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Overvalued and Underfunded: New Jersey’s Pension Time Bomb
September 24, 2010
“Trenton Makes, the World Takes” – the slogan that hangs from the trusses of the Lower Trenton Bridge between New Jersey to Pennsylvania serves as a reminder of New Jersey’s once robust economic history. However, nowadays “Trenton Takes More of what the Taxpayer Makes” is more befitting as New Jerseyans are on the hook for billions of dollars to finance the state’s seriously underfunded public worker pension system.
Public sector pension plans around the country face significant funding shortfalls, facilitated by accounting practices that understate true liabilities. New Jersey exemplifies this scenario as it faces billions of dollars in unfunded liabilities in its five public employee pension funds. The state’s current woes are a result of nearly 20 years of poor decisions based on the bad assumptions. And regrettably, those who will inevitably pay the tab will be New Jersey taxpayers. These are the same people who already face the highest property taxes in the nation: a whopping $7,045 per household for 2009.
The official state estimate in underfunded pension liabilities to New Jersey’s public workers stands at $46 billion. It is one of the highest liabilities in the nation, averaging $5,200 per capita. The estimate is based on an assumed rate of return on pension assets of 8.25 percent – a number determined by the State Treasurer. Herein lies the problem: the interest rate overvalues the pension and results in governments underfunding the plans. This approach – valuing pension liabilities according to what the assets are expected to return in the market is based on a standard set by the Government Accounting Standards Board (GASB) which is followed by all states. Financial economists argue GASB’s recommendation is flawed and that liabilities should be discounted according to the liability’s risk characteristics.
Eileen Norcross of the Mercatus Center highlights this issue in her recent working paper on pensions. She notes that the higher value of the pension from an assumed 8.25 rate of return has another outcome. It alters governments’ spending behavior. Legislators opt to defer payments into the system to pay for other priorities and/or extend benefits under a false assumption the pension is well funded, or that any shortfall can be recouped quickly through more aggressive investment strategies If the state had valued its pensions using methods required by the private sector, which value liabilities according to the likelihood of payment rather than the return expected on the asset, Norcross estimates the state’s unfunded liability at a staggering $176 billion, or $19,867 per capita. To determine this she used a 3.5 interest rate, the yield of a 15 year Treasury bond.
Let’s look at how a higher assumed rate has compounded New Jersey’s pension problem over the years. Starting in the 1990s New Jersey increased the interest rate assumption used to calculate plan liabilities from 7 to 8.75 percent. As a result of a higher assumed rate of return the state and localities reduced their pension contributions by millions of dollars. In addition, reductions in the Cost of Living Adjustment (COLA) assumption and average salary scale led the state to further reduce contributions. These deferrals allowed the state to balance the budget in FY 1995 and dedicate revenues meant for pensions into other areas. The state then proceeded to reduce the amount required for employees to contribute to their retirement. And lastly, adding insult to injury, benefits were extended in 1999 to surviving spouses and subsequently increased further for current and retired workers by 9.12 percent in 2001. The result of these actions: a fund that has consistently been underfunded for the last decade.
Recently, Governor Chris Christie unveiled his plan to address the problem during a series of town hall meetings. His plan, one of the most pro-active to date, calls for changes that would affect all current and future employees enrolled in any of New Jersey’s five pension plans. The plan would raise the retirement age, roll back the 9 percent benefit increase granted in 2001, require all public workers to contribute 8.5 percent of their salaries toward retirement and eliminate annual cost-of-living pension increases for all state and local retirees. Christie’s plan also calls for changing the anticipated rate of return used by the Pension Fund from its current 8.25 percent rate to 7.5 percent.
These reforms would have a significant effect on the liability - and will set a precedent for other states, if passed. Yet, the main driver of underfunding is not addressed: the metric used to value the plan. Calculating the value of the pension by using an assumed rate of return on pension assets of 8.25 (or even the newly proposed 7.5 percent rate) does not take into account the risk free nature of accrued benefits for public workers and is not in line with the average annualized 3.9 percent return for pension funds over the past 10 years. The current method of accounting allows public sector pensions to assume they can earn high investment returns without any risk. Corporate plans use a discount rate based on corporate bond yields. Pensions should adopt a similar measure by basing its expected rate of return on a similarly risk free investment: Treasury bonds. Currently, the discount rate is 3.5 percent on Treasury bonds with a maturity of 15 years.
This lower rate has substantial impacts for pension funding. Lower rates of return increase the unfunded liability of states by billons. For New Jersey it results in an increased liability of $130 billion more over state estimates. Big numbers are a major reason why many in government hesitate before cutting expected return rates. However, the decision over funding needs to be made. Either it’s the state that ponies up the doe or public employees through increased personal contributions.
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