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The Public Pension Debate

March 1, 2011

A quick comment today on private version public pensions.

This is a topic I have tremendous passion for so it will be difficult to be brief.    Simply, I support defined contribution plans more than I support defined benefit plans.  Generally speaking, defined benefit plans have their basis in economic optics using assumed rates of return and discount rates which can lead to gross underfunding, and ultimately bail-outs and bankruptcies.

In the Wall Street Journal today, Ms. Jeannette Neumann (see http://on.wsj.com/eUZeD1) writes an article titled “States Mull Shift In Workers Pensions.”  An excerpt:

“….Many government-worker unions oppose a switch to 401(k)-type plans. The debate has become heated in Florida after Gov. Scott called for such a move. Florida’s pension system was 87.9% funded as of July. Doug Martin, legislative director for the Florida branch of the American Federation of State, County and Municipal Employees, opposes abandoning the pension plan and says the costs of switching to a 401(k)-like plan can outweigh the savings for at least 25 years.

A switch can increase the payments a public employer has to make to any pension fund it closes, particularly if the pension is underfunded, which many are. That is because when a fund closes, over time there are fewer workers contributing. The burden can fall on the public employer to make up shortfalls….”

The last paragraph above is outrageous; it defies logic, or at least any rational logic.  It suggests an underfunded (defined benefit) pension fund should not be closed because the funding gap will have to be made up by fewer workers – and then further suggests that the burden would then fall to the public employer (i.e., the taxpayer).  One can only use “Other People’s Money” for so long. Eventually the money runs out.  Leverage only works when it can be paid back and there is a “plan B” for exit.  “Hope” is not an investment strategy.

The root cause must be highlighted.  Even today, public pension plans use an average investment return approaching 8% (coupled with strict investment restrictions limiting the permissible investments to generally higher quality securities which return no where near 8%).  If someone were to guarantee an 8% return (for life),  one would be wise to not only find several lawyers to get this guarantee in writing, but beg and borrow to secure funds to invest in such a return.  When it is determined that the investment assumptions are flawed, and they are, it leads to only one conclusion:  the liability mechanics must change to match the asset.

Without getting too deep in the weeds, GASB (Governmental Accounting Standard Board – the functional equivalent to FASB) has muddied the waters with its various pronouncements surrounding this issue to the point where it is impossible to tell which plans are funded properly and leave the municipalities entirely too much room for interpretation and manipulation.

In short, there needs to be a seismic change in the analysis of public financials.

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