Monday, February 28, 2011

This is the Place Between A Rock and A hard place

People are beginning to ask the question, how did Wisconsin and 42 other states find themselves in such serious financial difficulty? In many cases, as I said in the last blog, the states made promises they couldn’t keep. 

Everything starts out with an assumption and if your assumption is wrong and you don’t change it you get deeper and deeper in a hole. The actuaries in the United Kingdom made the assumption that most males under the public pension would die by 76 and females by 82. There was no room in their assumptions for the fact that thousands if not hundreds of thousands of men and women would live past 100. The increased longevity has drained the public funds and now they are looking for ways to solve the problem.

As you can see from the chart at the top of this article the median return for pension funds is 3.42% for the last 10 years. Now compare this to the assumed return that the state pension funds have used for the last 10 years of 8% per year. Benefits are paid in dollars not percentage points. Let’s look at the numbers. We will use $100,000,000 for our example. If over 10 years you actually earned 3.42% then in 10 years on a compounded return you would have $103,112,223. If you were supposed to earn 8% for the same 10-years you expected to have $199,900,463. The shortfall amount between what you actually earned and what you projected you would earn was, in our example, $98,788.240. 
In Sunday’s New York Times magazine supplement an interview with New Jersey Governor Chris Christie revealed the investment performance problem for New Jersey. It had an assumed rate of return of 8.25% and for the last 10 years it has actually earned 2.6%.  One of the other parts of the problem is that for 17 years the State of New Jersey, and in some cases the local governments, have  failed to make their full contribution to the pension plan. Between 2006 and 2009 under the then governor John Corzine 49% of the mandatory increases went to salary and benefit for employees. The auditors now feel that based on the current level of benefits the plan is $100 billion under funded. Richard Keevey who was budget director for both a Democrat and Republican governor said. “You couldn’t tax your way out of this problem.” When you told your retirees that you would pay them based on what you expected to earn, you sell bonds in the market to make the current payments then you have to make the interest payments on the bonds and continue to make the level of payments to the retirees and in some case to increase the payments based on the CPI. 

Another issue that is not being discussed is that most people think that the state funds should reduce their expected return to something more close to what they have actually earned. If they did that over the last 10 years the amount of money that would have to be added to the fund would be astronomical. My guess would be that it would take most of the state revenue to fund the pensions. Now do you understand why nobody wants to talk about the real problem of public pensions and retirement health care? Some governors realize the problem and are looking for the employees to start paying more for their pensions and retirement heath care. The money that will be necessary to fund the shortfall will have to come from both the employee and the local and state governments. If you need 8% in return and you are only earning 3.42%, you are in trouble. The longer you wait to address the problem the faster it grows. We are far from solving this problem any time soon. I’m very concerned that if we don’t get this problem under control the stock markets will be in serious trouble.
Dan Perkins      


Anonymous said...

Dan, compound growth rate of 100,000 at 3.44% for ten years is more than $140,000

Your point is still well taken

Dan Perkins, RIA said...

I received a note that at 3.44% the account had to grow more than 140,000. The 3.42% was a total return which works out to be 34.2 basis points per year. Still better than the S&P 500 but not the 8% assumed.

Dan Perkins