The Greek sovereign debt crisis has grabbed global headlines over recent weeks, and has prompted the market to scrutinize other European sovereign debt situations more closely The Greek sovereign debt crisis has grabbed global headlines over recent weeks, and has prompted the market to scrutinize other European sovereign debt situations more closely, especially those of Portugal, Spain, Ireland and Italy. Hungarian debt, too, has been a focus of attention. In such an environment, the U.S. debt markets have benefited, as has the U.S. dollar, as investors fled the perceived higher risk European sovereign nations for the perceived safety of the U.S. But does this dynamic reflect the underlying safety of the U.S.? Commentators have noted that the U.S. has a fiscal situation that could become critical in a few years. The Greek situation may not be so much different from what lies ahead for the U.S. if nothing is done to rectify the fiscal train wreck we appear to be heading on.
Greece got into fiscal trouble because the government made commitments in the past without adequate regard to how it would meet them in the future. Greece has too many public employees enjoying compensation and retirement benefits that are outrunning the government’s revenue resources. The future is now here for Greece; investors fear Greece will default on its obligations and have refused to buy more Greek government bonds. The European Union has constructed a rescue operation, providing funds for the next several years. However, Greece will have to institute major fiscal reforms to avoid defaulting on its debt in the future.
We believe the story for many other jurisdictions in democratic countries is similar. To exaggerate a bit, the only difference between Greece and other democratic jurisdictions may be that the future has not yet arrived for the others. The issue is whether governments will act in time to maintain investor confidence in their respective government debt.
With specific regard to the U.S. situation, the Congressional Budget Office (CBO) stated the issue clearly in its June 2009 long-term budget projections:
Under current law, the federal budget is on an unsustainable path—meaning that federal debt will continue to grow much faster than the economy over the long run. Although great uncertainty surrounds long-term fiscal projections, rising costs for health care and the aging of the U.S. population will cause federal spending to increase rapidly under any plausible scenario for current law.1
Furthermore, in its March 2010 analysis of the President’s Budget for fiscal year 2011, CBO projected large annual deficits over the 10-year budget horizon, and a continuing increase in the ratio of government debt outstanding to GDP. CBO projects that debt will rise from 53% of GDP at the end of 2009 to 90% at the end of 2020, with continuing increases thereafter under current policy.2
With due respect, in our assessment, it is highly likely that these estimates are too low. CBO makes its estimates under current law; certain provisions of current law are likely to be changed in ways that will increase the deficit. For example, Congress has repeatedly enacted short-term relief under the alternative minimum tax provision of the personal income tax, and we expect them to do so again. Other supposedly temporary spending and tax provisions are also likely to be changed.
The federal budget imbalance is fundamentally due to Social Security and especially Medicare and Medicaid provisions enacted years ago. The future is now at hand for these programs. Yet, despite warnings over several decades outlining the dire fiscal situation we may face in the future, there appears to be little evidence of a serious effort in Congress to put the federal budget on a sustainable path.
It is not only the Federal government that faces serious fiscal issues. Many state and local governments are confronted with very similar problems. Current budget strains for certain states and municipalities have hit the headlines recently, but, in our opinion, the real problem is often overlooked: the enormous scale of unfunded future pension and health benefits for retired and retiring employees. A recent study by the Pew Center on the States found that, as of the end of 2008, total underfunding for all states together as reported by the states themselves was $1.04 trillion.3
While this number alone is staggering, it may underestimate the entirety of the problem faced at the state level. Similar to reasons why the CBO’s Federal budget deficit forecasts are likely too low, state and local government estimates are also unlikely to reflect the full future magnitude of their problems. The Pew study outlines two reasons why the above figure may be overly conservative: firstly, because the majority of states’ fiscal years end in June, much of the total assets underlying pension obligations calculated in the above figure were based on prices as of June 30th, 2008 – before the market plummeted (the equity market is yet to recover the full extent of this downturn). Secondly, most states smooth the full impact of gains and losses over time; as such, investment losses are unlikely to be fully reflected in the reported data.
Let’s examine another important issue that, in our opinion, severely undervalues the estimated level of underfunded pension obligations. Standard practice in the official state data is to calculate the present value of the obligations by the anticipated return on assets, commonly 8%. This figure is the assumed return on a portfolio of assets that has a substantial percentage invested in equities. That return might well be a reasonable estimate of the expected return on a portfolio with a mix of risky and safe assets. But is that the correct return to use in discounting the future pension obligations?
Shouldn’t the right discount factor be the rate of return on low-risk assets? After all, the pension obligations are fixed by law and are therefore certain. If the interest rate on U.S. Government bonds is used instead of the 8% expected return on assets, then the pension underfunding will be much larger. Research conducted by Robert Novy-Marx and Joshua D. Rauh, “The Liabilities and Risks of State-Sponsored Pension Plans,” published in the fall of 2009, follows this logic.4 The paper provides some eye-opening state-level data on unfunded pension obligations.
Using the Treasury bond yield as the discount factor derives an underfunding estimate of $3.23 trillion, more than three times the official estimates outlined above. This value represents more than four times annual state tax revenue and 24% of gross state product. These figures are truly sobering. Of all the states, the extent of underfunding, measured as a percentage of annual state tax revenues, is largest for Ohio. The extent of Ohio’s underfunding–$216.9 billion—is almost nine times annual state tax revenues. Looked at another way, if Ohio were to double its tax revenues while leaving its expenditures unchanged, it would take almost nine years to eliminate the underfunding.5
Pension obligations are not the only problem. A November 2009 GAO study, “State and Local Government Retiree Health Benefits”, found that in many states there is no funding of retiree health benefits at all. Using Ohio as an example, the GAO estimated an aggregate liability of $31.6 billion and assets of $11.2 billion, leaving $20.4 billion unfunded.6 As with pension obligations, however, in our opinion the present value of obligations is understated because of the use of a too-high discount factor.
These numbers relate to current underfunding. However, each year that current policies remain in effect is likely to increase underfunding of pension and retiree health benefits at both the federal and state level. The task ahead is not only to cover existing underfunding but also to revise compensation and retiree benefits, or to raise additional revenue, to prevent further accumulations of unfunded benefits in coming years.
Let’s consider again the appropriate discount rate to use in calculating pension liabilities. Using an 8% discount rate assumes some degree of investment risk, so a complete analysis should assess the probability of shortfalls of varying degrees. The volatility of the stock market in recent years demonstrates why this concern is a valid one. While a state may calculate a small or fully funded status using an 8% discount rate, an analysis of the risk profile of the assets underlying the obligations may find that the probability of substantial underfunding may be much higher than otherwise assumed. In our assessment, states and local government should properly assess whether the calculation process used to asses the funding level of pension obligations is the right one, and whether a more prudent level should be set for the discount rate applied.
It is clear that the federal government and many state and local governments have dug themselves, and us as citizens and taxpayers, into a terrible fiscal hole. While many of the concerns surrounding pension and health benefits promised by state and local governments have yet to garner national media attention, one only needs to look to the Greek situation as a possible harbinger of things to come if these problems are left unchecked. States and local governments may do well to heed Greek’s present fiscal malaise and, in our opinion, should act now to avert potential disaster down the road.