If during the past few years of fiscal instability, you consoled yourself with the fact that at least North Carolina’s pension fund for teachers and state employees was sound, I’m going to ruin your day.
Bond-rating agencies and regulators are about to change the system for evaluating state and local pension funds. Rather than use the average stock-market return to estimate the future returns of pension funds, they are going to use the average rate of return on bonds.
This may sound like some boring change instigated by some boring actuaries. But it could have great significance for your taxes, for your retirement planning (if you are a state employee or married to one), and for the business climate of North Carolina.
A pension isn’t a defined-contribution system like an IRA or 401k. A pension is a promise to pay employees a certain amount of money each month after they retire. That’s called a defined-benefit system. To fulfill the promise of future benefits, managers of public pensions direct the money contributed by employees and taxpayers each year into a diverse portfolio of stocks, bonds, and other investments. When a government employee retires, his benefits are financed by those accumulated assets and returns, plus new contributions coming into the system.
If the pension fund proves inadequate to the task of paying promised benefits, North Carolina government has two options. It can raise additional current revenue for the system by sticking current employees and taxpayers with higher bills. Or it can try to cut the retirement benefit (although there are arguably legal and certainly political reasons why this option may prove impossible in the short run).
As you can see, the ability of a pension system to pay promised benefits without excessive cost to employees and taxpayers relies on the performance of its investment portfolio. The more interest, dividends, and capital gains it earns over time, the less vulnerable it will be to cash-flow problems later.
Of course, we can’t know with certainty what those future returns will be. As investment firms are required to remind you, past performance is no guarantee of future results. So officials have to make educated guesses. In the past, managers of public pension funds have assumed a relatively high rate of return – 7.25 percent to 8.25 percent, depending on the state.
These projected returns are almost certainly too high, however. They put too much emphasis on the stock market, despite the fact that lower-risk securities are more appropriate for the portfolios of those close to retirement. In North Carolina, as in most other states, the average age of current public employees is higher than it used to be. We have many Baby Boomers about to tap the system. Even if Wall Street hadn’t been lagging the historical average of stock returns lately – and it has – using stocks as the main benchmark for our public pension funds would be a questionable policy.
Over the past few years, concern about the stability of state pension funds has moved beyond the ranks of professional worrywarts (like me) and spread to the wider financial and political establishment. For some states and localities, the pension crisis has already arrived. They are now spending an exorbitant share of their annual budgets paying retirees for past services rendered rather than paying employees for current services.
North Carolina isn’t there yet. But Moody’s and other agencies are about to make the pension-accounting rules more realistic by using private or even government bonds as the benchmark. Doing so will expose unfunded pension liabilities as about triple what everyone thought they were, at a minimum.
In our state, the probable result will be to add somewhere between $12 billion and $30 billion to our government’s fiscal liabilities. Will our next government and legislature respond by raising taxes by $500 million or more a year to build up future reserves? Will they slash benefits for future workers?
They’ll have to do something. Again, sorry to ruin your day.