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’.

If you fail to see the humor, this joke reflects the sometimes dubious assumptions in economic theory when making predictions and forecasts.  The latest example is the just-released Medicare Trustees Report.   (For a summary of the Social Security/Medicare Trustees Report, click here.) Obama administration cheerleaders are ooing and awing over the projected unfunded liabilities (the difference between the payroll taxes and seniors’ premiums used to fund Medicare and the benefit payouts.)  According to the 2010 report, the Medicare shortfall into the infinite horizon is expected to be just $36.6 trillion, less than half of last years’s reported liability of $89.3 trillion! What is going on here?  Some highly skeptical assumptions based on the provisions laid out in Obamacare, that’s what.  For example:

• It is assumed that physicians’ Medicare payments will be cut at least 30 percent (dubious assumption based on a Congress that has been unwilling to do this in the past).
• It is also assumed that Medicare expenditures will grow at a rate of about 1.4 percent of real GDP compared to actual real GDP growth of 1.5 percent (even more dubious since Medicare expenditures have historically grown much faster than GDP).

One would think somebody would challenge these assumptions — and indeed they have.  For the first time in Medicare Trustees’ Report history, an “Illustrative Alternative Scenario”  has been published by Medicare Actuaries.  This shorter report reveals the doubts of CMS actuaries as expressed in the following quote:

 “The Trustees Report is necessarily based on current law; as a result of questions regarding the operations of certain Medicare provisions, however, the projections shown in the report do not represent the ‘best estimate’ of actual future Medicare expenditures.”

In the Illustrative Alternative, Figure 4 shows how far off the new projections are from the projections in the 2010 Trustees Report.   Medicare expenditures are estimated to consume about 6.5 percent of GDP in 2080. says the 2010 Trustees Report (compared to just over 9 percent in for the same period in the 2009 Trustees Report).  When the actuaries use Medicare fee payment assumptions they believe will actually occur, the percent of GDP rises to nearly 11 percent in 2080. (see chart below)

To put it bluntly, the Medicare Trustees Report is ripe with…um…wildly optimistic projections (I could think of other terms, but this is a family blog).   No amount of rosy press coverage or administration cheerleading is going to hide this fact.

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?

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. 

Last year, the Social Security/Medicare Trustees reported this payroll tax revenue shortfall would not occur until 2016.   However, the early arrival of Social Security’s anemic condition is no suprise since in 2009, benefits had already exceed payroll tax revenues in 7 out of 12 months. 

What has surprised me, is the conversations I have had with folks over the last few days regarding the existence of the “trust fund.”  The Social Security trust fund is the accumulated surplus of payroll taxes over previous years that can now be spent on shoring up this payroll tax deficit we have today…or is it?  When I casually mention that the trust fund is on paper only and doesn’t really exist, there is usually a moment of stunned silence from the other person  followed by a gasp of  breath.  Then the question invariably follows, “What?  There is no trust fund?  Then how are my benefits going to be paid?”

The answers are as follows:  Correct.  There is no trust fund.  The surpluses from previous years have been invested in special-issue bonds which have no value.  Their interest rates and maturity dates are recorded in the yearly Trustees report, but they are little more than IOU’s.  The money that is allegedly “saved and invested” is being spent on other government programs.  That’s right – this money is not being spent on your future financial cushion, but on things like wars, welfare, Amtrak, stimulus…you name it.  For all intents and purposes, the government will have to borrow money, raise taxes, or eventually cut benefits in order to pay for the unfunded liabilities of Social Security and Medicare.

So let’s stop referring to the trust fund; like Elvis, it has left the building.  Instead, let’s get real about reforming entitlements.  If these truths do not sound the alarm bells for reform, I don’t know what will.

Medicare and Social Security, however, have largely relieved children of this primary role.  Even though filial support laws remain on the books in 30 states, only Pennsylvania and South Dakota have recent track records enforcing these laws. 

A Wall Street Journal article states that presently:

Each generation of workers pays for the retirement benefits of the generation ahead of it.  The system is powered by babies, who grow up to become productive little FICA contributors.  But even if you never have children, someone else’s kid will eventually pay for your Social Security benefits.

The government now takes the primary role in caring for aging adults in many cases.

Then came the voice of reason from Chuck Blahous at the Hudson Institute.  In his Washington Post piece from today, Mr. Blahous noted that this year, Social Security benefit checks increased 5.8 percent – the largest increase since 1982.  When one considers the fact that the Consumer Price Index has dropped due to the recession and falling prices, benefit payments are keeping pace well above inflation.  Furthermore, although Medicare Part B premiums increase as benefit checks increase, for most seniors, this will not be the case, due to a "hold harmless" provision.  Bottom line:  Seniors will be no worse off next year than they are this year; in fact, they will be better off.

But without a full understanding of how COLA works, many advocates and politicians will see this as a reason to increase benefit payments regardless of reality.  This would mean growing an already massive unfunded liability in senior entitlement programs that would be passed on to younger workers.  Let's hope the voice of reason prevails.    

For a single person, probably the most important question is how long do you plan to live?  If you are "in poor health and probably won't live past 78," you might want to take benefits at early retirement, says the Times.  Ideally, if you expect to live a long time and can work past retirement, then 70 is the best time to take benefits.  

If long life is the expectation, but you can't work till 70, then 66 seems to be the magic number.  This option is best even if a retiree has to use retirement savings to make it to 66 to file for Social Security benefits.  That's because the increase in benefits gained by retiring at 66 instead of 62, eventually makes up for the savings used to make it to 66.  Waiting any longer than 66, seems to exhaust savings too much to make up for higher Social Security benefits.

For married couples, according to the Times, experts advise the following:

In many cases, the higher-earning spouse should delay his or her benefits until age 70, while the lower earner begins to collect at age 62.  This ensures that the surviving spouse will end up with the maximum amount of benefits for the rest of his or her life.

If you have already taken early retirement benefits but wish you hadn't, you can pay them back to the government, interest-free, and reapply for benefits at age 70.  Economist Laurence Kotlikoff explains how this "do over" works, and it can increase your standard of living by as much as 60 percent!

This may all sound like doom and gloom, but keep in mind — according to the EBRI report, the actual median retirement age is only 62.  That is also the minimum age when one is eligible to receive early Social Security retirement benefits.  But the survey also notes that 21 percent of respondents plan on working into their 70s.  Sure, retiring before age 65 sounds ideal, and perhaps working into the 70s sounds like drudgery, but there are so many advantages to delaying retirement until age 70.  First, those who wait until age 70 to apply for Social Security benefits receive a delayed benefit credit, resulting in about 20 percent more Social Security income per year than retiring early.  Second, those with Roth IRA accounts can contribute to them indefinitely with after-tax dollars.  Third, those who choose to work beyond their full retirement age will escape the earnings penalty, which reduces their Social Security benefits by 50 cents for every dollar they earn.

Finally, people are living longer and staying healthier into retirement years.  So this may be an opportunity to regroup and change careers, or start earning money from that hobby you have tinkered with for 20 years.  I am still 20 years away from retirement but this survey has gotten me to thinking about what my next career might be….actually, the thought of working on the ground crew at the airport has always fascinated me….what do you think, folks?

But suppose both entitlement prograns ended tomorrow – no more payroll taxes collected, and no benefits paid to next generation retirees.  What would happen to that massive debt?  Not to ruin the holiday spirit, but according to NCPA Senior Fellows Andy Rettenmaier and Thomas Saving in their latest study, we would still owe our current retirees, baby boomers and younger workers who have accrued benefits a staggering $52 trillion!  Santa has a tall order to fill this year.