More and more people are coming to understand that the huge pension mess confronting more and more state and local governments is at least in part a result of unrealistically high estimates of investment returns, often projected at 8 percent annually by public pension funds, which have missed their investment goals consistently over the last decade. Theoretically, the higher the return from investments the less that taxpayers have to chip in to finance pensions, and the lower the returns, the bigger the bill for taxpayers. Just how much of a difference investment returns make are illustrated in a new study by the Center for Retirement Research at Boston College.
That study notes that funding levels at state and local pensions have sunk to 75 percent in 2011. Not good but tolerable. But that's using the projected annual return of 8 percent annually going forward for all pension funds.
The center also values pension funds using lower (more realistic) rates of investment return, including a "riskless" 5 percent rate that is meant to reflect the fact that government workers have already earned these unfunded pension benefits and state laws require that they will have to be paid. Under that riskless rate, the shape of our pension funds is far worse, with just 50 percent funding on average (see chart above). Under that assumption, about 20 percent of plans have extremely low funding levels, well below 50 percent.
As investment returns languish annual required contributions from governments (taxpayers) rise. Perhaps the most illuminating and distressing chart from the study is the one below, showing that the average ARC of state and local government pension funds has increased from just 6.1 percent of payroll in 2002 to 15.7 percent of payroll last year. Given that local government budgets in particular are made up largely of compensation (60 percent of school budgets are payroll and 20 percent are benefits), the sharp rise in pension contributions is playing a significant role in the budget squeeze being felt by many, many towns, cities and school districts in America.
To take one example. If, in 2002, you were a school district with a $100 million budget, your annual pension contribution would have been, on average, $3.7 million. If, for the sake of argument, your budget increased over the last decade by the rate of inflation, it would stand at $121 million today, but your pension contribution would be $11.4 million at 15.7 percent of payroll. That's $7 million more than you as the district budget officer would have anticipated having to pay based on the projections of investment returns by your typical pension fund a decade ago. That's the price, in other words, that governments on average are paying thanks to benefits granted to public workers based on unrealistic projections of investment returns that politicians were all too willing to believe.
The center also values pension funds using lower (more realistic) rates of investment return, including a "riskless" 5 percent rate that is meant to reflect the fact that government workers have already earned these unfunded pension benefits and state laws require that they will have to be paid. Under that riskless rate, the shape of our pension funds is far worse, with just 50 percent funding on average (see chart above). Under that assumption, about 20 percent of plans have extremely low funding levels, well below 50 percent.
As investment returns languish annual required contributions from governments (taxpayers) rise. Perhaps the most illuminating and distressing chart from the study is the one below, showing that the average ARC of state and local government pension funds has increased from just 6.1 percent of payroll in 2002 to 15.7 percent of payroll last year. Given that local government budgets in particular are made up largely of compensation (60 percent of school budgets are payroll and 20 percent are benefits), the sharp rise in pension contributions is playing a significant role in the budget squeeze being felt by many, many towns, cities and school districts in America.
To take one example. If, in 2002, you were a school district with a $100 million budget, your annual pension contribution would have been, on average, $3.7 million. If, for the sake of argument, your budget increased over the last decade by the rate of inflation, it would stand at $121 million today, but your pension contribution would be $11.4 million at 15.7 percent of payroll. That's $7 million more than you as the district budget officer would have anticipated having to pay based on the projections of investment returns by your typical pension fund a decade ago. That's the price, in other words, that governments on average are paying thanks to benefits granted to public workers based on unrealistic projections of investment returns that politicians were all too willing to believe.
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