Fareed Zakaria Is Really Mad About Public Pensions!

Thursday, 14 June 2012 16:27

We would probably all be mad if we were as confused as Mr. Zakaria. Fortunately, the problem is with his arithmetic, not with the public pensions.

Zakaria seems to have convinced himself that public pension obligations are going to turn state and local governments into future Greeces, but that is not what the numbers show. His column contains one inaccuracy after another.

For example, he tells readers:

"The numbers are staggering. In California, total pension liabilities--the money the state is legally required to pay its public-sector retirees--are 30 times its annual budget deficit. Annual pension costs rose by 2,000% from 1999 to 2009. In Illinois, they are already 15% of general revenue and growing. Ohio's pension liabilities are now 35% of the state's entire GDP."

If we go to the Public Plans database of Boston College's Retirement Center, we find a very different story. The database shows the liabilities of California's two make plans to be $322.2 billion and $196.3 billion for a total of $518.5 billion. If we look at Governor Brown's proposed budget for the coming fiscal year it shows revenue and transfers of $95.7 billion. That means the ratio of the funds' liabilities to revenues is less than 6 to 1, not Zakaria's 30 to 1. [RS corrects me on this point. Zakaria made the comparison to the budget deficit, not the budget. This deficit was originally projected at $16 billion, of course as the state gets the deficit down then Zakaria's ratio will get larger. The point is not clear, but Zakaria is correct.] And, the database shows that the funds are together more than 75 percent funded. (This is somewhat below the 80 percent level that actuaries usually consider acceptable.)

The 2000 percent rise in pension costs from 1999 to 2009 was due to the fact that the pensions were viewed as over-funded in the stock bubble days, which meant that the state had to pay in very little to maintain proper funding. Did Zakaria somehow miss the stock bubble.

The statement about Illinois, that annual pension contributions are 15 percent of general revenue is correct. This is due to catch up after years of serious underfunding. It's not clear why Zakaria thinks the share is growing. Like other states, Illinois' tax collections are still badly depressed due to the downturn. Revenues are likely to grow much more rapidly than pension payments unless the economy falters again.

The statement about Ohio is also true, but it's not clear why it should leave anyone terribly fearful. These liabilities cover a 30-year period. This puts the liabilities at a bit around 2 percent of state's GDP over this period. And, the pensions are almost 70 percent funded, which puts the unfunded liabilities at less than 1.0 percent of GDP. That is not trivial, but it also does not make Ohio into Greece either, which was running annual deficits of close to 10 percent of GDP even before the downturn.

Zakaria then tells readers:

"So states everywhere made magical assumptions about investment returns. David Crane, an economic adviser to former California governor Arnold Schwarzenegger, points out that state pension funds have assumed that the stock market will grow 40% faster in the 21st century than it did in the 20th century. In other words, while the market has grown 175 times during the past 100 years, state governments are assuming that it will grow 1,750 times its size over the next hundred years."

This should leave everyone scratching their heads. Most pension funds assume that their pensions will produce rates of return of between 7.5-8.0 percent. These numbers are derived from historic returns on the asset mix they hold. In the case of stocks, they generally assume a 9.0-10.0 percent nominal return. This was a very bad assumption in years of the stock bubble and in the still over-valued market of 00s as some of us argued at the time. (Where was Zakaria then, when his argument would have been true?)

However now that price to earnings ratios in the stock market are more in line with their long-term average, it is almost impossible to produce a plausible set of projections for stock returns that are not in the range assumed by pension fund managers.

The long and short of the story is that some pension systems clearly do have problems, but most are in reasonably good shape and none threaten to turn a state into Greece. The hit that state budgets incurred from a mismanaged national economy, and are still experiencing from an economy that is operating 6 percent below its potential level of output, dwarfs the problems that states will face dealing with their workers retirement pay.

Furthermore, it is important to remember that workers paid for their pensions. Workers in the public sector have lower pay on average than workers with comparable education and experience in the private sector. The better pensions in the public sector make up much of the gap. This is not a gift to workers.

This doesn't mean that there are not ways in which public sector pensions could be reformed. But defined benefit pensions provide an enormous valuable form of security. It would be good to see them restored in the private sector rather than torn down in the public sector.


[Addendum: Ben Tafoya and Mark Paul make good points in comments below. Ben points out that most public sector workers in Illinois and Ohio are not in Social Security. This means both that their pensions are for the most part their sole retirement income and that states are required by federal law to provide benefits that are comparable to Social Security. This limits the extent to which they can cut their pensions.

Mark points out that the California state pensions include many country and city workers. This means that the relevant revenue comparison would be for all levels of government in California, not just the state government. This would make the ratio of liabilities to revenue even lower than the 6 to 1 that I have in the post.

Finally, so that no intrepid foe of public pensions nails me on a conflict of interest charge, I should fess up to the fact that my mother is a retired public sector worker who is living on her pension from working for the state of Illinois for 30 years.]