Sense on Cents

Life will get increasingly expensive in America 2010.

Just because the calendar changed does not mean the smoke and mirrors disguising massive losses in banks, insurance companies, and federal and municipal operations have undergone some massive purging. If anything, the policies and programs developed in 2009 have likely only exacerbated the losses across a wide cross section of our economic landscape.

Our federal deficit obviously dwarfs all public and private deficits combined. That said, the obfuscation in other financial corners of our economic landscape are egregious. This obfuscation is often accomplished via an accounting practice known as smoothing. While this practice is not necessarily an indication of improper – if not illegal – financial chicanery, very often the two go hand in hand. Which financial institutions most seriously violated generally accepted accounting practices via smoothing? Hello Freddie. Hello Fannie. And we will pay.

Where else will American taxpayers pay? Public pensions. How much will the smoothie cost at the public pension Dairy Queen? How does $2 trillion sound, or a full four to five times the currently projected cost?

The Financial Times today provides a chilling, sobering, and smooth review of this story in writing, U.S. Public Pensions Face $2 Trillion Deficit:

The US public pension system faces a higher-than-expected shortfall of more than $2,000bn that will increase pressure on many states’ strained finances and crimp economic growth, according to the chairman of New Jersey’s pension fund.

The estimate by Orin Kramer will fuel investors’ concerns over the deteriorating financial health of US states after the recession. “State and local governments are correctly perceived to be in serious difficulty,” Mr Kramer told the Financial Times.

“If you factor in the reality of these unfunded promises, their deficits will rise exponentially.”

Estimates of aggregate funding requirement of the US pension system have ranged between $400bn and $500bn, but Mr Kramer’s analysis concluded that public funds would need to find more than $2,000bn to meet future pension obligations.

A shortfall of that size could force state governments to take unpalatable decisions such as pouring more public money into their funds or reducing pension benefits. State and local governments have already cut spending to close budget deficits.

Mr Kramer, chairman of New Jersey’s investment council and also a senior partner at the hedge fund Boston Provident, warned that outdated accounting models and unrealistic expectations of future returns had led states to underestimate their pension requirements.

Public pension funds do not use mark-to-market accounting, relying instead on actuarial numbers that average out value of assets and liabilities over a number of years – a process known as “smoothing”. Mr Kramer’s analysis used the market value of the assets and liabilities of the top 25 public pension funds at the end of the year.

What are the ramifications of this reality? Ongoing cuts in services. Ongoing layoffs in municipal payrolls. Increased taxes. Could a state or municipality default? The chances are not zero that a municipality will not default.

What other lesson should we learn from this story? When you see the term smoothing used for financial accounting purposes, get nervous and look deeper. Smoothies do not typically come in kiddie size.

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LD

This entry was posted on Tuesday, January 5th, 2010 at 11:11 AM and is filed under General, pension obligations. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.