The Cold Equations

Which do you think is more likely?

1. The portfolios of Illinois’s public employee retirement funds will grow fast enough to pay the promised benefits.
2. Illinoisan will pony up enough tax dollars to make up the shortfall.
3. The state constitution will be amended to allow the legislature to renege on the promises they’ve made to public employees (and they’ll do it).
4. The Federal Reserve will manage to create enough inflation to inflate the problem away.
5. The federal government will bail out the state of Illinois’s public employee retirement funds.

I don’t think that any of those are particularly likely but Illinois either needs one or more of those to happen or a miracle. Writing at MarketWatch Amit Sinha explains why:

The dilemma we face is that we have made future promises and don’t have enough money set aside today to pay them. Therefore someone has to make up the shortfall. Instead of trying to determine who makes up the shortfall, we try to bury our heads in the actuarial sand of high expected returns.

But where can Illinois get the additional $5 billion a year? And where can America get the additional $6 trillion?

Investment returns aren’t going to help:

The Teachers Retirement System assumes that investment returns over the long-term will average 7%. With liabilities of $108 billion, and assets of $41 billion, even if investments return 7% per annum, the hole will only continue to grow (see Illustration below). This is why using investment-return expectations to discount liabilities isn’t appropriate.

But investments don’t return 7% year-in, year-out. For simplicity, let’s assume the long-term horizon to be 10 years. Even if there is one year where returns are negative-20%, this results in an asset value that is over $20 billion lower (see illustration below).

When risk-free rates were around 6%-7%, generating 8%-10% expected returns required minimal risk and complexity. However, with risk-free rates at 2%-3%, generating even 7% is a lot harder. While investment teams at pension funds such as Teachers are extremely capable, high expected returns are forcing them to take on additional risk, either in the form of increased leverage or complex investments.

The graphs in the post tell the story. Read the whole thing.

I think that what’s most likely to happen is some combination of B and C. What should happen is that the pensions of retired Illinois elected officials should be cut first, pensions over $200,000 should be cut second, pensions over $100,000 should be cut third, that double-dipping should be eliminated, that the various jurisdictions that pay the notional employee contribution to pensions should stop, that all present employees should be converted to defined contributions plans with all due haste, and that if that fails taxes should be raised. I think they’ll try to solve the problem by raising taxes first.