The combined debt held by U.S. public pension plans will top $1.7 trillion next year, according to a just-released report from Moody’s Investors Services.

This “pension tsunami” has already forced towns like Stockton, California and Detroit, Michigan into bankruptcy. Perhaps no government mismanaged their pension as badly as Puerto Rico, where a $43 billion pension debt forced the commonwealth to seek protection from the federal government after having defaulted on its obligations to bondholders — a default which is expected to spread to retirees in the form of benefit cuts.

Pension Plans
Photo by stevepb (Pixabay)
Pension Plans

While the disastrous outcome of Puerto Rico’s pension plan — which is projected to completely run out of assets by 2019 — represents the worst-case scenario, the same series of events that led to its demise can be found in most public pension plans nationwide.

There are three primary culprits that can be found in nearly every state suffering from a public pension crisis:

  1. The use of accounting gimmicks that are designed to shift costs onto future generations — an approach outlawed for private pension plans and rejected by both public and private plans in Canada and Europe.
  2. Lawmakers, acting in their political self-interest, who have catered to the past demands of government unions to enrich their members’ benefits while passing the costs onto future generations.
  3. A broken governance structure where public pension board members are actually penalized in tangible ways for acting responsibly, and are rewarded by choosing to delay the day of reckoning.

[drizzle]Perhaps the most concise assessment of public pensions came from the former chief actuary for the nation’s largest public pension fund — CalPERS — who noted simply that: “Politics and pensions just don’t mix.”

And it’s not just “liberal” states like California who have succumbed to the siren call of public pensions. My home state of Nevada — historically thought to be a bastion of limited government thought — is in a proportionally deeper hole than our California neighbors!

The Trouble in Nevada

While most financial experts are warning of future teacher shortages, decaying roads, higher taxes and cuts to public safety, the Public Employees’ Retirement System of Nevada (PERS) is confident they can avoid all that by doing one simple thing: produce investment returns higher than what even Warren Buffett expects to get!

Because PERS has failed to hit its investment targets over the past 5-, 10-, 15-, 20- and 25-year periods, government workers’ retirement costs have soared to today’s record-high 28 percent of pay (40.5 percent for police and fire officers) — which now consumes more than 12 percent of all Nevada state and local government tax revenue combined.

And as more money is sent to PERS, less is available for salaries, like the only $34,684 offered to new Clark County school teachers last year — almost certainly a driving factor behind the district’s perennial teacher shortages.

What’s worse, over 40 percent of what all government workers — excluding police and fire officers — pay towards PERS is spent on the system’s previously accrued debt, rather than on financing the employee’s future benefits.

Consequently, all new hires are expected to be net losers under PERS — receiving a benefit worth less than its total cost — which, unsurprisingly, will “negatively affect current teacher quality and retention,” according to scholars at the Bureau of Labor and Statistics.

Retirement costs for police and fire officers are even higher: Paying PERS an amount equal to 40.5 percent of their salary means fewer cops on the street.

The Las Vegas Metropolitan Police Department, for example, has sat on roughly $100 million in funds explicitly designated for hiring new cops for over a decade now — likely anticipating the future explosion in retirement costs to come. In fact, despite the surplus, Metro is pushing for yet another tax hike, citing their ever-increasing personnel costs.

But that was just the tip of the iceberg.

PERS debt is projected to explode over the next decade, rising from roughly $11.4 billion to over $38 billion if the average 5.85 percent annual investment return forecast of the consultant hired by PERS — Wilshire Associates — is accurate:

To put that in perspective, in 2013 Nevada spent less than $3 billion on police, highways, and fire protection combined.

Servicing a debt of this size would require similarly massive increases in contribution rates, inevitably requiring lower wages for government workers, cuts to vital services, and higher taxes.

At that point, it’s likely that there would simply not be enough taxes to hike and services to cut to make PERS solvent — leaving no other choice but to cut the benefits promised to retirees.

In order to avoid that fate, and save PERS, Nevada lawmakers must act with the urgency that this situation demands.

How We Got Here

PERS is different from retirement accounts in the private sector, where workers’ contributions are deposited directly into individually owned accounts.

In PERS, workers’ retirement contributions are all pooled together in one large fund, with members promised a fixed future benefit based on salary and work experience — similar to how Social Security works.

Consequently, PERS must make a series of projections to determine how much workers must contribute in order to ensure their promised, future benefit is fully funded. One of the most significant projections PERS makes is its assumed 8 percent annual investment return.

In other words, PERS would consider a $10 payment due in 30 years as fully funded with only $1 today — as the expected gains from investing that $1 would bridge that $9 gap over time.

Unfortunately, if PERS investments underperform that target, taxpayers and government workers must bail them out via higher contribution rates.

But using expected investment returns to discount guaranteed future benefits amounts to serious malpractice, which is why such an approach is rejected by private US pension plans, public and private plans in Canada and Europe, and 98 percent of financial economists. US public pension plans are the only dissenters from this consensus.

The easiest way to see why this is wrong is to look at what happens by raising that rate. Imagine if the governor and the legislature uniformly demanded the PERS board must immediately pay down the approximately $11 billion unfunded liability it currently reports.

That sounds like an impossible task, right?

But because of the flawed PERS accounting methodology, the board could appear to pay off that entire amount in an instant. All that would be needed is for the PERS investment advisor to claim that instead of an 8 percent annual return, he now believes PERS can return 10.5 percent.

Presto! PERS would have eliminated their entire $11 billion debt, and would actually enjoy a slight surplus to boot!

Of course, their actual unfunded liability — over $50 billion using correct accounting — hasn’t changed.

If that approach sounds fishy to you, you’re in good company.

But given that this is the approach PERS board members employ, they should be extremely vigilant in ensuring their assumed investment return is one that they can confidently expect to hit.

Instead, they ignore both their poor past performance, as well as the projections of their own, hand-picked consultants who are warning that the board’s assumed annual rate of return is far too high.

After a careful selection process, PERS last year commissioned a second-opinion review by Wilshire Associates, which, on August 20, 2015, informed the Board that it

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