September 3, 2013 / 7:15 PM / in 4 years

Pension liability looms over U.S. states' economies: group

WASHINGTON (Reuters) - Public pension liabilities in five U.S. states could represent more than 40 percent of their local economies, according to an analysis released on Tuesday by a conservative group that lowered the assumed rate of return for pensions’ investments.

The group, State Budget Solutions, which aims to reform budgeting practices by state and local governments, used a rate of return that is less than half the historical averages that are used by most public pensions.

State Budget Solutions found retirement systems are short $4.1 trillion to pay future benefits in total, based on a projected rate of return on investments of 3.225 percent, which it said was the 15-year Treasury bond yield on August 21.

Historical averages are usually between 7 percent and 8 percent. Because they have to deal with long periods of time, pension administrators prefer the averages, which they say are the safest measures for anticipating future performance.

Ohio has the greatest shortfall as a percentage of its gross state product, at 56 percent, followed by New Mexico, at 53 percent, according to State Budget Solutions.

Conservative political leaders such as Senator Orrin Hatch, a Republican from Utah who is making a strong push for public pension reform, say pension systems should rely on a “risk-free rate” in line with the yields paid by Treasuries.

Projected rates of return have been at the heart of public pension battles over the last half-decade, as investments provide about 60 percent of the systems’ revenues.

Using the “risk-free” rate, State Budget Solutions said Ohio has a shortfall at $287.37 billion.

Other states with big shortfalls as a percentage of their economies are Mississippi, at 48 percent; Alaska, at 46 percent; and Illinois, at 41 percent, according to State Budget Solutions.

On the other side of the spectrum, South Dakota, Washington, and Texas have the smallest pension gaps, equal to 17 percent of their gross state products.

Looking at how much states have on hand to cover pension payments, State Budget Solutions found Illinois has the smallest amount, at only 24 percent of the funding needed. In June, a comparison by Moody’s Investors Service of pension liabilities to states’ revenues found that Illinois was in the worst shape, with a pension bill equal to 241 percent of all its revenues.

Critics such as Hatch, who introduced legislation to put public employees into annuities, and Representative Devin Nunes, a Republican from California with his own bill on the funds’ projections, say those averages are too high and force pensions into risky investments.

Currently, Treasuries only make up 20 percent of pensions’ portfolios, and equities more than 55 percent, according to Wilshire Associates.

Few researchers, analysts or retirement administrators expect pensions to see the meager returns that State Budget Solutions anticipates in the near future. In a report last month, Wilshire found that over the last year public pensions had a median return of 12.4 percent and over the last five years, which encompasses the financial crisis, the median return was 5.2 percent.

The crisis devastated pensions’ investments. At the same time, states that had short-changed their pensions for years pulled back even further as their own revenues buckled during the 2007-09 recession.

Of late, though, the stock market has bounced back, and states are pitching in more - all leading to a turnaround in many pensions’ finances.

Pension assets surpassed pre-recession peaks this year to reach record highs, according to the U.S. Census.

Both Fitch Ratings and Standard & Poor’s Ratings Service have said that recent reforms and slowing declines are leading to better financial performance.

Reporting by Lisa Lambert; Editing by Leslie Adler

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