Sunday, June 30, 2013

Meredith Whitney: States Should Privatize Assets to Cover Unfunded Pension Liabilities (Interview With Steve Forbes)

Meredith Whitney, founder and CEO of Meredith Whitney Advisory Group and author of Fate of the States, told Steve Forbes in an interview> on June 4 that states should privatize assets to cover their unfunded pension liabilities. Illinois' unfunded pension liability is currently at or near $100 billion. And according to DealBook (via Moody's Investors Service), "the 50 states have, in aggregate, just 48 cents for every dollar in pensions they have promised. That is much less than the 74 cents on the dollar that the states now report, suggesting the states are short by about $980 billion."

But, as noted below, the number could be anywhere between $1 trillion and $4 trillion depending on the discount rate used to value the pension liabilities. I'm not a big fan of using financial models to predict the future, but the debate is whether the risk free rate (treasury yield) or average annual return in the stock market (7-8%) should be used to calculate the present value of each state's pension liabilities and the unfunded portion (pension assets-liabilities). Read the AEI quote below for more info.

Either way, it looks like asset sales to the private sector could definitely help close funding gaps. Meredith Whitney mentioned that Indiana raised $4 billion by privatizing its toll roads.

"Indiana did all that. It also privatized. It’s an interesting story. They privatized the Indiana toll road. Leave it to Mitch Daniels bested Macquarie and Morgan Stanley. So a lot of politicians are against privatization. Follow Mitch Daniels’ lead. And you’ll see how they got close to $4 billion to reinvest in paying down debt, investing in education.

He was committed. Mitch Daniels was committed to not using that money to pay for ordinary expenses but actually using it towards a program that had a higher return on investment than in fact the Indiana toll road did. I hope that more people take his lead."

"They could privatize certainly municipal airports. You could privatize a Midway versus an O’Hare or a Teterboro versus a Newark. But there are plenty of certainly transportation areas where you could privatize. Tollways. Texas has done a lot of that.

You could privatize the railways. You could privatize the postal system. You could privatize a lot on a state-by-state basis. There’s enormous property. States have become effective asset managers. That was never their intention. The lottery. Other things that are happening now are things like Pennsylvania saying, “We will absolutely never have gambling in this state. One arm bandit’s so bad.

Or dry counties where you can’t buy alcohol are now saying, “Beer or wine. That’s not so bad.” So you’re really seeing a lot of bending of the rules. New York State is going to build all these new casinos.”

Here's the full interview which is also available at Forbes.com.




The total amount of state unfunded pension liabilities outstanding

As noted above, Moody's Investors Service believes that state pension funds are short by about $980 billion. The article also mentioned that Moody's used the "high-quality taxable bond rate" as its discount rate to better reflect expected annual investment returns.

But this number could still be too low. During Meredith Whitney's interview, she mentioned that "estimates were anywhere between a trillion and then Professor Rauh out of Northwestern points it closer to $4 trillion." Here's what Professor Rauh said about the states' unfunded pension liabilities in a blog post on October 6, 2011 (emphasis mine):

"More importantly, the true financial value of the liabilities that have been promised have grown substantially due to much lower bond yields. Pension liabilities are greater when market interest rates on securities of comparable risk are lower. The basic economic rationale is clear: the appropriate discount rate for measuring liabilities depends on the risk of the cash flows being discounted. So while reports from state governments continue to discount pension liabilities at 8%, a financial valuation needs to take today’s market interest rates into account, and in particular interest rates on very safe assets such as government bonds. The only reason to use a discount rate higher than a default-free government bond yield is if one wants to reflect in the measurement the possibility that taxpayers might be able to default on these promises.

Assuming that accumulated pension promises will be paid, liabilities were $5.4 trillion in June 2009 using Treasury discounting. But at that time, the yield on the 30-year Treasury bond was 4.4%, the yield on the 10-year Treasury bond was 3.6%, and the yield on the 5-year Treasury bond was 2.6%. Today, in October 2011, these rates are all approximately 150bp lower, which assuming a duration of 15 years would imply that liabilities are 23% larger.

Together with the estimates of assets, these calculations imply an unfunded liability in October 2011 of $4.0 trillion."

The American Enterprise Institute (AEI.org) released a paper in May 2013 titled "Understanding The Argument For Market Valuation Of Public Pension Liabilities" which explained how pension liabilities are valued (emphasis mine).

Plan Valuation under GASB Accounting Rules

Pension plans measure their financial health by comparing the value of their assets to that of their liabilities. The difference between assets and liabilities is referred to as the unfunded liability, while the ratio of the two is referred to as the funding ratio. Public sector pensions perform these calculations using guidelines issued by the GASB. Although GASB rules are not legally binding, a government must disclose if its calculations do not follow them.

Because a benefit payment made in the future is less valuable and less costly to finance than a payment made today, it is necessary to discount future benefit payments to the present to make them comparable to the value of plan assets. Discounting is a process similar to compound interest. While compound interest begins with a current dollar amount and adds interest to determine the future value, discounting begins with the future value and subtracts interest each year until a present value is arrived at.

The present value of a plan’s liabilities depends on the interest rate at which the liabilities are discounted. Under standard actuarial accounting as outlined by GASB, a public pension plan discounts its liabilities using the return it expects the portfolio of assets it holds to generate. The average expected return on assets used in such valuations is currently slightly below 8 percent. The discounted value of plan liabilities is then compared to the value of assets to calculate the plan’s funding ratio (assets divided by liabilities) and its unfunded liability (assets minus liabilities).9

Present values of plan liabilities also are used to calculate the plan’s annual required contribution. This amount reflects the contribution the plan sponsor would need to make in a given year to both fund benefits accruing to employees in that year and to gradually pay off any unfunded liabilities from prior years.

The effects of changes in the discount rate can be dramatic. Under GASB accounting, the same plan, with the same assets and future benefit payments, could reduce its measured liabilities by nearly one-fifth by shifting from a portfolio with an expected return of 7 percent to one with an expected return of 8.5 percent.

When public pension liabilities are discounted at an 8 percent average interest rate, plans were around 77 percent funded, on average, as of mid-2010, and unfunded liabilities were equal to about three-quarters of $1 trillion. And the situation could appear significantly worse if a different interest rate had been used in the calculation.

 (h/t Hypnotoad Girl).

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