It’s a dry subject, but a storm is forming offshore that could cost taxpayers billions.
Here’s how the NC’s pension plan works: Say the state hires 25-year old man and promises to pay him a pension. That amount, when he retires in 30 years, will be determined by a formula- but let’s say his pension will be $50,000 a year.
For the next thirty years, both the employee and the state each pays a fraction of his salary into the state pension fund. The Pension Fund, itself, which is managed by a Board of political appointees, invests the money.
In theory, when the worker retires, the money he has paid in, plus the money the state has paid in, plus the money the Pension Fund has earned on its investments – like Treasury bonds – will be enough to pay his $50,000 a year pension.
But what if it’s not? What if – 30 years from now – the money in the fund will only pay him a $35,000 a year pension? If that happens the state steps in and pays him the additional $15,000 each year.
It’s what’s called a Defined Benefit Pension Plan. And it’s great for workers. No matter what happens to the economy – dips, recessions, stock market meltdowns – state retirees face no uncertainty.
At one time these defined benefit plans were commonplace. But with all the ups and downs in the economy over the past decade governments are now about the only ones still offering them.
Most private companies long ago changed plans – where they say to their employees, You invest part of your salary in a pension plan, we’ll match part of your salary, then whatever the plan earns over the years will determine how much pension you receive.
Now, NC is obligated to pay state retirees nearly $69 billion in pensions. But the latest projections show the pension fund will only have the money to pay out $65 billion. So there’s a $4 billion shortfall (or unfunded liability) taxpayers will pay. That’s a problem. But given the size of the state budget it’s not an end of the world problem.
Except there’s another hitch.
To end up with only a $4 billion deficit the Pension Fund will have to earn a 7.25% return on its investments each year.
But can it?
Once upon a time earning a 7.25% return on investments – like Treasury Bonds – was simple. But then the world changed: Markets collapsed and interest rates turned upside down.
Today, the 30-year return on U.S. Treasury bonds isn’t 7.25% – it’s 2.5%.
That creates a massive problem for the state Pension Fund – which the political appointees on the Board ignore.
When the Board met in January it chose, even in the face of overwhelming evidence, to not adjust the retirement fund’s projected returns. It voted overwhelmingly to stick with the 7.25%.
Now surely the Board Members know, just as average citizens know, that a return on investment of 7.25% in today’s world is a dream. But in government decisions about spending money aren’t always rational.
So what’s the difference between a return of 7.25% and a return of 2.5%?
The result is shocking: Instead of a $4 billion deficit (or unfunded liability) the Pension Fund’s deficit soars to $47 billion – and taxpayers will be on the hook to pay every penny of that money.
By their nature, politicians aren’t inclined to face a multi-billion-dollar crisis that’s years away. Plus, state workers want bigger pensions – which isn’t likely to happen if the Pension Board projects a $47 billion hole in the budget. So ignoring the problem will work out fine for the politicians and for the political appointed board. By the time the storm makes landfall they will have long since retired. And paying those unfunded liabilities will be someone else’s problem.
By ignoring this problem and dreaming of 7.25% returns the Pension Board has us heading straight for a fiscal cliff. But it may also be true that using today’s Treasury rate of 2.5% is too low. The actual return may well fall somewhere between 2.5% and 7.25%. The problem is figuring out where.
So here’s the billion dollar question: What’s the number?