All state pensions are in trouble to one degree or another.   A recent NCPA study, “Unfunded Liabilities of State and Local Government Employee Retirement Benefit Plans,”  found that the gap between pension benefits owed to state/local employees and money set aside for these benefits is a whopping $3.1 trillion (almost 3 times more than the actual plans report).  Of course, California’s share of this is almost $500 billion, which is equalivant to about 27 percent of their annual GDP. 

But let’s put it in laymen’s terms – California’s pension obligations are only about  50 percent funded.   In other words, somebody, ie. the taxpayer, will have to cough up money sooner or later to make up for the lack of funds to pay for the 50 percent shortfall.  Some states with smaller shortfalls than California are facing up the fact that the future is not pretty, and have started doing something about it in the form of hybrid pensions.  (See my July 12 blog entry, ”State Hybrid Plans are Compassionate, Progressive and Good for the Environment“).

If I were a taxpayer in the Golden State, I would be bailin’, not dreamin’.

But before desperation and panic set in, consider all options with the goal in mind of accessing the exact amount of money you need as cheaply as possible.  Although I have pontificated before about the pitfalls of borrowing against a 401(k), this could be an alternative to taking a costly distribution, provided that you are certain of being able to pay the loan back.  See the NCPA publication, “401(k) Loans = Retirement Insecurity.”  Also, check out our 401(k) Borrowing Calculator to get an idea of how much a loan could cost you in the long run.

First, the basic reason: although the rewards of stock investment are worthy, stock investments can be risky. To expect an absolute guarantee on any investment, no matter what it is, is not realistic. Even putting money under the mattress carries the risk of inflation (which I addressed in a previous publication,” Is the Mattress a Good Place for Money?”). Driving an automobile, climbing a ladder and parachuting out of an airplane are also risky. Bottom line: life is full of risk.

Second, investing in an energy company in and of itself carries inherent risks: price volatility due to supply disruptions, changes in the regulatory environment, spills and the like. Add to that investing in a foreign company, which carries risks associated with currency exchange rates, political and social upheavals, and different rules regarding foreign markets. This is not your typical U.S. savings bond. Because it is well known that equity investments carry risk, it may be difficult for such a class action suit to have any merit, since it would have to be proven that BP intentionally committed fraud.

Third, looking beyond the merits of the lawsuit, even if state pensions won such a suit, what would these pension managers win? A coupon in the mail for a free gallon of gas? Everybody who has been affected by this spill wants in on the action. BP has already agreed to establish a $20 billion compensation fund. It may or may not be enough to compensate those who are economically affected by the spill and to pay the costs of state and local cleanup efforts. But if  BP is ordered to pay everybody who owned stock, their profits will fall as well as their stock prices. Does this not defeat the purpose of investing in the company in the first place?

Finally, it is no secret that state pension funds are … well … underfunded. A newly-released NCPA study finds (see Courtney Collins and Andrew Rettenmaier, “Unfunded Liabilities of State and Local Goverment Employee Retirement Benefit Plans“) that Ohio, one of the two big players in the class action lawsuit, is one of the 10 worst states in terms of their funding ratio (how much money they have to pay promised benefits) and how much of their GDP this liability costs them. While a class action lawsuit may help state pension funds recoup some losses, it is a band-aid approach to the reality: state and local pension funds are in trouble, and they cannot rely on companies with “big pockets” to bail them out. Whether BP played fast and loose with safety precautions will eventually be sorted out, but milking them for money is not going to resolve the long-term solvency issues faced by state pension funds face.

The real question is: what are these state pension funds going to do after the BP mess is over?

Unemployment Benefits Create a Disincentive for Work.  Many economists, including NCPA senior fellow Bill Conerly, have examined empirical data and written about the disincentives associated with extending unemployment benefits.  (See our previous publications, “Is Extending Unemployment Benefits a Good Idea?” and “Extending Jobless Benefits May Prolong Unemployment,”).  In other words, if a person is out of work and getting a consistent supply of money that is enough to sustain a reasonable standard of living, why make a concerted effort to look for work?   This could prevent unemployed workers from making hard, but necessary choices, to adjust to the economic environment brought on by the financial crisis, such as changing jobs or relocating.

Unemployment Benefits Encourage Bad State Policy.  Since only states  experiencing  unemployment rates greater than 8 percent will be eligible for federal money, there may be a perverse incentive not to pursue policy adjustments necessary for long-term economic growth.   Additionally, unemployed workers might have less motivation to move to states with lower unemployment.   Unemployment is not the result of market failure, but typically the result of government failure…tax and regulatory policies that inhibit job creation.  Rewarding states with high unemployment rates simply encourages bad policies to continue.

Unemployment Benefits Expand the Federal Debt.  The Congressional Budget Office has said the bill will cost $33 billion over the next decade.  Some Republicans have argued such spending should be offset through cuts in federal spending elsewhere. With the $700 billion bailout program and the $787 billion stimulus program passed last year, can we really afford a multi-billion dollar policy which will not likely fix unemployment?

So what is the solution?  Individually owned, personal, portable accounts for unemployment insurance.  (Read all about it in NCPA’s  ”Unemployment Insurance in a Free Society.“)  Chile uses payroll taxes from both the employer and the employee to prefund accounts for each worker.   Workers can then draw upon their accounts during times of unemployment, regardless of the reason (whether a worker quits, is fired, or is laid off).  Funds left in the accounts that are not used during unemployment periods can then be withdrawn at retirement.

In this way, workers have an incentive to prepare for possible unemployment, the flexibility to use the funds when they need them and the incentive to find work so they can build up these accounts to supplement their retirement income.

As Neumann notes, six other states have hybrid plans as well…not enough, in my opinion, but hey, it’s a start.  If I am a bit enthusiastic about this undertaking of pushing workers to fund more of their retirement plans, it is not for a lack of compassion.  Indeed, hybrid plans are compassionate, progressive  and environmentally responsible.  Let me explain:

States that are adopting hybrid plans recognize the burden of debt placed on future generations if they don’t act now.  Saddling our children and grandchildren with unfunded pension liabilities means raising their taxes, cutting their state and local services and leading them down a path of low growth and high unemployment.  To boldly act, even in the face of protests from some who may be used to the old way of doing things, is true compassion.

Hybrid plans are progressive.  What?  How so, one might ask, if government benefits are being reduced and employees have to cough up the difference?  Since many who identify themselves as progressives often look to Europe for solutions, this is probably one of the best ideas we can take from Europe.  Many countries already have public-private pension systems in place and have operated in this vein for decades.  Think the Netherlands, Switzerland and the United Kingdom to name a few, as well as non-European countries such as Chile and Argentina.  At least 30 countries in the world have varying degrees of private participation in public pension systems, so one could say that the United States is a little “behind the times” in this regard.

Finally, the move to hybrid pensions is good for the environment – the  financial environment of every potential retiree.  There is so much hype these days about being good stewards of the physical environment.  But we often overlook the environment of personal finance.  Free market economists argue that when individuals have ownership in something – a house, for example – they are more likely to invest in it, take care of it and maximize its potential than if they rent the house and have little or no vested interest.

Likewise, when workers are contributing their own money knowing that their contribution is a key compoment in their retirement security, they will more likely want to know what is going on with it.  They will ask pertinent questions:  Which investments provide better returns with lower costs?  Is the employer providing the information and resources I need to make sound decisions?  Whereas, pensions that consist entirely of government employer contributions leave workers at the mercy of poor investments, underfunding and political maneuvering. 

Bottom line:  This is a step forward, not two steps back.  Now if we could just get Social Security reform on the table!

I recall years ago in high school when I first opened a checking account.  I paid a small monthly fee and did so for many years.  But as banks proliferated and competed for customers, those fees begin falling away.   (Alas, the beauty of competition and consumer choice.)   But now that government has decided that consumers need more protection from something or another, they have stepped in to regulate bank card issuers.  Most of us are credit card holders and may benefit from some of the new provisions, but the perks associated with banking and borrowing are coming to an end.  Isn’t it ironic how that works…government passes laws designed to “benefit” consumers and they really benefit only  a small select group of people (if any at all). The rest pay in some way or another.  This means costs go up for ordinary checking and savings account holders, small business owners and others who just want to keep their money deposited in a place other than a mattress until they need it.

Welcome to the department of Unintended Consequences.  How may I assist you today?

But before you empty out all of your retirement accounts and dump them into a Roth, keep in mind some important considerations:  Individuals can only convert traditional IRAs and 401(k)s from a previous employer, not 401(k)s from a current employer.  Each person’s financial situation is different, so various ages and incomes will have different effects on your retirement living standard.  Those who are further away from retirement and can pay taxes from a non-retirement account have the most to gain.  To see if a Roth conversion is for you, visit the ESPlanner website and check out the basic version.

Known as the Community Living Assistance Services and Supports (CLASS) Act, this government-run program looks like long-term care insurance at first: participants pay monthly premiums, which the government invests and then uses to pay long-term care benefits for participants down the road.  But truth be told, it violates the principles of sound insurance:  no investment of premiums and no underwriting for health conditions, leaving future taxpayers footing the bill.

If one were to peruse the CLASS legislation, it would appear that taxpayers are off the hook.  Consider the following passages from H.R. 3590:

“No taxpayer funds shall be used for payment of  benefits under a CLASS Independent Benefit Plan (H.R. 3590  pg.1972),”

and

“One-hundred percent of the premiums collected…” for the CLASS program will be deposited into the CLASS Independence Fund (H.R. 3590  pg. 1946).

Though technically true, these claims are deceptive.  They give the impression that CLASS premium dollars will be invested, as would be typically done by a private insurer and that tax dollars will never pay for CLASS benefits.

ObamaCare doesn’t explicitly outline how CLASS dollars will be invested.  Rather, it points to regulations outlined by the Social Security Act, which appeal to the United States Code for further clarification.  Apparently, the authors of ObamaCare prominently positioned the details they wanted to draw attention to while constructing a scavenger hunt to the facts they believed would be less popular.  Upon completing this scavenger hunt, the more serious reader will find that:

CLASS premium dollars may only be invested in “interest-bearing obligations of the United States,” “in obligations guaranteed as to both principal and interest by the United States,” or in U.S. “public-debt obligations” (H.R. 3590  pg. 1965) and [subsection (c) of Section 1841 of the Social Security Act (42 U.S.C. 1395t)].

Consequently, CLASS Act premium dollars will be allowed to flow into the U.S. Treasury’s general revenue fund, permitting CLASS dollars to pay for things like Social Security benefits, the health care overhaul and any other program congress wishes to implement.

Additionally, the government (i.e. taxpayers) will guarantee all CLASS Act investments, ensuring that taxpayer dollars will be used to buy back the investment obligations held by the CLASS Independence Fund.  When CLASS expenditures exceed revenues, as the Congressional Budget Office predicts will happen in about 20 years, benefit promises will be guaranteed by tax dollars.

Bottom line:  It may look like a duck and quack like a duck, but in reality, CLASS is a goose.

When panic sets in, keep investments in perspective.  If a company’s stats are good (no long-term debt, potential for growth, for example), the rewards of buying now will show up in those quarterly earnings reports.   With 24-hour Internet and cable bombarding us with bad news and predicting dire long-term scenarios based on these radar screen blips, people will want to panic, sell off, hold cash (subject to inflation) and buy bonds with the undying belief that these investments are safer.  But look at Greek bonds which were at a BBB- rating a few days ago (one step above junk bonds) without the help of the European Central Bank.  There are no guarantees on any investment.

So calm down, practice deep breathing and ride out this rough period.

However, I am hopeful that the Gallup poll shows that non-retirees still rank retirement savings first as a major source of their income.  Since any chance of meaningful Social Security reform is not likely (and when I say “meaningful,” I am referring to a type of reform where workers actually get to pre-fund their retirement with their own payroll contributions that are invested in real assets), then government could tweak a few things that would encourage more retirement savings.  For example, let’s start by putting all personal retirement accounts on equal footing;  allow workers with traditional or Roth IRA accounts to contribute as much as those who have 401(k) accounts.  Given the right tools, I believe individuals can do a much better job of saving for retirement than government can.