against future taxpayers. The finding that, for example, New York, Chicago and Philadelphia all have unfunded liabilities of $35,000 or more per city household should be sobering to all concerned. Moreover, the authors are correct that current Government Accounting Standards Board guidelines for choosing interest rates ignore risk and thus seriously underestimate any pension obligations evaluated using approved methods.
Yes, local officials in the units of government studied do dispute the researchers’ findings. St. Paul teachers’ fund officials don’t agree that taxpayers in the district really are potentially on the hook for more than $13,000 per household except in the bleakest of possible circumstances. But the paper’s general conclusions that pension managers do not adequately consider risk and variability of return in the investments they make are solid. What we are arguing about is the degree to which public plans are underfunded, not whether they are.
Finally, the study illustrates the broad principle that when one needs to compare two sums of money at different times, the interest rate one uses to make the calculations is critical. In government finance, this applies not only to questions of how much a school district must set aside today to cover pension benefits promised for 10 or 20 years from now, but also to issues like whether the future benefits of a floodway to keep the Red River from inundating Fargo, N.D., justify spending hundreds of millions of dollars now.
The basic problem is familiar to a lot of baby boomers today. The lower the interest rate, the more you have to save today to have a given sum available when you retire.
Moreover, securing higher rates of return inevitably involves talking on more risk. I have a retirement account from a teaching job I left 24 years ago that I allocated conservatively. It has earned a compound return, after inflation, of about 5 percent from 1986 through 2008. But it has earned very little since then. Meanwhile, a friend who had all his money in “aggressive growth” funds barely has his principal.
When times are good, and especially when an asset bubble is inflating, many succumb to irrational exuberance and plan on high returns continuing uninterruptedly. In the same way, corporate and government pension managers who look back at 10 or 15 years or more of 8 percent returns plan on their continuation. But as Nassim Taleb explains in his book “The Black Swan,” irregular adverse events often confound unwarranted optimism.
When a reporter asked a representative of the St. Paul teachers’ fund about issues raised in the report, the official criticized the gloom of economists who don’t anticipate investment returns returning to pre-2008 levels. Call me gloomy, but there are plenty of historical examples of investment returns remaining at very depressed levels for a decade or more. Our country after 1929 and Japan’s extended travail after its bubble burst at the end of 1989 stand out. Moreover, while I know of no formal poll, it is clear that many economists expect inflation-adjusted interest rates to remain depressed for years as we re-adjust after our own financial deep-knee bend. If they do, expect public pension funds to run into trouble more quickly than their cheery managers suggest.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.