0:33 Intro. [Recording date: October 29, 2012.] Russ: Before we get started: recording this in the suburbs of Maryland on Oct. 29, which is the day that Hurricane Sandy, the storm is supposed to arrive. So, unusually, out of character for these podcasts, my family is all home; school is canceled. If you hear any noises in the background--small children fighting, large children fighting, etc.--just ignore them. It's just my family. Guest: It's a little foggy on the West Coast this morning, but otherwise not so bad. Russ: A little tit-for-tat. The West Coast has lots of catastrophic environmental effects every once in a while; nature rears its head. So this is our turn to get worked up and sell out on batteries, flashlights, milk, etc. Our topic for today is the work you've done on the fiscal challenges at the state level: public pensions. That is, pensions that have been promised to current and future state employees. Why is there a problem? What's the nature of it? What's there to worry about? Guest: Most citizens in the United States who have been following economics or politics are very aware that the Federal government in Washington is facing severe financial imbalances, which means that the tax revenue that the Federal government is taking in are substantially less than the amounts that they are paying for government programs and services. And furthermore it's been widely publicized that the promises that the Federal government has made about Social Security and Medicare far exceed the projected revenues that will be used to fund those programs. We also regularly hear news from Europe about the debt crises being experienced there--Portugal, Ireland, Greece, Spain, possibly Italy. But what many outside economic policy circles don't realize is that state and local governments around the United States are also facing very severe financial imbalances. I say, "outside economic policy circles" because this is a point that most academic policy experts seem to agree on. The U. of Chicago has run an online experts' forum for a while where they surveyed economics professors who are public policy experts--and this is a panel that is quite diverse with respect to university, geography, and political tendencies. At the end of last month they were asked whether they agreed with the statement that during the next two decades some U.S. states, unless they substantially increased taxes, cut spending, or changed public sector pensions, will require a combination of severe austerity budgets, a federal bailout, and/or default. And 92% of the Initiative on Global Markets (IGM) experts either agreed or strongly agreed with that statement. 5% were uncertain. 3% had no opinion. To get to your question, to get to pensions, which is what I work on--a lot of people will look at that polling result and say: How could this be? I thought that under the balanced budget requirements of most states that state and local governments have to run quasi-balanced budgets. Russ: Yeah. So, how could they default? Guest: Well, in fact every state except Vermont must balance its budget according to some definition, with the earliest of these provisions going all the way back to the 19th century, when the federal government had establish a sort of precedent for bailing states out of their war debts after the Revolutionary War and the War of 1812. But after the Financial Panic of 1837, they declined to step in and absorb state debts. A bunch of states defaulted at that point. Eight states, including Pennsylvania and Maryland--also the Territory of Florida, not yet a state--defaulted on their debts. And subsequently many states implemented balanced budget requirements. So that gets to the puzzle: how can we have reached the point that according to 92% of academic economic policy experts, U.S. states are going to require austerity budgets, federal bailouts, or default if they've set these rules in the past that limit the extent to which they can borrow money? How can it be that many of them seem to be facing the likelihood of what essentially sounds like a sovereign debt crisis? Not unlike what European nations have been experiencing. And the answer to how this could have happened is really what my research is about. Which is that it must lie in promises for future spending that have not been and still are not recognized in today's budgetary processes. So in other words, these balanced budget requirements--they may require states to spend as much in current spending as they take in, in tax revenues and other revenues; but they don't prohibit states from making promises in the future to make payments in the future that they can't keep. And in the instances of the states, those promises or the largest of those promises are actually promises that the state will take care of the retirements of state and local public employees. Russ: So, the technical term for this is unfunded liabilities. Which is just a fancy phrase to mean: You've got promises down the road, that you haven't set the money aside yet, in the current period, to fund those promises. Guest: That's exactly right. And the balanced budget requirements tend to focus a lot on what's going on in sort of the near term budgetary planning. But if the state is promising that they are going to pay for the pension benefits of public sector employees, when those employees retire, then it becomes critical to ask whether the state or local governments are doing sufficient planning to be able to pay those benefits. And the reason it's critical, in terms of understanding whether the state really, truly is running a balanced budget, is that--imagine for a second that we kind of told all police and teachers and firemen that we were going to pay them annual pensions when they retire, from the time they retire at age 50, 55, 60, 65--that varies based on the state--until the time that they die. We do that. But imagine that we didn't set aside any money at all. That we just did no planning for that. Well, that would clearly not be in the spirit of running a balanced budget. And that would clearly also not be in the spirit of what economists like to call intergenerational fairness. Because the next generation of taxpayers, our kids or maybe us in 10, 15 years when the employees of today are retiring--that next generation will have to pay both for the services from public safety officials and teachers and other public servants that they are consuming at that future time, and for the pensions of the retired public servants, who served us in our time. So, for that reason, the sense in which we are running a balanced budget is very critical to understand, to what extent we are running a balanced budget. And that's going to require understanding whether we are planning sufficiently well for the promises we are making to take care of the retirements of public sector employees.

8:46 Russ: But of course, you could just say: Well, okay, so we haven't planned enough. But we've got, when we hire people, in certain professions at least, a pension plan is the competitive outcome of a hiring process. We'll discuss in a minute what kind of pension and how big it is. As you said, when retirement starts, those are all dimensions that are going to be important. But it could just be: Well, it turns out we haven't fully planned for the future, so taxes will have to be a little bit higher than they otherwise would have to be. So the real question I think it comes down to is the magnitude. And you've done quite a bit of work to try to figure out what that magnitude is. And I'm curious both what your estimates of that magnitude is, how big that magnitude is, and also how you go about actually trying to figure out what that magnitude is. Because that methodology, it can't be totally straightforward. Guest: Not at all. The methodology is not totally straightforward. In fact, one of the biggest issues with this is that the costs that state and local governments are ascribing to the pension promises that they are making to state and local workers today are very different, much lower than what economists and financial professionals would view as being the true financial costs of a pension promise. And the problem with that is that that leads state and local governments to be able to say: Hey, we've--we are really running a balanced budget here, because we are costing these pension promises out at some number. But in fact the costs that are being ascribed by the governments today are a lot lower than the true costs. And what we see until now is that there already is now a large gap between promises that the government has made to public sector employees--under their own accounting and measurements relative to the assets that have been set aside, relative to the planning that has been done. Even their own measurements, of the governments themselves, are vastly under-measuring the order of magnitude of the problem of promises that have been made relative to the assets that have been set aside and the ability of the state to pay. So, in terms of numbers: What we did was we added up the liabilities--and "we" is myself and my co-author Robert Novy-Marx, who is a Professor of Finance at the Simon School of Business at the U. of Rochester. We started out by adding up all of the disclosed unfunded liabilities, that's total pension promises and unfunded pension promises across all of the systems in the United States that we could get data on. And we found that there were around $1 to $1.25 trillion in pension liabilities in the system. And that's a number, it's also very similar, to what you see having been reported by the PEW Foundation, which has studied this issue. And others. If you go and you just go look up your government's report, if you add up for California CalPERS and CalSTRS--these are the pension systems that pay for public sector employee pensions. If you aggregate up all of the systems in the country, you get to kind of $1-to-1-and-a-quarter trillion dollars of unfunded pension liabilities. Which sounds like a lot. But it really is a lot less than what the true unfunded liability is. And I'll talk about that in a minute. Just to make sure that listeners can think in trillions: I like to think about one trillion dollars as around $9000 per U.S. household. That's what it works out to. Others like to think about trillions of dollars in terms of how far a stack of a trillion dollar bills would reach to the moon. But I don't think that's as useful; it kind of depends on physics and stacking and folding and things like that. We're used to thinking about a trillion dollars as being about $9000 per U.S. household. So, to get to the measurement point, the point of our research, we investigated what kind of assumptions the systems were making in terms of arriving at that number. And what we discovered was the governmental accounting standards were basically selling the systems to project out the money they were going to owe, that we were going to owe, the taxpayers were going to owe, to public sector retirees. And then to discount that back or turn that into one number today based on an assumption that the assets will earn a certain amount of money. So, yes, they were setting aside; what they were setting aside would earn a certain amount of money. And with that, had it been implemented, would have been that every dollar that goes into the pension systems was going to earn roughly 8% compound annualized returns going forward. With certainty. And the idea here behind these governmental accounting standards was, you can say: Look, historically, we achieved an 8% return, so therefore we are going to budget going forward assuming the money we put in the fund is also going to earn an 8%. Going forward. And you know, if it achieves the 8% return, then great. If it surpasses the 8% return then we'll be able to reduce some contributions in the future. And if it falls short of the 8% return then taxpayers will have to make up the difference.

14:45 Russ: Before you go on, clarify where that money currently being invested comes from. So, there's good news, so far. You point out that the government does put some money, state governments do actually put some money aside for pension funds. That that money is earning some return. And you are saying that the expected return and the accounting that's done on how healthy the system is, that it's assumed that it earns 8%. Which is of course really high. But putting that aside for the moment: Tell us where that comes from. So, the fact that they've put some money aside is somewhat encouraging. So where is it coming from? Guest: Well, absolutely. It's far better than they are putting some money-- Russ: than not-- Guest: than originally where you just make promises and don't set any money aside. The money comes from both the public sector employers--that means the state and local governments themselves--and the employees. And it's difficult to get a really good breakdown of what percentage breakdown each of those. Because it's actually very complex. The way it ends up working is there is a sort of cost that's ascribed to the ongoing accrual of new benefits. That's called the normal cost or the service cost. And then there's also a cost that is related to the making up of unfunded liabilities. Which these accounting standards suggest are supposed to try to do. Meaning that if you get to a point where you haven't been making the 8% returns--and indeed we haven't been making the 8% returns in the last decade--then you have to start putting additional money into the fund. You also have the problem that even though a contribution could be nominally an employee contribution, it came out in Wisconsin for example, during the discussion about the Union measures, that the State was actually picking up the employees' contributions. So the true incidence is difficult to say, whether it falls more on taxpayers or more on employees. Certainly employees have taken lower salaries in exchange for these pension promises. Russ: Sure. Guest: But contributions are coming from a mix of resources of general government revenues and resources that would be used to pay public employees. Russ: And of course this also happens as well in the private sector as well, in a certain way. So, let's talk about that distinction. You and I both work at Stanford. Stanford chips in. I don't have to make all of my retirement contributions on my own. Stanford pays some of it--my employer. That seems like a normal thing. What seems like what's going on at the state employee level? Guest: Okay. Okay. We have to draw a big distinction here. At Stanford, and most private sector employees, we are in systems that are called defined contribution plans. Like 401K types of plans. Like the 401K, where the employer contributes some money, the employee contributes some money, into an individual account. The account is managed by the employee. The account may grow in value. And then the employee, him- or herself is basically responsible for turning that balance into something that is going to pay for their retirement. They are responsible for spending it down or buying an annuity or something like that. The state and local governments are Defined Benefit Systems. These are systems where the government is promising: We will pay you a benefit. We will pay you a benefit that is a function of the number of years you have worked for the state and what your salary, your late-career salary, is. At the government, say the government, that you are working for. And that promise is a pledge to pay the benefit no matter what the stock market does. So, the issue is, if we are not budgeting enough today for these things, for these pension promises, and we are not setting aside enough money for the pension promises, then the employees are going to reach retirement and they are going to say: We don't care how much money you set aside in the fund or how much you told us to set aside. You made us this promise; and we took lower salaries for that promise. And as a result, there is going to going to have to be great tax increases or spending cuts or something. Some finding of resources to be able to pay for the difference between the cost of the actual pension promise and the much smaller amount that was set aside.

19:30 Russ: So, your point, which we just took a little road trip, a little diversion, to clarify: Your point is that the amounts that are being set aside are only a fraction of the necessary amount. Partly because the presumption that is set aside is going to grow at 8%. So, if you think that is unrealistic, the question then is: What's a more realistic number? Guest: I think it's worth understanding where this 8% discount rate number came from, and on what basis, say, local governments justify it. And I will say that a lot of the difference between what we are measuring as the true unfunded liability of state and local governments and what they are measuring as their unfunded liabilities comes down to this discount rate, this 8% number. So, historically, in the last 30 or 50 years, pension funds have been investing in a portfolio of stocks and bonds that has returned about 8% per year. That's kind of a historical, realized value. And they are therefore using, as their budgetary plan, an 8% number. That is, they are assuming that, okay, going forward, we are going to earn this 8% number. And you know, a lot of people would look at that and say-- Russ: well yeah, that seems fair-- Guest: Yes. Russ: But we are often warned that past returns are no guarantee of future success. But it seems like the right place to start. Guest: Exactly. Past returns are no guarantee of future success. I think the thing we are going to see--I'm going to illustrate this for you wish some examples in a second--is that because the public sector pension promise is a guarantee, that is exactly the reason why you cannot use the returns on risky assets to try to measure what the value of that guarantee actually is. So, I'm going to give you an example. I want you to actually think for a minute--I'm going to try to not give you too many numbers--but this is an example that I think will kind of help clarify things. So: now, suppose that you have a debt of $100,000 due in 15 years. I'm going to set up a simplified financial household for you. So that's your debt. Now suppose you also have some cash in a bank account; and that cash is approximately $31,000. So, you have a debt of $100,00 that's due in 15 years; you have $31,500 in cash; and you go to a bank and you want to apply for another loan. So, this is your household's financial situation. Now, the bank is going to assess your financial position. And if you have a steady, high-paying job the bank might say: Fine; you are approved for the loan. If you don't have a job, are unemployed, haven't had a job in a long time, the bank would probably look at you and say: You are probably not a great candidate for this loan. So, imagine you are in the position of someone who had applied for this loan and had not received the loan. What if you did the following: you went home and you thought about it, dejected that you had been rejected for this loan; so you decided you were going to move the $31,500 in cash into a portfolio of stocks and bonds. And a portfolio of stocks and bonds, you've observed, historically has earned an 8% return. And in fact, you have an idea, which is that you are going to go back to the bank the following day and you are going to say: I'm the guy you saw yesterday and I applied for this loan here, and now something has changed. So, yesterday I had the $31,500 in cash. Now I've got it in stocks and bonds; if you take $31,500 and you multiply it by, gross it up by, 8% a year, compounded for 15 years, you will see that my $31,500 that I have in this account today is going to be sufficient to cover the $100,000 debt that I have in 15 years. Russ: I'm debt free. I'm a great risk because I don't have any net debt. Guest: I'm debt free, because this $31,500 is perfectly going to offset the $100,000 that is due in 15 years. And of course the bank would not accept that logic. And no one in the private sector would accept that logic. And if you really try to do something like that and sign your name to it, you would be taken to jail. So I definitely not advocate that any listeners attempt to make such a statement. But the government accounting for pensions says: Yes, you can do that. You can assume, when you budget, that every dollar that you've got on hand is going to earn 8% returns, with certainty. Now, I'm going to talk a little more about what's really wrong with that. There's so much wrong with that example that it's hard to know where to begin. I mean, the first thing is that, a lot of people are recalibrating their investment expectations. Russ: Yes, they are. Guest: The 8% returns that were achieved historically--these were achieved historically at a time when you could get pretty decent returns on essentially risk-free assets. You could get--Treasury inflation-protected securities were giving you, as of the late 1990s, 3% returns above inflation. So, if inflation were running at 3%, you could get a 6% return in just about the security around. So, achieving an 8% return with a little bit of risk in some other part of the portfolio didn't seem that unlikely. Today, risk free assets earn basically zero real--inflation plus 0--or even negative. If you want to even get a guaranteed return of inflation, if you bought a Treasury inflation-protected security--these are bonds that the U.S. Treasury issues that are tied to inflation--your return, to keep up with spending power, if you buy a 20-year, a 25-year government security but not a shorter maturity security. So, the kinds of returns that seem to be available in the market today are a lot lower. So one of the problems with my example that I gave you, one of the things that listeners would say, is: We may have earned 8% historically, but there is kind of a new normal going on in financial markets that suggests it's just going to be a lot harder to earn those same returns going forward. That's one problem. Another problem is that, what I just said is why: the bank won't give you any credit at all for moving your assets from cash into stocks. They wouldn't just say: Well, we won't allow you to calculate 8% but we may allow you to assume 4 or 5% return on this stuff. And I think that's interesting, because if you ask me if I think stocks will outperform government bonds over the long run, I would say it's maybe more likely than not. But the point is that there is substantial risk there. And as they are saying: Past returns are no guarantee of future performance. We've told the public employees that we will pay for these pensions no matter what the stock market does. And proper financial accounting reflects that as a guarantee. It does not allow us to say, to make a contract, with our kids that says: Look, you guys will pay for the pensions if the stock market does badly; we will have budgeted sufficiently if the stock market does well. The returns on stocks we got historically were not a free lunch. Stocks are risky. Very bad outcomes are possible. And furthermore, very bad outcomes are going to come exactly at those times when the future generations or our kids are not going to be in a very good position to come up with more money in the way of tax revenues or be able to handle government spending cuts in order to pay for the retirements of public sector employees. So, it's really a problem of we've set this up so exactly at those times when the private sector would be most unable to pay for their own retirement, they are going to have to come up with money to pay for the retirements of public sector employees that should have been properly--where the system should have been properly set up in the past--is taxpayers in the future are going to have to make up the at the worst possible times.

28:24 Russ: Yeah. Another way to say it is that the risk falls on the taxpayer rather than on the employees. Which is nice for them. That's okay--if you pay for that in the form of lower wages. There are a lot of things we do in life where we trade security--we are happy to accept security for a lower return. But they are getting a generous promise where the riskiness of that promise is paid for by someone else. And that's a recipe for--that's a bad set of incentives. Guest: Yeah, think of it this way--basically, we have written a large insurance policy on the stock market. And we have got to come up with a lot of money, additional money, for public sector employees if the stock market does not perform. There are ways to provide guaranteed pensions to people. They are called deferred annuities. And if you look at what other countries do--let's look at, so the Netherlands is my favorite, because they have a very long tradition of providing occupational defined-benefit pensions, these kinds of pensions that we have here in the public sector, for just about everybody in the Netherlands with a job. They are eligible for one of these occupational defined benefit pensions. And what do they do? Well, they measure the promises using risk-free interbank swap rates, which are essentially 0% for near-term liabilities. So they are using essentially 0% discount. And for the longest term payments, a payment that is 30, 40, 50 years out, they allow no more than around 4%. And you look at many other--you can compare this to what goes on in the U.S. corporate sector, when companies sponsor pension systems. It's clear when I go speak to international audiences about the way that we measure pensions in the United States. I think they think our governments are behaving very irresponsibly. Russ: But the worst part of this--that's all very interesting and great to know--but you said: Even by the states' own assumption of 8%, it's a one and a quarter unfunded liability. Right? So the actual liability, if you used a more reasonable projection of expected return, is dramatically larger. Guest: The actual unfunded liability is $4.4 trillion, as of the end of 2011. Russ: And that would be about $36,000 per American household? Is that correct? Guest: Yeah. $38,000 per U.S. household. That's a huge burden. Some interesting notes about that, that I would add. If you live in a major metropolitan area--some examples that come to mind are Chicago or Los Angeles--your unfunded liability is actually a lot bigger than that. Because cities have larger public sectors; they are providing more in the way of services. This hidden debt, this debt in disguise, this off-balance-sheet debt that we owe to public sector employees, is higher in places where there is a larger public sector. And so, in Chicago you are looking at about $80,000 per household of unfunded debt. So basically credit card debt that the city and state have run up on your behalf. Russ: It's a bargain. But that's a bargain for the high-quality schools that they have, Josh. Sorry about that. Let's put that to the side. But it's $80,000 per household in Chicago for the current value of expected future promises? Guest: Yes; and after using the assets that have already been set aside. So, the unfunded promises. And, just to come back to--what I've worked on has not really said much at all about the overall generosity of pensions for public sector employees or whether they are paid too much or too little. The real point is whether we have been pretending that we are compensating them less than we actually are. And we've been doing this stuff with deferred compensation. We are paying in promises. And when you have paying in promises and those promises aren't measured properly, you really have a kicking-the-can down the road kind of dynamic where no politician wants to touch this. Any time somebody brings up the idea that maybe somebody should lower the discount rate because it's unrealistic, the response is: Well, wait a second; we can't afford to lower the discount, because that would mean we would have to put more money into the pension fund today. And what that doesn't recognize is that the cost of making a deferred guarantee promise is invariant to what you want to set aside today to fund that cost. Financial markets tell us very clearly what it costs. You can look at markets for deferred annuities. If the state went to an insurance company and said: We'd like you guys to pay these pension benefits; can you give us a price? The insurance company would surely not say: Yeah, we'll give you a price, and since we've seen you've earned 8% historically on your investments, we'll give you a price based on an 8% return. No. The insurance company is going to say: Well, you want us to pay this, you want us to pay deferred annuities for your employees; deferred annuities have a price in today's market, and those are going to be based on discount rates that are pretty close to 0 these days.

33:57 Russ: There's this literature on whether private or public sector employees of the same skill level are paid competitive salaries, right? I don't know whether you've looked at that. But it makes me wonder whether they've included pensions in assessing the comparability of private/public sector pay. Guest: Yeah, I think there has been some work that has been done. I've seen various papers that attempted to re-measure the public sector, cost of the public sector pension promises, using the lower financially-based discount rates. It is very hard to get true comparables. In economics this is very difficult to be able to say these two people are truly comparable. Another point about this unfunded debt, the $80,000 for the Chicago household and the Chicagoans, and the $4.4 trillion of unfunded liabilities around the United States. Compared to Federal debt of $16 trillion, and usually much more in Medicare and Social Security, it's not that big. At first glance, it may seem small; but this is just another big debt. Russ: It's a wart, is all it is. Guest: Let me tell you why I think it's not a wart, and that's for the following. The Federal government controls the money supply. They can print money. State and local governments cannot. And that's why I think actually a comparison to Europe again is quite useful. Let's look at Greece. Greece is not a systemically important country. It's a small state, 2% of GDP, within a broader Europe. But its financial overextension led to the realization--well, two realizations, really. First of all that there are others that actually weren't in such great shape, either. And secondly that the legal frameworks do not and did not exist for restructuring this debt; that there's no legal way to work this out because we've been assuming all along that the money was just going to be there. And like California and Illinois, Greece does not have its own currency. So, I think when you look at it in that light, the magnitudes of the unfunded liabilities, say, of the German government may be a lot bigger than those of Greece. The problem is that even smaller states, when they don't control their money supply and they make these overextended promises can really lead to crises of confidence. Financial markets, they don't see an exit from this. They don't see a legal pathway for restructuring the debt. And that kind of uncertainty can really do a number in financial markets. Russ: But I think it's worse than that, actually. It seems to me that the real risk is the breakdown of civilization which we saw a little bit of in Greece--not so bad because eventually a mechanism was discovered, partly because they are a small country relative to the rest of the countries involved. If you think about California, you think about California coming to a point in the semi-near future where it cannot honor the promises it's made to its public employees without either very large increases in taxes on current taxpayers, pleading in Washington that all other Americans chip in, or telling its retirees that the promises we made aren't going to be kept. Now, normally in politics you'd think all three things would happen. You kind of get a mix. You get a compromise. But that's because there's often governance measures that let that compromise take place. And I think what you are really pointing out is that those measures don't exist. We don't have a--what we've done in the past, you mentioned 1837, the government said: You can't. As a Federal politician, a national politician, I can't make other taxpayers outside of California pay for California's irresponsibility. So, then you go inside California. These aren't a small group of 100 or 1000 people. These are thousands of people who are expecting large sums of money, and they are going to fall very unpleasantly on another group of people. I don't know how that's going to turn out. Guest: Hundreds of thousands of people. Also, when these hundreds of thousands of people happen to provide services that we rely on every day for our public safety and the education of our kids. Could there be a worse arrangement than to borrow huge amounts of money that we can't pay back to people whom we depend upon every day for government services? You can imagine what's going to happen if we tell public sector employees we can't make these guaranteed promises. Russ: Strikes. Guest: Exactly. I think the breakdown of civilization over these things, the breakdown of a functioning government that can provide these services that we rely on, is unfortunately going to become increasingly likely. Russ: Yeah, but I think the strike is the least. That would be a great outcome. Then you negotiate some settlement. But that's a settlement you'd usually negotiate with current employees over future benefits. We're talking about trying to renegotiate past promises to current retirees. Guest: Right. Russ: It's going to get nasty.

39:32 Russ: But before we go a little further, and we're going to talk about--it's pretty depressing so far, on this rainy day on the East Coast and high winds are promised and it's not a good day to be outside. We are eventually going to talk about, I hope, what might we do to make this better down the road, or at least deal with it. Before we do that, you said--we haven't said anything about whether these pensions are too big or too small. The only thing you've talked about so far is that they've not been planned for. But there is this other political, unpleasant problem, which is the size of the pensions and the way they are calculated have been negotiated in the past in a way that a lot of people would say is not so attractive or fair. Can you talk about that? Do you want to talk about it? Guest: Well, I can talk about it a little bit. Russ: What I'm asking is--I've read these cases; I don't know how representative they are--where a chief of a fire department or police will retire at a young age, having taken lots of overtime in the year or two before they retire, because the pension is based on the last year. Which seems like a nice thing, except they pile in lots of stuff and they end up making a pension well over $100,000, sometimes $150,000, that dwarfs anything available to somebody in the private sector because of the way the rules have been made. Is that a weird outlier that just makes the news? Or is that all too common? Do we know anything about that? Guest: We know that it is not--so what is uncommon, I think the situation in Bell, California, where you had public sector employees making $7-$800,000 per year without people really understanding, and setting their pensions accordingly, I think that is not that common. Russ: Few. Guest: What is quite common--here in California there was a scandal in Contra Costa County where a fire chief was earning a $186,000 salary before he retired, and he was somehow about to turn this into a $241,000 pension per year that was going to grow. These pensions grow, by the way; there are cost-of-living adjustments. $241,000 was his starting pension per year, which he took when he was 50 or 52. Russ: Only 30 or 40 more years of it. Guest: Yeah. He was able to get this by having the city repurchase unused sick pay credits that he had left there. And that reset his pensionable salary to this $241,000 number. Russ: And then if I remember correctly, he then went back and worked part time. Guest: Yes. Russ: At a very large salary, while he was collecting his pension. Guest: That's another issue--that public sector employees can often go back and work part time. If people can go back and work part time, it's not clear what the justification is for providing them with a benefit that looks like this. The actual spiking piece of this--so, spiking is what he did to get his $186,000 salary up to a $241,000 pension. Spiking is something that a lot of states have tried to take aim at in legislative action. What's somewhat either depressing or amusing is that even spiking, it's very difficult for them to say that current employees will be unable to spike their pensions, because there are a lot of both political muscle and also legal analysis behind the argument that these guys are protected; you can't tell them not to spike their pensions. Even sometimes you read about a reform, a widely touted reform that says it targets abuses, and spiking, it says: New hires will not be able to engage in pension spiking. We're talking about whether somebody 30 years down the line is going to be able to turn their $186,000 salary into a $241,000 pension--that's not going to be much help during the 30 years between now and then when people can. I've seen evidence, papers that suggest that spiking might cost California some number in the hundreds of millions of dollars per year, which is not insignificant relative to tens of billions of retirement costs. But is not really the root of the problem. If we had been, if all of these things had been transparent from the outset and it had been possible for taxpayers or for taxpayer watchdog groups or for legislators who had an incentive to care about fiscal soundness to actually monitor what was going on, we would have said in real time: Whoa, these things are really expensive; we need to make sure that we are offering people something that we can pay for and that we are budgeting properly. But all of this is hidden behind the shroud, mostly again of these return assumptions and these discount rates. The only justification for using a discount rate that is higher than a default free rate, like what's used in the Netherlands, is if you want to credit the government for its option to default on these benefits. And companies have recognized this for quite a while. The Financial Accounting Standards Board, or the FASB accounting, companies using high grade corporate yield curves to measure their pension liabilities. Which makes a lot of sense for companies because those pension promises are really like corporate bonds. As companies approach, if they end up in bankruptcy, like United Airlines for example, they become absolved of their pension obligations; and those obligations are taken over by the U.S. government where they are hair cutted and then re-measured using Treasury curves. So--I got away a little bit from the spiking question. I guess it just highlights the fact that I think while spiking adds to the costs, the true problem is that all of this, these are hidden ways for state and local governments to circumvent their balanced budget requirements. And to spend more money today than they are taking in in tax revenue and to be able to call that a balanced budget because of the assumptions they are making in their planning.

46:11 Russ: I wonder how aware public employees are of this problem. A lot of young people that I talk to expect to get nothing from Social Security and their current contributions. Guest: A bad expectation; that would be, not Social Security, that would be an incorrect expectation. Russ: I think so. But who knows. They expect zero. Which is a little bit overly pessimistic. Guest: Yes. They are not going to get zero. But they are not going to get what the statement says they are going to get. Russ: Probably. And that I assume also is maybe kind of true at the state level? I don't know. What's going to happen with Social Security is that I think the retirement age is going to be bumped up; the tax rates, the so-called contribution level of payroll tax is going to be increased. Maybe the benefit is going to be indexed differently. That's different though, because those are all Federal legislation--you know, Congress can change Social Security any time it wants. But the things we're talking about, these are contractual obligations between a state government and a union that I think are of a different legal nature. Or am I wrong? Guest: That's really the problem. That's exactly right, Russ. We have a history in this country of adjusting Social Security, making technical adjustments to Social Security benefits and contributions in order to put the system back into balance. In the 1970s and early 1980s. And Social Security is a pay as you go system, but it's one with an understanding that--now we need the political will to be able to do this, and to the extent to which Congress is polarized and there is the political gridlock that we have in Washington, that may be a tall order. But there is a history of revising Social Security benefits. The problem that we see in the states is that governor after governor in the U.S. states have tried to put forth proposals that change pensions and they've been met pretty much with the resistance of the groups--the public sector unions and the people who have been promised these pensions, who have said: Look, this is a contractual promise; you can't change these. And then what's happened is that the governments, the governors, the legislators, have typically backed down and said: Okay, we'll water this pension plan down so it only affects newer employees. Brand new employees, not just newer. So, these are promises that are viewed as having been part of the contract. So, just like Greece has no way of restructuring its sovereign debt, we have no way of restructuring these promises. And I think the result is going to be that we are going to reach a point where there is serious, even more serious competition for scarce government resources to pay for schools and roads and teachers and public safety officials, versus to pay the pensions of the people who worked in the past. It's just not easy to make technical adjustments or to change benefits that are already being received by people or are going to be received even by the current working group of the public sector employees. Russ: But it does--I mean, maybe I don't have enough knowledge of the legal system, legal issues involved, and maybe you don't either--but it seems to me that if I'm negotiating with the firefighters, of today, about current salaries, current overtime, current pensions, and I've made past promises to firefighters that have turned out to be much more expensive than I'd thought, or I didn't put enough aside, for whatever reason, as a state--it seems to me that I could, it's imaginable that that past contract could be renegotiated on the basis of current terms--current terms could play a role in that. Is that imaginable? Could that be? Guest: It's imaginable. I think the retirees, they have very strong political power themselves. The question is: Would there ever be a situation where the kind of younger public sector workers would be able to negotiate things and in a sense sell out the older retirees. The dynamic that makes that really difficult is that who really controls the bargaining that goes on? Who are the people who are really at the table when public sector unions are doing the bargaining? They are individuals who themselves are only a couple of years away from retirement. They don't want to lower their own packages. Russ: True. Guest: It would be very hard for them to be able to find a way to draw the dark line right between the workers and the retirees, the people who are at age 60 or something. So, I think that dynamic, while it's conceivable that we could get there, is very difficult. I'll certainly say that if I were a younger public sector employee, I would think of these contributions that I was making to the pension systems as pretty much not going to get me anything. I think that there, compared to Social Security, it would be a bad assumption to think that your Social Security contributions are going to get you nothing. It would probably not be that bad an assumption to plan, if you are a younger teacher or public safety official, that the money you are putting in, is being deducted from your payroll to go to these defined benefit systems, is probably not going to get you very much. Which actually leads me to what I think is a very frightening point, which is that there are 5 or 6 million public sector employees, retirees, who are outside of Social Security. They do not, they are not in the Social Security system at all. Their systems never opted in when the Social Security Act was passed. And as a result they are reliant only on this pension as a source of retirement income. So, on the one hand, stories are going to come out of people who retire very early and in fact I was in Rhode Island and they were talking about their municipal system where there are people who are retiring in their 40s, recharacterizing pensions as disability. You are going to have people abusing the system; you are going to hear about these costly things. But on the other hand there are going to be many rank and file individuals who are not trying to game the system, who are trying to have a secure retirement, who may not have great employment prospects after they leave the public sector at age 55. And they are completely dependent on the state pension for their retirement. They have no Social Security. So, I think that is something that should make younger public sector employees, particular the public safety officials, many of whom are not in Social Security, worry. And should want to address this problem. Russ: It's a nasty thing.

53:26 Russ: Let's talk about what might be done. What could we do that would be better if we were thinking about this from scratch? And then, what possible things might be done now that we are in the middle of it? So, one obvious way to fix this going forward is to have a more realistic assumption about the growth rate or the discount rate--what we've been talking about: the 8% should be assumed to be 2%, or 3%, or 1.5%. That's one way to make it clear. Now, the goal here isn't to get rid of public pensions. The goal is to figure out a way to make it transparent so that the political process can make the decision rationally in some dimension--whatever that means. But at least there's some understanding of what's going on. Guest: That's exactly right, yes. Russ: So, one way to do that is lower the discount rate to a more realistic number. The other would be to move away from Defined Benefit (DB) and toward Defined Contribution. Correct? Guest: Yeah, exactly. And I'd put it even a little more strongly, which is that as long as state and local governments are going to reject proper cost measurement, they shouldn't be offering new defined benefit promises; and they should be moving to defined contribution. If they want to accept, are willing to accept the financial reality that a guaranteed deferred promise, you've got to cost that out at very low discount rates--as has been recognized around the world and by corporate accounting used by everybody else--then the DB systems could continue. Unfortunately I see nobody who wants to go near this discount rate. Anyone who wants to claim they are doing pension reform, they just want to do something that sort of nibbles around the edges. Now, there have been, some of that nibbling has gone into some farther reaching, more biting measures, I suppose. As I mentioned before, a lot of the pensions have Cost of Living Adjustments associated with them, often called COLAs. And some of the most far-reaching reforms have been those that have actually tried to modify those COLAs, under the argument that these aren't really part of the true contractual promise. The base benefit might have been, but this COLA is sort of a technical thing that we can potentially try to change. And New Jersey suspended the Cost of Living Adjustments. They'll be reinstated if and when funding gets back to some certain level, the government's own measures. Rhode Island did something similar, suspending Cost of Living Adjustments while also moving people a little bit more to some mixed defined benefits/defined contribution plans that I'll talk about in a second. So, those Cost of Living Adjustments are actually really expensive. And reductions in Cost of Living Adjustments, which have received traction in a lot of states, do actually reset the liability to a level that could be, depending on the parameter, you could deal with with 30-40% of the unfunded liability problem by eliminating the COLAs. Now, eliminating the COLAs also, in some places the COLA is not just a 3% giveaway but also is a link to inflation of a not very generous initial base benefit. So some retirees would feel that very strongly. But I think the point is that at least when you see this reduction in COLAs, they do reduce the kind of benefit, the unfunded liability in the near term. But they don't put the future on much better footing because as long as you are still running these defined benefit systems, you are still running these imbalanced budgets; and that savings that you just earned, that you just created from reducing the Cost of Living Adjustment, are just going to slowly be eaten away by the fact that we are still continuing to mismeasure every new day of pension promises that we make. Russ: It just says that--instead of being $8.8 trillion it's really only $4.4 trillion. Guest: Right. So, and then that $4.4 will continue to grow. If the only thing we change is the Cost of Living Adjustment--those numbers I gave you before, by the way: those are only the legacy liabilities. That's the present value of what we promise today even if we thought it was advisable and could and did freeze all of the pension promises at today's levels. And compensated using defined contribution plans going forward. Even then, that $4.4 trillion would still be there. So, the point is that unless we reform the system, we are in a situation where that $4.4 trillion is growing. So, adjusting the Cost of Living Adjustment, that gets you a sort of near-term reduction in that kind of number, but it also doesn't change the fact that that number is going to continue to grow. So it kind of buys time.

58:42 Guest: So, then in terms of, less say we want to move out of the defined benefit realm. What about defined contribution options? What about the option of: let's just give everybody 401Ks. I think it's worth pointing out that part of the difficulty here is that 401Ks have suffered in the private sector from poor investment choices and high fees; and have not exactly been a resounding success for guaranteeing the retirement security of private sector Americans. There is a lot of bad stuff happening in the 401K world. What's important to recognize, and what's been recognized in foreign countries and very small pockets of our country, is that 401K plans are not the only kind of fund contribution pension plan that you can have. So, first of all, there are very simple improvements to 401Ks that could make them a lot better. So, the Federal government employees, the ones that have been hired in the last 20 years, they are on a defined contribution plan. It's kind of like a 401K plan. It's called the Federal Thrift Savings Plan. Because the federal government is big, they are able to negotiate very low fees with the providers of these plans. And they are also savvy in setting up a plan that gives people reasonable investment choices, not large numbers of very high expense mutual fund choices and things like that, but is a plan that provides people with very good choices for them to elect and also gives them the option to make an annuity out of their wealth at retirement. So one thing one could imagine is having a Thrift Savings Program for state employees. Which would really just be an individual account system for state employees where states would use their bargaining power to negotiate low fees with mutual fund advisers. So, that's one option. Another option is to say: Okay, well, maybe we don't necessarily want to go all the way to the individual account. Maybe we are concerned about the choices that behavioral economics suggest that people are making in 401Ks. And what you could do then, if you believe that's the right way to look after public sector employees, is you could set up what's called a Pooled Defined Contribution Plan. And what that is, the best way to describe that is, take one of these big systems like CalPERS, the California Public Retirement System--instead of there being a baseline guarantee, you are in a pension, your salary, etc., instead basically you just give employees shares, ownership stakes in CalPERS. This is a pooled elective defined contribution vehicle. And then what happens is when the employee retires, they will get a pension that is based on the value of their claim in the pension fund. And this is not unlike what has been offered by TIAA-CREF for many years to some college professors. I've never been part of TIAA-CREF myself, but these pooled defined contribution vehicles allow individuals to have an ownership stake in the pension fund. Then they are not making their own investment decisions if they don't want to. And they can get a pension when they retire that's a function of how these assets have performed. But without taxpayer guarantees. So, there is a way to still have pooled investment without taxpayer guarantees. And I think that's a reasonable option to consider as well. I think we have to put all these options on the table. And if they won't accept the imperative of properly defined cost accounting, then some kind of defined contribution arrangement seems necessary.