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The 50 State Pension Puzzle

October 28, 2010

We all know that the states are on budgetary thin ice. Deficits are looming for all but one or two states, the stimulus money is ending, the tobacco settlements have been spent, the rainy day funds are drying up…… you get the idea.

We all know that the states are on budgetary thin ice. Deficits are looming for all but one or two states, the stimulus money is ending, the tobacco settlements have been spent, the rainy day funds are drying up…… you get the idea. What you may not have heard about are the massive pension and health liabilities coming due soon to a state and city near you.

There have been many promises made to state and municipal employees in the form of labor contracts and sometimes even enactments of law. The problem is that these promises haven’t always been fully financed. For many years that didn’t seem like too much of a problem because the stock market gains provided an escape route and made up for the contribution shortfalls. But … these times are a changing and it’s not good news for municipal pensions and retiree health plans.

First, it’s important to understand that most municipal employee pensions and retiree health plans are structured as defined benefit plans – this means that regardless of whether the account balance goes up or down, the pay-outs are preset. In the current investment climate, the balances have been going nothing but down - therefore the money must come from someplace else - i.e. the current state and city budgets. You didn’t hear much about this before because the states and municipalities had a formula of lofty investment gains, but now that small gain reality has set in, the formula isn’t working. To help you understand the magnitude of this, here are some statistics:

From 1982 to 2000 the S&P 500 stock index rose over 19% a year
From 2000 to 2010 the S&P 500 stock index FELL almost 2% (after a big run up and crash)

The think tanks and groups that calculate this stuff estimate the total underfunded amount to be $1 trillion dollars (that’s a million, million – think about it). Over a very long period of time (70 plus years), stocks have historically returned only 8% if you include dividend payments. With companies experiencing their own budget and profit problems, you can expect that dividends and stock prices will stay low for some time (probably less than 8% and forget about 19). Out of all this one thing is sure - you are going to hear a lot more about it and it will likely be in the form of tax increases.

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