Next year alone, the city will set aside for pensions more than $8 billion, or 11 percent of the budget. That is an increase of more than 12 times from the city’s outlay in 2000, when the payments accounted for less than 2 percent of the budget.
I could see the same thing happening where I live, in Montgomery County, Maryland. At some point, citizens will be paying much of their taxes not for current services but instead to try to keep unsound pension systems afloat.
The core problem is that returns have not tracked with the city’s optimistic projections. In 2012, the city finally lowered its projected return to 7 percent from 8 percent, but after decades of excessive optimism, that left it with a giant hole; the payments had to be stretched out over more than two decades in order to minimize the fiscal hit. Yet this still may not be enough; it’s possible that 7 percent is still too rosy.
And of course, as many people have pointed out, a private firm’s auditors would not sign off on this sort of pension accounting.
“The core problem is that returns have not tracked with the city’s optimistic projections…”
Worse. The core problem is that this is not an open=ended expected returns debate. It is a fairly narrow exercise on what is an appropriate risk-adjusted dicount rate of future liabilities. If the entity’s liabilities are deemed to be GUARANTEED, then the discount rate should be somewhere between UST or the taxable yield of the municipality. Talk about underfunding.
Part of the problem is that both market returns and tax revenues are correlated to overall economic growth, and so the exposure is leveraged instead of hedged.
If you assume high returns and are surprised to the low side, then you would want higher tax revenues to offset the drop in rates. But instead you are also likely to have lower tax revenues than expected, because both expectations are correlated to expectations regarding the overall economy.
By the same token, when pension fund returns fall short of expectations, then in order to fulfill benefit obligations one needs to raise tax rates and take even more money away from working households just at the time that their wages and aggregate consumption would also be falling short of expectations. And then, just like with Detroit, they’ll move the the closet neighboring jurisdiction with less black-hole legacy costs and where they’ll get a better value in their services-to-taxes ratio. And it’s a vicious cycle.
So good times are really good, and bad times are catastrophically, irrecoverably bad without some incredibly positive surprise, the odds of which seem to be diminishing during this era of slow growth and stagnation.
The solution is to formalize government obligations in terms of purchasing conventional financial instruments like annuities. But then making future promises would cost so much today that taxpayers would balk, so it’s politically preferable to encourage voters and beneficiaries to believe someone else will be left holding the bag and that they’ll still have a seat when the music stops.
At 11%, they are getting by cheap.