NJ Fiscal Folly

Friday, February 24, 2006

Pension Plan Pretend

According to the NJ Benefits Review Task Force (December 2005), NJ's public pension plans (for both state and local employees) have an unfunded liability of $12.1 billion.

True or false?

Almost certainly false. The real number is bigger, maybe much bigger.

First of all, the liability figure was calculated as of June 30, 2004. The chance that this number has decreased since then is lower than your chance of winning the lottery.

Second, and here's my real point, the calculation of the unfunded liability involves a major dubious assumption: the future investment return on pension plan assets.

If an actuary assumes that future investment returns on current plan assets will be high, then future pension plan contributions may be reduced. Of course there's a day of reckoning if investment returns fall below your assumption, and pension plan contributions have to be boosted to make up for a shortfall in plan assets.

NJ's public pension plans currently assume a future investment return of 8.75% per year. This rate was mandated by the State Treasurer in 1992. However, back in the real world, investment performance has been quite a bit lower. Over the last seven years (FY 1999 through FY 2005), the actual cumulative return has been around 4.46% per year (4.29% per year lower than assumed). If the total market value of plan assets is now roughly $75 billion, a similar shortfall in future investment performance would add billions per year to the unfunded liability, unless offset by dramatically increased pension plan contributions.

Pension plan valuation and accounting is a complex area. Small changes in key assumptions have a dramatic financial impact. Actuaries and accountants use various smoothing techniques to handle fluctuations in investment return and plan assets. And, as you've also heard, "past (bad) performance is no guarantee of future (bad) performance". Nevertheless, an investment return assumption of 8.75% per year would be considered aggressive (to put it kindly) anywhere in the private sector. Given NJ's dismal record in all things financial, it's little short of delusional.

The unfunded pension liability of $12.1 billion is way too optimistic. A more realistic investment return assumption would increase the number, maybe by a lot.

Update: Based on a rough calculation, an investment return assumption of 8.00% per year would increase the unfunded pension liability by more than $5 billion.

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