No one needs to be reminded that pension funds have taken a big hit over the course of this crisis. As Yeva Nersisyan and I have shown, for private pensions, the value of accumulated assets falls short of meeting promised pay-outs of defined benefit pension plans by about a fifth, amounting to a $400 billion shortfall. Public pensions provided by state and local governments have a shortfall estimated to run as high as $2 trillion. On any reasonable accounting standard, the PBGC (Pension Benefit Guarantee Corporation) is troubled because its reserves will be wiped out by the failure of just a couple of large firms on “legacy” pensions.
There has been a long-term trend to convert defined benefit plans to defined contribution plans—which means that workers and retirees take all the risks. Indeed, this is often the outcome for “legacy” defined benefit plans that require bail-outs. In spite of some attempts to improve management and transparency of pension funds, it likely that the PBGC, itself, will need a government bail-out, and retirees will certainly face a more difficult future.
The total volume of pension funds grew rapidly over the postwar period, especially since the late 1970s, and are now huge relative to the size of the economy (and relative to the size of financial assets). The dot-com bust as well as the current crisis have hit pensions hard. The attached figure figure shows private and public pension funds relative to GDP.
Obviously, pension funds suffer when financial markets crash. It is important to understand, however, that this is a two-way street: pension funds have become so large that they are capable of literally “moving markets”. As they flow into a new class of assets, the sheer volume of funds under management will cause prices to rise. Pension funds often follow a strategy through which they allocate a per cent of funds to a particular asset class, and this can occur on a “follow the leader” basis. This pushes up prices, rewarding the decision by fueling a speculative bubble. Of course, trying to reverse flows—to move out of a class of assets—will cause prices to fall, rapidly. Pension funds contributed mightily to the commodities market bubble and crash a couple of years ago.
Just before the current global crisis hit, pension funding was, on average, doing well—thanks to the speculative bubble. To restore funding levels, pensions need a new bubble. Indeed, they are looking into placing bets on death through the so-called life settlements market (securitized life insurance policies that pay-off when people die early). Ironically, this would be a sort of doubling down on death of retirees—since early death reduces the amount of time that pensions have to be paid, even as it increases pension fund assets. Or, perhaps, securitized “peasant insurance” (contracts taken out by employers on their workers that pay-out in the case of early death). Or securitized developer “turn-over” fees—1% of the sales price of homes every time they are sold for the next 99 years. Whatever that bubble will be, pensions will need it to temporarily restore their finances.
To conclude, pension funds are so large that they will bubble-up any financial market they are allowed to enter—and what goes up must come down. The problem really is that what Hyman Minsky called managed money (including pension funds, sovereign wealth funds, university endowments, money market funds, etc), taken as a whole, is simply too large to be supported by the nation’s ability to produce output and income necessary to provide a foundation for the financial assets and debts that exist. Hence, returns cannot be obtained by making loans against production (or even income) but rather can be generated only by “financialization”—or layering and leveraging existing levels of production and income. This is why the ratio of financial assets and debts grows continually—and why managed money has to continually innovate new kinds of assets in which to speculate.
The New York Times reported on September 17 that several states have found an accounting gimmick that apparently improves the actuarial status of their pension funds. (www.nytimes.com/2010/09/18/business/18pension.html) This will sound familiar to anyone who has been following the various tricks employed by, say, Goldman Sachs to hide debt. States slash benefit for future workers and record savings today. Obviously it is very difficult to cut pensions of existing workers—but it is relatively easy to cut the benefits or raise the retirement ages of unborn workers! Since they cannot protest, why not shore up today’s pension funds by promising to cut pensions of workers who won’t be hired for decades?
Now, if those future savings are discounted back to the present, they do not amount to much. But state actuaries have been using the lower pension costs, applied to today’s workers who have suffered no such cuts. This dramatically reduces the amount that must be set aside in pension funds. That also makes state finances look better overall, which earns higher credit ratings and lowers the cost of borrowing today. Of course, it vastly overstates the condition of the pension funds. The SEC has accused New Jersey of securities fraud, and might go after other states, including Illinois, Rhode Island, Texas, and Arkansas that have used similar tricks to make their pension funds look better.
Ironically, the Trustees of Social Security use these tricks to make Social Security’s finances look worse! This aids and abets the enemies of the program, who have never tired in their efforts to destroy Social Security. Here’s how they do it. They claim that over a 75 year horizon, Social Security is just as bankrupt as are private pensions; and over an infinite horizon its shortfall amounts to trillions of dollars. Thus, they claim, the only solution is to cut benefits and raise payroll taxes today. Exactly the opposite accounting machinations employed by state governments to make their pensions look good.
Unlike private pension plans or state and local government pensions, Social Security is a federal program backed by the full faith and credit of the US Treasury. It cannot go bankrupt, and it cannot really face a shortfall. And unlike a private pension plan or a state and local pension plan, the entire productive capacity of the United States is potentially available to support the guarantees made to beneficiaries. Guarantees made to General Motor’s retirees depend on the earning capacity of GM as well as any pension funds accumulated to be liquidated in future years at a good enough price to cover promises. As GM’s market share declines it becomes increasingly difficult to meet its promises to retired workers. And if market prices of the assets accumulated in its pension fund decline, retiree benefits will be hard to cover. Ditto, to a degree, the retirees who worked for the Great State of Missouri—which might find that its tax revenue cannot make up for losses on its pension fund assets. Social Security, as a Federal government program relies on the fiscal capacity of our national government to provide nominal benefits, but more importantly, on the real productive capacity of our economy to provide the real benefits to tomorrow’s seniors, workers, and other dependents. For that reason, Social Security’s financing is irrelevant to its prospects for meeting its promises.
Yes, the Trustees are mandated to report expenditures on benefits and revenues from payroll taxes (as well as interest earned on Trust Funds). On a flow basis, Social Security typically runs a huge surplus (the current deep recession has lowered tax revenues significantly, but recovery will restore the surplus). The Trustees, however, decided to provide a calculation of discounted expenditures and revenues over a 75 year horizon. They provide three estimates: optimistic, pessimistic and midrange. On the optimistic assumptions, the program’s revenue always exceeds expenditures through the entire 75 year period; the other two scenarios show deficits at some point in the future. The optimistic projections are almost never discussed in polite society—since Social Security’s enemies prefer estimates that show “unfunded entitlements” of trillions of dollars.
But here’s the deal. These calculations are nothing more than an exercise in mental masturbation. It does no good to reduce Social Security benefits paid to today’s retirees—the problem, if there is a problem, comes decades into the future. In 2050 it is conceivable that payroll tax revenue will be lower than benefits paid, meaning that Uncle Sam will be committed to covering the difference. He might decide at that time to cut benefits, raise taxes, or run a deficit. Nor would it help to raise taxes today—that would simply increase surpluses today that take the form of a claim on Uncle Sam that he will “balance” by cutting benefits, raising taxes, or running a deficit in 2050.
Hey, why not follow the states? Let us mandate lower Social Security benefits and higher payroll taxes in the year 2050! Abracadabra, unfunded entitlements disappear!
Of course, whatever we do today will not really constrain what our grandkids decide to do in 2050. They can repeal the benefit cuts and tax hikes scheduled to take place. And they are the ones who, in any case, will have to decide what to do with their seniors. Who knows, they might indeed be much more stingy than we are—maybe they will decide to let their parents and grandparents live in poverty, surviving by dumpster diving and living in cardboard crates. But they can do that without our mandated cuts and tax hikes.
Here is the reality I see: defined benefit pension plans (whether private or state and local government) are going to go the way of the Dodo bird. It is simply not possible for firms to compete in a global economy in which most of our competitors do not rely on private pension guarantees for retirement. And our state and local governments will not be able to cope with the demands placed on them by an ageing society in which state and local government tax revenues need not grow as fast as the retired population of government employees. These programs only worked in the early postwar economy that had a huge population of babyboomers with relatively rapid growth of output as well as of state and local government tax revenue. Government employment grew, as well as employment in our nation’s factories. That is long over.
Defined contribution plans similarly worked only so long as we maintained the fiction that financial assets and liabilities could grow at a much faster pace than our nation’s output. In the past decade, that required serial bubbles. That, too, is now over. There is a role to be played by private retirement savings and by public pensions, but it must be much smaller—on a scale commensurate with our ability to produce.
What we now need to realise is that the Social Security leg of our retirement stool will play the biggest role for most of tomorrow’s seniors. Effectively what Social Security will do is to tax tomorrow’s workers so that they cannot consume all of tomorrow’s output. And it will pay benefits to tomorrow’s seniors so that they can buy some of tomorrow’s output. Exactly how that division of tomorrow’s output will be made is a decision that must be made by tomorrow’s voters. All that we can do today is to try to keep our economy strong, educate our young people so that they will be productive tomorrow, and improve our longest-lived public infrastructure.
L. Randall Wray is a Professor of Economics, University of Missouri—Kansas City. A student of Hyman Minsky, his research focuses on monetary and fiscal policy as well as unemployment and job creation. He writes a weekly column for Benzinga every Thursday.
He also blogs at New Economic Perspectives, and is a BrainTruster at New Deal 2.0. He is a senior scholar at the Levy Economics Institute, and has been a visiting professor at the University of Rome (La Sapienza), UNAM (Mexico City), University of Paris (South), and the University of Bologna (Italy).