What does “unfunded liability” mean?

Sgt. Jim Foster, Vice President, Long Beach POA

Here’s a thoughtful analysis by Long Beach Calif. Sgt. Jim Foster: 19-year-veteran, Vice President of the Long Beach POA, and 1990 graduate of the US Naval Academy.

The term “unfunded liability” has become synonymous with a black cloud of impending doom hovering over every taxpaying citizen. To be fair, it is a problem if left unchecked, and it must be addressed.  However, it is also clear that the problem is being exacerbated by a few in order further their political agenda.

The phrase alone is designed to cause concern. By combining two negative sounding words such as “unfunded” (ewww) and “liability” (ouch), you create a super-phrase that is intended to cause despair. The phrase could easily be reworded as “future payments required for services already rendered,” but then no one would pay attention.

By definition, it is the amount of money, at any given time, by which future payment obligations exceed the present value of funds available to pay for them.

Think of an unfunded liability as a credit card or mortgage payment.  If you buy a house for $500,000 and make a $100,000 down payment, then your unfunded liability is $400,000. You don’t have $400,000 in the bank today to cover the cost, but over time you pay it down little by little. Ten years from now, your unfunded liability may be down to $300,000.

It is definitely a downer to have a 30-year, $400,000 mortgage floating over your head, but the only other alternative is to not have a house.  You can try to renegotiate your mortgage to save some money, but unless you pay it all in one lump sum, there will always be an unfunded liability.

Our pension fund also has an unfunded liability. Our pensions include certain contractual obligations (money due to our past and present members for benefits they earned).  The total cost of these benefits is projected over time using a series of complicated assumptions.  Actuaries look at amount of money currently in the pension fund and estimate how much it will be worth at any given time in the future.  If the projected obligations exceed the projected assets, then the plan has an unfunded liability.

The difference between a pension fund and a mortgage is that the pension fund obligations are a moving target.  Depending on the economy, the stock market, infrastructure costs, tax revenues, and a dozen other factors, the unfunded liability goes up and down over time.

Just two years ago, the Long Beach, California’s contracted actuary (John Bartell) told the City Council that the estimated unfunded liability of our pension fund was $1.2 billion dollars.  His presentation came at the height of the financial crisis and before any of the City’s major employee associations had enacted pension reform. The number came as a shock especially since our pensions were “super funded” just a few years prior.

But don’t be fooled. The entire purpose of Mr. Bartell’s presentation was to give the City the ammunition it needed to increase the pressure for so-called “pension reform.”  The $1.2 billion number was designed to have shock value.  No one really remembers the rest of Mr. Bartell’s presentation or how he finally calculated that number.  All they remember is the big number.

What did that number really mean?

It meant that if every city employee immediately left service and began collecting their retirement checks for the rest of their lives…and…no one was hired behind them…and … all of Mr. Bartell’s numerous assumptions turned out to be true…then…after 30 years the plan would have needed $1.2 billion more dollars to break even.

Now, to be fair, Mr. Bartell is very good at what he does, and his assumptions are based on historic trends, but even he will admit that the numbers are a best guess.  No one really knows what the future entails.  The number is simply a planning tool to be used by governments to make future financial decisions.  No one could have predicted that CalPERS would have two consecutive banner years following the crash of 2008-2009.

In fact, Mr. Bartell’s full presentation clearly pointed out that changes in current assumptions could have enormous differences when they are applied over 30 years.

By the way, the unfunded pension liability estimate in 2007 was zero because we were super-funded.  In 2010, it had ballooned to $1.2 billion dollars and there was panic in the air.  After a few changes to our contract and improved economic conditions, the 2012 estimate is $700 million (nearly half of what it was in 2010).  Clearly, the number changes radically as corrections are made to the system.

Is an unfunded liability bad?

Well . . . no, not really, but it can be if left unchecked.

Over time, an unfunded liability goes up and down. But, unless you maintain a 100% funding level at all times, it is nearly impossible to get away from having some level of “payment owed for services already rendered.”

In fact, all of the money spent for employee wages and benefits is a “funded liability”.  The “liability” is the men and women who provide the services needed to run the City.  The only way to eliminate the “liability” is to have no employees.

Just like a Visa bill, the trick is to ensure that your payments do not get out of control.  You want your overall credit health to be good.  The goal is to pay off the credit card to zero every month, but that is not always possible.  Just because you have an “unfunded liability” does not mean the world is ending.  You just need to ensure your payment plan is structured correctly to keep the unfunded liability from growing.

How do we fix the problem?

The easiest way to fix an unfunded liability problem is to attack it early before it has a chance to swell.  The effect of compounding interest makes debt payment increasingly difficult.  Anyone with a big Visa bill can attest to the fact that it’s the interest that kills you.  If you can pay down the principal early, then you have a much better chance of managing the debt.

During a recent City Council workshop, the City’s Financial Director, John Gross, told the Council that the City’s annual pension costs currently total $70 million, but could increase to $226 million per year in 30 years.  This number was intended to produce a major shock in the hopes of inspiring change to the current system.

However, assuming a 3% inflation rate over a 30-year period, $70 million dollars in today’s money is equal to nearly $170 million dollars in 2043.  That means the difference over a 30-year period is about $56 million in 2043 dollars ($226M – $170M).  Somehow we need to get $56 million extra 2043 valued dollars into the system.

How do we do that?

Well, if you pay an extra $1.1 million dollars into the system each year starting this year, and you assume a 3% inflation rate each year, by 2043 you have an extra $56 million dollars, and your relative payments are the same as they are today.  In fact, the earlier you pay into the system, the quicker you reach relative balance.

Why is this a political problem?

Up until 2008, unfunded liabilities were very manageable and nearly non-existent. The Great Recession, however, caused a massive short-term collapse of the financial system but it did not relieve the government of their bills (aka liabilities).

Some politicians have tried to blame all of government’s financial problems on our pay and benefits, especially our pensions.  But is that really fair?  The bills were not a problem before the economic collapse.  The problem started after the Great Recession when our government’s income shrank.  This was primarily due to the collapse of the housing market, which subsequently dried up the government’s property tax revenue.

Imagine losing your job and then blaming your mortgage for being the cause of all your problems. No! The problem is, you lost your income and now you can’t pay the mortgage.

You are really left with only a few solutions to your problem.  You get a new job to make more income, you refinance your home based on your new income, or you sell the house.

In the government’s world, you can get more income (increased taxes), you can refinance your bills (renegotiate contracts, downsize, restructure), but you really can’t sell the house.  Government must provide certain functions that the private sector cannot, and the first function of government is the protection of its citizens.  Some cities (such as San Jose) have lost sight of that fact and have cut public safety (sold the house) back to a point where the entire community suffers.

Over the last several years, we have seen government increase taxes and restructure their bills.  That seems prudent and reasonable.  All of us have been partners in that process because we realize the importance.  But, at some point we have to realize that there are political opportunists out there who will use this issue to their advantage in order to further their agenda regardless of the facts.

Who should you fear the most?  Watch closely and you will find that the powerful financial and investment institutions are the ones promoting the attacks on your pensions.  Firms like Berkshire-Hathaway and the Koch brothers are backing political candidates and causes all over the country in the hopes of making this issue relevant and in the mainstream media.  Why?  Because if they can crack your pension and turn it into a 401(k), they will make billions.  Your pension is the golden egg that they are dying to get their hands upon.

By the way, it was those same financial geniuses that brought about the Great Recession in the first place.  After nearly collapsing the entire financial system of western civilization, they successfully managed to deflect the blame off of themselves and onto government employee pay/benefits.  They caused government’s lack of income, but now they want everyone to believe it was the government’s obligations that caused the problem.