Public Pension System Heuristics

dont_panicDouglas Adams’ Hitchhikers Guide To The Galaxy famously advised us on the book cover “Don’t Panic,” and I think that’s a useful starting point for discussing public pensions in Texas.

You see, I started by wondering “should we panic?” when I began a personal project of studying public pensions, for a variety of reasonable suspicions, which I’ll share. After sharing my suspicions, I’ll tell you what I think the informed citizen – that’s you and me! – should worry about, and monitor, with respect to Texas pensions. Next week I’ll tell you specifically more about the biggest public pension plans in Texas.

The stakes for these multi-decade math models are particularly high for cities and counties that offer pension plans to employees.

Just ask the folks of Central Falls, Rhode Island (2011), both Stockton and San Bernardino, California (2012), and Detroit (2013), where insufficiently-funded and/or overly generous pensions sent those governments into bankruptcy protection. The City of Chicago is currently engaged in a multi-year game of chicken over its pension benefits. Some see bankruptcy as the future for Chicago, or possibly its public school district.

My suspicions

My first suspicion began because we’re in an environment of extremely – historically significant – low returns from bonds, such as 1 to 2 percent over the next ten to thirty years. Meanwhile, almost all public pension plans in Texas routinely model a 7 to 8 percent annual return over decades. That assumed annual return matters because with even a moderate allocation to bonds, risky assets like stocks have to make up the difference. Stocks and other things in the pension investment portfolios – like private equity and real estate – have to return 10 percent or more on average – every year for decades – just to make up the high returns that bonds can’t. That seems like an uncomfortable assumption over the next few decades. That made me suspicious.

On top of the current market environment, pension plans always represent some of the most complex financial systems in the universe. Complexity makes me suspicious too.

Actuaries, the poor souls charged with solving the math problems to figure out whether pensions will support public workers in old age – or conversely drive governments into bankruptcy – have a lot to keep track of.

Tracking the money going into a pension may at first seem relatively straightforward, depending as it does on employee headcount, employee salaries and contributions, and employer contributions. It gets a little trickier when you have to make assumptions about long-term investment gains – for the next thirty years.

Money paid out of a pension plan, however, really increases the complexity. The easy part of the equation here are the costs of administering a plan. The hard part comes from the fact that payouts generally continue for the life of workers. We don’t know exactly when people will die, so actuaries have to accurately model the expected length of the lives of workers. They also have to estimate when workers will separate from employment, and when they will claim benefits, and how much those benefits will be. On top of that, they have to model such things as dependent-spousal benefits, as well as rates of disability, both of which increase benefit payouts.

Ideally, these actuarial estimates need to work over long time periods. Contributions made to support a thirty year-old worker today may need to fund payouts for that worker fifty years from now. That’s a long time to estimate anything.

It seems analogous to those scientists at the Southwest Research Institute in San Antonio who planned the science behind the New Horizons space probe of Pluto launched in 2006 who then waited for a few seconds of planetary flyby in deep space in 2015. I picture these scientists sort of praying at launch ten years ago, like, “I hope our math works?”

No, pensions are easier (although in some ways harder!) than that Pluto mission, because there’s a political component to public pensions. If the teacher’s or policeman’s fund runs out in ten years, they don’t just throw up their hands and say “whoops, don’t worry about it.” Instead taxpayers – that’s you and me – will pay one way or another to honor previous public pension commitments, even if generally future retirees after that take a hit as well.

So how do we make sure public pensions are on the level, despite their complexity, and despite historically low returns from bonds?

One answer is first, not panicking. And then, vigilance. That’s what former Texas State Comptroller Susan Combs urged through her office with the publication of the 2014 report “Your Money and Pension Obligations,” and the creation of a searchable pensions database.

But how to you continue vigilance in the face of all the complex moving parts of public pensions?

I’m a big fan of that Texas Transparency site. You can see important data online, and I’m here to tell you the three things to look for in that public data.

Heuristics

My frequent answer to complexity: Heuristics! (I love that word.)

I mean, rules of thumb. Here are the three main rules of thumb that pension board members use to figure out whether their plans are healthy or in trouble.

First: Are liabilities (future payouts) at least 80 percent covered by money already in the pension plan? This is called the “Funded Ratio.” If you’re at 80 percent, then you’re pretty good. It doesn’t have to be 100 percent. Less than 60 percent and you’ve got a potential problem.

Second: If you have a shortfall – meaning your future payouts are less than 100 percent funded – then how quickly can you pay down your debts? Is the estimated time to pay off any pension shortfalls between 15 and 25 years? If yes, then according to the Texas Pension Review Board (PRB) you’re probably good. State law (HB 3310) and PRB Guidelines sets up a maximum of 40 years or else they start to get all up in your pension’s grill with reporting requirements and restrictions on benefits.

Third: Are the return assumptions over the next thirty years reasonable?

Reasonable right now means something kind of within the range of what other pension plans assume. NASRA – The National Association of State Retirement Administrators, but you probably already knew that – reports the average return assumption nationally as 7.62%.

As I’ll mention in a follow-up story on Texas’ Big Four Pension plans, three out of four of the state’s biggest pension plans assume annual returns above that average, with an assumed annual rate of return of 8 percent. Sadly, we can’t expect Texas to be the financial equivalent of Lake Woebegone, where all the market returns are above average. I wouldn’t conservatively plan on anybody consistently being able to earn an 8 percent return over the coming decades, especially when bonds return 1 to 2 percent. And even small “misses” on that measure, compounded over decades, can cause huge headaches down the line.

So yeah, I’m worried about that measure for millions of public employee retirees, and then I’m worried for all the taxpayers acting as unwitting backstops to those pension plans.

A version of this post appeared in the San Antonio Express News.

Please see related post:

Dallas Pension Plan – An Example Of What Can Go Wrong

The Big Four Texas Pensions

Houston Pensions – Worth Monitoring

 

 

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I founded Bankers Anonymous because, as a recovering banker, I believe that the gap between the financial world as I know it and the public discourse about finance is more than just a problem for a family trying to balance their checkbook, or politicians trying to score points over next year’s budget – it is a weakness of our civil society. For reals. It’s also really fun for me.

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