John Mauldin is another of my favorite economists. He excels in bringing in other smart people to write for his Outside the Box commentary, and today is a perfect example. Ed Easterling of Crestmont Research has connected the dots: because of bad assumptions, public pension plans are continuing to be underfunded. Most people know that. What they don’t know is how desperately underfunded they are, and what the implications are for the taxpayers who ultimately back up those failed assumptions.
He summarizes how pension plans work:
But the plans expect to distribute more than the contributions that go in—and they almost always can. Down in the basement, the pension plans invest the contribution money over many years to produce a return. The return and the contributions combine to meet the obligations promised to the workers upon retirement.
However, if that combination of funds is insufficient, then the taxpayers are expected to make up the shortfall.
It’s the taxpayers. It’s always and forever the taxpayers.
The key assumptions are how much the plans will have to pay out. That’s pretty easy to calculate. The next is how much will be contributed to the plans by the employees and by their employers (the state and local governments).
It’s the third assumption that can jump up and bite you: how much do those contributions earn before they must be paid out?
It’s complicated so I’ll cut to the chase: current assumptions are that the plans will earn 8 percent, perhaps a little less. That means that one dollar today will grow to $30 in 30 years. So most of the heavy lifting will be the earnings on the contributions and not the contributions themselves. It’s the “eighth wonder of the world” – so proclaimed by Albert Einstein – and its critical to whether those plans will have the money in 30 years to pay out the income promised to the plans’ beneficiaries.
Easterling then does the unthinkable. He asks: “What if those plans don’t earn 8 percent? What if they only earn 4 percent?” Answer: one dollar grows to $3.20 in 30 years. That is a 70 percent shortfall!
And guess who gets to pick up the tab for that?