How Political Incentives Ensure a Pension Collapse

The State of Illinois just offered a wonderfully explicit example of how political incentives can lead to financial ruin.

The topic at hand was one of the state's numerous government pension funds--the Teachers' Retirement System (TRS). And like most, if not all, government pension programs, this one is deeply underfunded. As it stands, the pension fund's assets are estimated to cover just 42% of its obligations.

In essence, this means that under current assumptions about workers' life expectancy, future benefit payments, future investing returns on the pension assets, and future government contributions to the pension fund, the plan would have to start paying 42 cents on the dollar to pensioners right now in order to be sustainable in the long term. That gives you some sense of how bad things are.

But in reality, however, things are actually much worse.

The problem is that at least one of the assumptions used to calculate the pension's status is entirely implausible. The TRS assumes that they will earn an average 7.5% investing return on its funds. But the Federal Reserve's aggressive monetary stimulus efforts have pushed interest rates and bond yields to extremely low levels. And rates have stayed that way for years on end. For example

All of this has severe negative ramifications if you're a pension fund that invests in bonds to provide a safe and reliable return. As of this writing, even long-term US government debt like the 30-year Treasury yields a mere 2.24% return, and corporate debt doesn't offer much higher returns. Thus, in the current environment, pensions can no longer count on earning a 7.5% return with an acceptably low level of risk. But when the pension accountants go to calculate just how deep in the hole they are, this reality is forgotten. The accounting assumes the fund pension will continue to make 7.5% in spite of the fact that it has no realistic chance of doing so.

And this is where politics come into play. A growing number of analysts and observers are starting to note the obvious--that it is clearly absurd for pensions to assume a 7.5% return. Some have suggested a more modest figure like 4% would be much more credible and achievable, and honest, for anyone who cares about that.

But if this reality were acknowledged for a pension like the TRS, then the government would be obligated to contribute dramatically more funds to the pension to try to make it sustainable. This means higher tax rates or less spending in other areas--neither of which are going to be politically popular.

Thus, the governor of Illinois, Bruce Rauner, is trying to do everything in his power to kick disaster down the road, and presumably beyond his tenure as governor. There's nothing especially novel about a politician trying to ignore reality and delay negative consequences. But this case is still exceptional for just how bluntly they are willing to explain this rationale.

As Reuters reports, a senior adviser wrote a memo on the TRS pension situation, which included the following:

If the (TRS) board were to approve a lower assumed rate of return, taxpayers will be automatically and immediately on the hook for potentially hundreds of millions of dollars in higher taxes or reduced services.

And so, Illinois' Senate Minority Leader Christine Radogno proposed a bold political solution. Just kidding. Here's what she said:

This issue is important enough at the very least to put the TRS board on notice [that] we don’t want them taking any action that could cost taxpayers $200 to $300 million without appropriate scrutiny.

In other words, the TRS needs to continue to pretend that all is well with its investments, so that Illinois isn't forced to take action to address the problem now.

Of course, a compelling case could be made that the pensions in Illinois are already well-beyond saving. But what this latest exchange shows us is that even if they could be saved, mathematically and economically, it will always be impossible to save them politically.

Faced with the current pension crisis, the right response economically is to start acknowledging and addressing the problem as soon as possible. That would allow the financial pain, to pensioners and/or taxpayers, to be spread out over a longer time frame and could avoid an outright collapse. But the right response politically is to deny a problem exists to avoid causing voters any pain until the problem is too big to ignore (or fix).

In a case where rational long-term decision-making could produce a softer landing for the pension problem, politically motivated decision-making all but ensures the problem will end in full-on collapse.

It's true for Illinois and it's true for Social Security. It's not because the politicians are bad or stupid (though they may be). It's just that their incentives are wrong.

We can't trust people with short-term incentives to make good long-term decisions, yet that's what government pension programs ultimately require. Thus, we should not be surprised to see them slowly, tragically crumbling all around us.

(For readers interested to read more about this story and additional context on the Illinois pension crisis, this summary from Zero Hedge offers an excellent analysis.)