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[quote="Barron's"]The $2 Trillion Hole

MONDAY, MARCH 15, 2010

[img]http://barrons.wsj.net/public/resources/images/BA-AS265A_pensi_D_20100312162248.jpg[/img]

LIKE A CALIFORNIA WILDFIRE, populist rage burns over bloated executive compensation and unrepentant avarice on Wall Street.

Deserving as these targets may or may not be, most Americans have ignored at their own peril a far bigger pocket of privilege -- the lush pensions that the 23 million active and retired state and local public employees, from cops and garbage collectors to city managers and teachers, have wangled from taxpayers.

Some 80% of these public employees are beneficiaries of defined-benefit plans under which monthly pension payments are guaranteed, no matter how stocks and other volatile assets backing the retirement plans perform. In contrast, most of the taxpayers footing the bill for these public-employee benefits (participants' contributions to these plans are typically modest) have been pushed by their employers into far less munificent defined-contribution plans and suffered the additional indignity of seeing their 401(k) accounts shrivel in the recent bear market in stocks.

And defined-contribution plans, unlike public pensions, have no protection against inflation. It's just too bad: Maybe some seniors will have to switch from filet mignon to dog food.

Most public employees, if they hang around to retirement, can count on pensions equal to 75% to 90% of their pay in their highest-earning years. And many public employees earn even more in retirement than their best year's base compensation as a result of "spiking" their last year's income by working ferocious amounts of overtime and rolling in years of unused sick and vacation days into their final-year pay computation.

A survey by the watchdog group California Foundation for Fiscal Responsibility found that some 15,000 Golden State public employees are knocking down $100,000 or more, while some 200, mostly police and fire chiefs and school administrators, are members of the $200,000-a-year-and-up club.

THE PROSPECTS ARE BLEAK for many state and local governments as a result of all this. According to a survey last month by the Pew Center on the States, a nonpartisan research group, eight states -- Connecticut, Illinois, Kansas, Kentucky, Massachusetts, Oklahoma, Rhode Island and West Virginia -- lack funding for more than a third of their pension liabilities. Thirteen others are less than 80% funded.

Governments could fill that gap by raising property, sales and income taxes, but most are wrestling with huge revenue shortfalls in trying to balance their budgets.

The more likely outcome is dramatic cuts in essential services, such as police and fire protection, health spending, education and infrastructure improvements, in order to cover ballooning pension payments. State and municipalities, after all, must do something: Most have a legal obligation to pay out earned pension benefits. And some don't even have the courage to switch new teachers, bureaucrats and police to a defined-contribution system, to prevent the funding problem from worsening as time rolls on.

THUS, MORE DEBT DEFAULTS and bankruptcy filings probably lie ahead, unsettling the $2.7 trillion municipal-bond market. The possibility of taxpayer revolts and likely insolvencies has shaken some investors' confidence in general-obligation bonds -- those backed by the "full faith and credit" of the states or localities. Once the gold standard for munis, GOs are under a cloud in financially troubled areas.

The size of the legacy-pension hole is a matter of debate. The Pew report puts it at $452 billion. But the survey captured only about 85% of the universe and relied mostly on midyear 2008 numbers, missing much of the impact of the vicious bear market of 2008 and early 2009. That lopped about $1 trillion from public pension-fund asset values, driving down their total holdings to around $2.7 trillion.

Other observers think the eventual bill due on state pension funds will be multiples of the Pew number. Hedge-fund manager Orin Kramer, who is also chairman of the badly underfunded New Jersey retirement system, insists the gap is at least $2 trillion, if assets were recorded at market value and other pension-accounting practices common in Corporate America were adopted.

Finance professors Robert Novy-Marx at the University of Chicago and Joshua Rauh of Northwestern University asserted in a recent paper that the funding gap for state pension plans alone might exceed $3 trillion, in part because state funds are using an unrealistic long-term annual investment return of 8% to compute the present value of future payments to retirees, as is permitted in government standards for pension-fund accounting.

This establishes a "false equivalence" between pension liabilities and the likely investment outcomes of state investment portfolios, which are increasingly taking on more risk by beefing up their exposure to stocks, private-equity deals, hedge funds and real estate. Using a much lower expected return -- say, one at least partially based on the riskless rate of return on government securities -- would both properly and dramatically boost the present value of the pensions' liabilities while decreasing their likely ability to meet them. The academic pair, using modern portfolio theory, claim that state funds, as currently configured, have only a one-in-20 chance of meeting their obligations 15 years out.

MAKING THE STATE AND local pension problem all the more trying is that government entities can do little to wriggle out of their exposure, even if spending on essential services is threatened. The constitutions of nine states, including beleaguered California and Illinois, guarantee public-pension payments. And most other states have strong statutory or case-law protections for these obligations. "One shouldn't be surprised by this, since state legislators, state and local judges and the state attorneys general are beneficiaries of the self-same public pension funds that they've done so much to promote and protect," Orin Kramer notes wryly.

True, a dozen or so states, including New York, Nevada, Nebraska, Rhode Island and New Jersey, are attempting reforms such as raising retirement ages, cutting pension-benefit formulas, boosting employee contributions, curbing income "spiking" and partially switching employees to less costly defined-contribution plans. But these changes affect almost exclusively new employees and do little to solve the existing funding gap.
...
(To read the full article via Google, 
http://www.google.com/#hl=en&source=hp&q=The+%242+Trillion+Hole&fp=1&cad=b)

http://online.barrons.com/article/SB126843815871861303.html#articleTabs_panel_article%3D1[/quote]

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