The Crash Course - Chris Martenson [64]
For example, if a town’s pension administrators knew that they’d need $100,000 in 10 years to pay off a pension obligation, their assumption of an 11 percent rate of return would only require them to place approximately $35,000 into the pension fund. If instead they assumed a much more modest and achievable return of 5 percent, which averages out the good years and the bad, they would be required to put roughly $61,000 into the fund, or 95 percent more. This is why plan administrators have often made wildly unrealistic assumptions about plan returns. Once again, the miracle of exponential growth has crept into a story, this time with seemingly minor assumptions about percentages compounding into very substantial predicaments, and once again exponentials are proving to be a substantial foe.
The problem with using such wrong assumptions is that instead of working for you, compounding works against you. Even a slight miss in returns a few years back will mushroom into a very large future shortfall. That’s just how compounding works, and that’s exactly where hundreds of underfunded pension plans now find themselves.
To illustrate how this will play out, consider the case of Vallejo, California, where mandatory pension payments, long-deferred but finally unavoidable, ate into the current budget too deeply to avoid cutting other current services. Faced with unmovable public employee unions, escalating pension costs, and a rapidly shrinking budget, the city was forced to declare bankruptcy in 2008.7 By 2010, the city had slashed its police force from 160 to 100, requested that its citizens use the 911 system as little as possible, and cut funding to youth groups, a senior center, and arts organizations. In other words, past promises have caught up with current spending. For the leaders of Vallejo, the future they hoped would never come has arrived. This critical tension between pension promises that were far too generous to ever be supported (even under a regime of healthy economic growth) and the need to direct municipal and state revenues to current services is sure to dominate the financial landscape of the twenty-teens.
What does it mean when we say that the state and municipal pensions are underfunded by a trillion dollars? How is that calculated? The trillion-dollar shortfall is what is called a Net Present Value (NPV) amount. An NPV calculation adds up all the cash inflows and offsets (or “nets”) those inflows against all the future cash outflows. Since a dollar today is worth more than a dollar in the future, the future cash flows have to be discounted and brought back to the present. We net all the cash inflows and costs, and discount them back to the present to determine if the thing we’re measuring has a positive or negative value.
This is the methodology used to calculate the status of state and municipal pension funds. Growth in the value of the pension fund assets plus future taxes are offset against cash outlays to pensioners, brought back to the present to indicate that in order for the pension funds to have zero value (in other words, to avoid having negative value or being “in the hole”), $1 trillion would have to be placed in those funds today.1 In 2008, corporations, coming off one of the highest levels of profitability in history, had similarly underfunded pension obligations amounting to over $400 billion (again, in NPV dollars).8
But it’s only when we get to the U.S. federal government entitlement programs that the truly scary numbers emerge. Lawrence Kotlikoff (a Boston University economics professor) has studied the issue as closely as anyone and calculated in 2010 that the U.S. federal obligations are underfunded by $202 trillion, or more than 8 times