In his daily column at Carolina Journal today, John Hood informs us of a potential change in how liabilities for North Carolina’s pension plan for retired state teachers and employees is calculated could shed some rather discouraging – but realistic – light onto the true condition of the pension system.
Bond-rating agencies and regulators are about to change the system for evaluating state and local pension funds. Rather than use the long-term average for returns to corporate stocks to estimate the future returns of pension funds, they are going to use the rate of return on corporate bonds.
This may sound like some boring change instigated by some boring actuaries. But it could have great significance for your tax bill, for your retirement planning (if you are a state employee or married to one), and for the business climate of North Carolina.
What he is referring to is an announcement by ratings agency Moodys stating their desire to lower the rate of return most state and local governments use to calculate the soundness of their pension plans. Because a majority of North Carolina’s state pension plan’s income comes from investment gains in the fund, the rate of return on those investments is crucial to the plan’s ability to pay out its obligations to retirees. More and more followers of government pension plans have been declaring that the pension plans have been overly optimistic in their estimates for future returns of the pension funds when evaluating the fund’s ability to meet future payment obligations. Most government’s use a projected 7.5 to 8.5 percent average annual return, however Moodys is recommending a change to 5.5% (reflecting average returns on high-grade long-term corporate bonds). The two to three percentage point difference may not sound like much, but when applied to a pension fund like North Carolina’s with tens of billions of dollars worth of investments, it makes a major difference.
Due largely to recent poor returns, NC’s pension fund is no longer considered to be fully funded, and has an unfunded liability of $2.8 billion as of 2010. But the recent market downturn merely revealed the unsustainable nature of the state’s pension system. This year’s state budget includes a roughly $811 million appropriation to help shore up the pension fund (that’s your tax dollars). That expenditure is projected to grow to more than $1 billion in five years. And that is using an unrealistically optimistic expected return rate of 7.25%.
Bottom line: the state’s current pension program is unsustainable. If Moodys gets their way and evaluates the pension plan using more realistic projections, we may be in for some sticker shock when we see what poor condition the pension fund is truly in.
Reforms are needed now – and foremost among them should be to begin converting to a 401(k) style defined-contribution retirement system. That way, taxpayers will no longer be on the hook for state retiree pension benefits, and state employees would have greater control over their retirement funds.