'Something's Got To Give': Massive Pension Fund Shortfalls Threaten To Bankrupt States

06/05/2010 05:12 am ET | Updated May 25, 2011

State governments have already been slammed by the recession, but there's an even more massive financial threat looming in the form of immense projected shortfalls in public-employee pension funds -- in some cases so big there is literally no way the states can make them up anytime soon, even if they tried.

Chronic underinvestment (particularly in the bubble years), poor management of assets before and during the financial crisis, and, in some cases, unfunded benefit increases have put many pension funds wildly out of balance.

But state taxpayers are contractually obligated to make good on the retiree benefits -- even as those promises threaten to crash headfirst into obligations to pay for schools, public safety, health care and the like.

"Something has got to give," says Joe Nation, the director of a Stanford University graduate program that is reporting today that the cumulative shortfall from California's three giant pension funds alone is somewhere around $500 billion.

Not only is that considerably more than the state is currently projecting, but it's almost six times the state's entire general fund budget. In other words, it would take California six years -- with no spending on education, public safety, health care or anything else -- to fill the gap.

"What is so alarming is there is no way that the state will be able to meet these obligations," Nation tells HuffPost. "The odds are so heavily stacked against the state on this one. The question is how we dig out of this."

It's a profoundly grim situation across the nation, for everyone involved -- with the usual exception. A new analysis by the New York Times concludes that the nation's 10 largest public pension funds have paid private equity firms more than $17 billion in fees since 2000, without reaping the rewards they were promised.

So that's where some of the money has gone.

Indeed, pension fund administrators, far from investing with great caution as would seem to befit their calling, have instead contributed greatly to the explosive growth of private equity firms -- the folks who the Times dubs the "kings of corporate buyouts."

And now that times are tough, the pension funds are actually doubling down.

A report titled "The Trillion Dollar Gap" from the Pew Center on the States last month called renewed attention to the pension shortfalls. The title reflects the gap "at the end of fiscal year 2008 between the $2.35 trillion states had set aside to pay for employees' retirement benefits and the $3.35 trillion price tag of those promises."

But as NPR and others noted, that $1 trillion figure is unrealistically low.
Experts like Joshua Rauh, an associate professor of finance at the Kellogg School of Management at Northwestern University, say pension funds are using exaggerated assumptions about investment returns.

"Our calculation is that it's more like $3 trillion underfunded," Rauh told NPR.

The Stanford report, for instance, concludes that the California pension funds have been using an inappropriately high "discount rate" to calculate future liabilities, and uses 4 percent instead. (The report also reflects the three California funds' $110 billion -- or 24 percent -- loss in portfolio value between mid-2008 and mid-2009. But if the portfolios have continued to more or less mirror the performance of the Dow, they have likely gained back much of that loss by now.)

The Wall Street Journal reports that the General Accounting Standards Board, the accounting board for governments, is likely to force states to publicly adjust their calculations to reflect more realistic expected returns.

"If the modifications are approved, many already cash-strapped states and municipalities would likely have to increase the amount they are supposed to pay annually to their pension funds to help cover the shortfall," the Journal noted.

How have the states gotten into this mess? As the Pew report puts it, the predicament "reflects states' own policy choices and lack of discipline." Political pressure, in particular, often leads elected officials to cut payments to the fund during boom years, since they're doing so well. Then during a recession, when the funds' needs become more apparent, there's no political will to further worsen the budget picture by increasing payments.

And it's not just states, either. The Civic Federation, a Chicago-based group that keeps tabs on state and local government finances, recently determined that the shortfall for ten major Chicago-area public pension funds reached $18.5 billion in fiscal year 2008, or about $5,821 for every Chicago resident.

So what are states doing about it now? It's all over the map. Illinois just rushed through a massive pension reform bill, which dramatically cuts pensions for future employees (though it doesn't do much about the existing shortfalls); Connecticut State Comptroller Nancy Wyman is simply delaying $100 million in payments to the state pension fund to help make ends meet; Merrill Lynch said last week that New Jersey's pension fund (and other) shortfalls are so serious, its bond ratings should be lowered.

A major factor underlying these shortfalls is that state (and some local) governments are virtually the last refuge of the defined-benefit pension.

Workers in private industry and the federal government generally get defined-contribution pensions, like 401(K)s, where money is put into a private account -- and whether its value goes up or down is the worker's problem. By contrast, defined-benefit pensions promise retired state employees a specific amount -- averaging somewhere around $20,000 for current retirees -- regardless of how well or poorly the economy and the market are doing.

And it is not fair to blame the employees, said Jon Shure of the Center on Budget and Policy Priorities. In fact, quite the opposite. "We have to fight to get economic security back for private sector workers, rather than have the debate be how can we take it away from the few people who have it in the public sector," he said.

Worries about the shortfalls can be exaggerated, he said. "It's a big number, but it's not due right now," he said. Policymakers, meanwhile, should not "succumb to people who are using this as an excuse to promote less of a role for government in their workers' economic security."

So what should states be doing? "The alternative is not a very sexy alternative," Shure said. "It's to stop pretending you can meet all your obligations and cut taxes at the same time."

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Dan Froomkin is senior Washington correspondent for the Huffington Post. You can send him an e-mail, bookmark his page; subscribe to RSS feed, follow him on Twitter, friend him on Facebook, and/or become a fan and get e-mail alerts when he writes.