If you are a current or former state employee in the state of Minnesota, watch out. Your pension depends on hot air, sketchy arithmetic, and the willingness of future taxpayers to make huge sacrifices to cover the deceit, wishful thinking and sketchy math at the heart of your pension system.
According to a recent analysis in the Minneapolis Star-Tribune by Mark Haveman (Executive Director of the Minnesota Taxpayers’ Association), Minnesota’s pension plans, even after recent mandatory increases in employee contributions, are essentially hollow. Even using the state’s extremely aggressive ‘assumed’ rate of 8.5 percent annual return on its investments, the pension fund is about $10.5 billion short of being able to pay off its future obligations. For every $1 the state has promised to pay retired civil service workers and teachers, it expects to have about 79¢. The good fairies and the wood elves are responsible for coming up with the rest of the money.
Most of us think of Minnesotans as a little dour and down, but when it comes to estimating future performance of their investment funds, they turn out to be a bunch of cockeyed optimists: much more Ted Baxter than Lou Grant. Minnesota projects that its investments will average 8.5 percent growth year after year; this is the highest projected rate of return of any state in the country. Using the more common (and perhaps still a bit optimistic) rate of 8 percent, the fairies and the wood elves will have to come up with another $2.9 billion. (In fact, Minnesota’s investments have done pretty well over the years, averaging 9.7 percent over the last thirty years. But those years were an unusually benign period in financial markets; the two longest economic expansions in the US occurred back to back with only a very mild recession in between. Few expect such calm waters ahead.)
The fairies and the wood elves may have to work even harder. There has long been concern among accountants and finance experts that states use skewed assumptions and tweaked numbers to understate the true cost of their pension liabilities. For politicians, this is a convenient Ponzi scheme: they can promise the moon to future retirees and then cook the books to avoid raising taxes to cover the benefits they have promised. Mounting concern about the horrors lurking in the murky waters of state accounting has led to pressure to adopt a national set of accounting standards; if proposed new standards are accepted, most state pension funds will have to face the unpleasant fact that they are even more in the hole than previously thought.
According to this Boston College Retirement Research report (full text available as PDF) the average state pension fund will see its shortfall rise from 23 percent to 47 percent of the funds needed. That money will have to made up from higher taxes, higher employee contributions, lower benefits, or tribute from the fairies and wood elves.
The lesson for public sector employees should be obvious: your personal retirement planning should assume that you will only receive about 75 percent of your state-promised pension benefits. In some states (Illinois and California spring to mind) you are likely to receive even less. The farther you are from retirement, the higher the discount rate you should apply; this is a classic Ponzi scheme, and those who get out early tend to get out ahead. It’s the late investors who lose the most: younger workers and new hires, this means you.
You should also be fighting for defined contribution rather than defined benefit plans. In a defined contribution plan, you pay into your pension fund and the employer matches all or part of your contribution. Your income at retirement will be based on the amount you and your employer put into the fund, and the performance of the assets in which the money was invested. The biggest risk is that poor investments or bad luck could mean that there won’t be as much money as you had hoped.
The other kind of pension plan is known as a defined benefit plan. In these plans, you and your employer pay in, but (in theory) your final pension is based on some formula based on your number of years on the job and your annual earnings. Under some circumstances, these programs can be safer than defined contribution programs because you are protected against investment risk. If the funds in the pension kitty aren’t enough to pay your pension, the company is supposed to make up the difference.
These days, those defined benefit plans aren’t as safe as they used to be. In the old days, companies like Kodak and Chrysler were believed to be safe; in effect your defined benefit pension was a claim on the earnings of a blue chip company. But these days, fewer companies are such safe bets for the long term, and many workers have been hit hard when their past employers folded or, desperate to stay alive, used bankruptcy or other methods to cut pension payouts.
With state governments the risk is that when the funds run short, voters will balk at higher taxes to make up the gap. This is almost certain to happen going forward; states are cutting school, university and health care funding as it is. Voters were never told how much these obligations would cost; they won’t feel responsible for honoring what many will see as fraudulent contracts.
Under modern conditions, for younger workers especially plans where you make contributions matched by your employer are safer bets than defined benefit plans. In defined contribution plans, they can’t touch your money to pay pensions for older workers; in other plans they can suck you dry to keep the better connected and better organized geezers happy. Your union reps and state legislators won’t tell you about this, but it’s true: badly funded defined benefit programs will be looted to pay the oldsters in full as long as possible, and younger workers will be stiffed when the bill finally comes due.
Save more on your own, and fight for defined contribution plans that will let you keep what you save. Otherwise, expect to be eating acorns and drinking bark tea with the wood elves.