It’s official: after a decade in which the New York State pension fund’s annual return on assets averaged less than half its target rate, the fund will need to jack up its taxpayer-funded contribution rates next year, Comptroller Thomas DiNapoli announced today. DiNapoli said the rate in 2011-12 would rise from 11.5 percent of salary to 16.3 percent for members of the Employee Retirement System (ERS) and from 18.2 to 21.6 percent for members of the police and Fire Retirement System, (PFRS).

This is no surprise.  In fact, almost precisely the same rate of change in pension contributions was projected by Governor Paterson’s Division of the Budget (DOB) eight months ago, in the 2010-11 Five Year Financial Plan (see table on page 59).

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Don’t look now, but the feds are dropping more cash from helicopters — and the Empire State is already grabbing a big handful.

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Last month, the state-run MTA said that it might raise the price of a 30-day subway and bus pass from today’s $89 to $104 — a pretty hefty 17 percent increase. That’s still the case in the MTA’s latest on-line literature about fare hearings, too.

But read the fine print elsewhere. In today’s Times (p18, right below Rick Lazio and the mosque), the MTA ran a legal notice for public hearings with a new option to “increase the price of a 30-Day Unlimited Ride MetroCard to as much as $130.00 and/or introduce a 30-Day MetroCard, priced at less than $130.00, with use capped at no less than 90 paid trips.”

The MTA is keeping its options open, then. While the authority’s goal is to raise total revenues by 7.5 percent starting in January, it could do this in a variety of ways. It could introduce a new “limited” unlimited pass, for example, allowing 90 rides, for, say, $104, along with the higher-priced unlimited card.

Or, it could leave bonuses for pay-per-ride purchases at 15 percent with a minimum $8 purchase, rather than slashing them to 7 percent with a minimum $10 purchase as planned.

To either of these options, though, the MTA would have to hike the 30-day passes by more than it has previously proposed — obviously, as the new legal notice points out, to as much as $130.

The MTA could face some pressure to take this tack and push the unlimited card up further, even if not to $130. Purchasers of the 30-day passes earn more money than people who buy their fares by the ride. The MTA’s progressive fare system, then, could become more progressive.

Middle-class riders should know that they may be in for a bigger January surprise than they thought.

And as I wrote here last month, fares in general once lagged inflation, but not anymore.

New York’s state comptroller reportedly is going to reduce the state pension fund’s discount rate from 8 percent to between 7.5 percent and 7.75 percent, Bloomberg News just reported.  The lower the discount rate, the higher the required tax-funded employer contribution.  So the public pension bill for New York taxpayers is about to grow higher. even higher than already expected given the fund’s performance over the past few years.** [See postscript for caveat, however!]

The comptroller’s move comes as no surprise, given the recent performance of the pension fund’s assets.  The problem is that even a 7.5 percent rate — the lowest used by the fund since 1985 — will significantly understate the true size of the pension fund’s liabilities.

The discount rate applied to future obligations is a crucial determinant of any pension system’s necessary funding levels: the lower the rate, the larger the contributions required to maintain “fully funded” status. Private pension plans must discount their liabilities based on a market rate—typically, a corporate or U.S. government bond rate—which is often much lower than the plans’ projected returns.

Public funds, however, are allowed by government accounting standards to discount their long-term liabilities based on the targeted annual rate of return on their assets—which, for most public funds, is still pegged at an optimistic 8 percent or higher. In other words, the risk premium in the investment target is compounded in the liability estimate.

The typical public pension manager doesn’t just hope to earn 8 percent a year. For all intents and purposes, he or she assures trustees, beneficiaries, and taxpayers that the fund is certain to earn an average, long-run return of 8 percent.  In New York’s case, it appears this target is about to be lowered every so slightly.

But ask yourself: do you know anyone in the world of private investing (anyone not named Madoff, that is), who is willing to guarantee you a 7.5 percent rate of return?  How about 7 percent?  Or even, for that matter, 6 percent?  No junk bonds allowed.  Remember: public pensions are guaranteed by the state Constitution.  The money has got to be there.

While most public pension managers continue to resist the idea, a growing number of independent actuaries and financial economists agree that the net present value of risk-free public pension promises should be calculated on the basis of low-risk interest rates such as the rate on a thirty-year U.S. Treasury bond, most recently dropped below 4 percent.  This is not an argument for actually investing pension funds in T-bills, mind you; it is simply a way to recognize how much it actually costs to guarantee generous such generous pension benefits.

At 8 percent, the state pension fund discount rate is an economic fallacy.   At 7.5 percent, it will still be an economic fallacy.

** PS — For the state government, and for local governments that opt into a pension “amortization” (i.e., borrowing) plan initially proposed by Comptroller Thomas DiNapoli, a change in the discount rate won’t necessarily affect annual pension fund contributions.  Under a gimmick approved as part of the 2010-11 state budget, the annual increase in contributions will now be  capped at a percentage point a year and required payments over that amount in any given year can be spread over a 10-year period.  For participating  employers, a higher discount rate effectively will translate into more borrowing from the pension fund, pushing an even larger (but still underestimated) liability onto the backs of future taxpayers.**

PPS — New York City has separate public pension plans unaffected by the state comptroller’s action.  The city’s pension actuary recently began a customary five-year review of assumptions,  which could easily lead to a similar change, however.

New York’s state budget gap for 2011-12 — the first year of the next gubernatorial administration — is now projected at nearly $8.2 billion, according to the 2010-11 Enacted Budget Report released today by Governor Paterson’s  Division of the Budget (DOB).   That’s 52 percent larger than the $5.4 billion gap projected just six months ago, in DOB’s previous financial plan update.  It’s also nearly $700 million larger than the preliminary budget gap estimate attributed to Paterson’s budget director just a month ago.

Projected gaps over the next three years now total $37.2 billion. That’s up more than 30 percent from the $28.4 billion three-year cumulative gap projected in the February financial plan, which was issued in conjunction with the Governor’s 21-day amendments to the Executive Budget.

In short, New York’s budget hole got deeper during the protracted budget process that ended Aug. 3.  And it could grow deeper still by the time the governor elected this coming November presents the 2011-12 Executive Budget next Feb. 1.

The following chart contrasts the February gap projections with those in the latest financial plan update.

InvestmentNews says that more residents of high-tax states, mindful of looming federal tax hikes as well as higher state taxes, are moving south. As Ernst & Young tax partner Greg Rosica tells author Hilary Johnson:

We haven’t had a situation like this in quite a few years. We have this impending tax increase, and people are trying to look for ways to hide from that, but they’re not seeing many from the federal perspective. One of the ways they’re looking to do it is changing their state income tax rate.

A cottage industry exists to help people with this transition, overseeing everything from changing driver’s licenses to veterinarians.

The Financial Times reports today (log-in required) that Wall Street banks “are bracing for a slump in trading profits.” As we said a few weeks ago, second-quarter profits for banks like Goldman weren’t great. July wasn’t much better, even slower than normal summer seasons.

A few more months of quiet trading, and Mayor Bloomberg won’t be able to count on yet another unexpected multi-billion-dollar surplus from record financial-industry profits to close next year’s $3.3 billion deficit.

The good news is that commercial and consumer banking are doing better as mortgage and credit-card defaults slow. That’s nice for the national economy, but small comfort to New York City, which needs banks to reap huge trading profits year in and year out to keep the budget bubble going.

**UPDATED**

Just when it looked like New York’s free-spending public schools were finally about to meaningfully tighten their belts, news came from Washington yesterday that the U.S. Senate had cleared the way for another $26 billion dose of “stimulus” that will earmark $600 million for K-12 education in the Empire State.  This is enough to restore a large chunk of the $1.4 billion school aid cut in the recently enacted 2010-11 state budget.   The aid package also includes **$800 million of an added** $1 billion in extra Medicaid reimbursements the state has been counting on.

Chuck Schumer and Kirsten Gillibrand now get to bask in the media afterglow. “DC coming to NY’s re$cue,” the New York Post headlined, next to a photo of Schumer (who is seeking a third term this year).

In fact, assuming the House follows suit in a couple of weeks next week, the added federal aid will translate into another year of spending at levels that the state cannot afford to sustain—and Washington cannot afford to continue subsidizing (in part with New Yorkers’ own taxes).   And then what? (more…)

Noting a reported increase in wealthy households in the New York City metropolitan area, Robert Frank of the Wall Street Journal is mystified that “New York still has huge budget problems given the wealth surge in 2009 and much-publicized tax burden of the wealthy.”

In other words, if we’re so wealthy, why does Albany still have a budget deficit?  Well, aside from the state’s lamentable failure to, you know, actually reduce spending from boom-time levels, the answer is simple.

Frank’s hook was a reported rebound in the number of “high net worth individuals,” or HNWI’s, in the New York metropolitan area.  HNWIs are further defined as “those having investable assets of $1 million or more, excluding primary residence, collectibles, consumables, and consumer durables.”  In other words, stocks, bonds, certificates of deposit, money-market funds, and cash sitting in the bank or stuffed in the mattress.

New York HNWIs

New York State does not tax financial assets, per se.  It taxes interest income, dividends and capital gains derived from those assets by state residents.  However, some New Yorkers with $1 million or more in financial assets are nonetheless living on modest incomes, and thus pay little or nothing in taxes.  This is especially true for retirees who have much of their net worth invested in low-risk assets now yielding very low returns.  If you have $1 million or more invested entirely in tax-free municipal bonds, you pay zero in state taxes.  If you’re heavily into stocks and have been lucky enough to match or even beat the market during its recent recovery period, you also may still have a backlog of capital losses from the 2007-08 bear market, which can be used to offset your taxable income.

Consider the example of a wealthy retired federal government employee living in Chappaqua.  The stocks he owns may have been worth $1.2 million in 2007, dipped in value to $900,000 in 2008, and rose back over $1 million in 2009.  However, his 2009 state tax bill wouldn’t necessarily have been any higher unless he cashed in some of last year’s market gains to meet higher expenses — say, the down payment on a lavish wedding for his daughter.  And even then, he might still be able to offset his tax bill with capital losses he experienced in the 2007 market downturn.  Indeed, if his capital losses were big enough and his income from other sources hasn’t grown, he may not be paying more for a few years to come (although, to be sure, he’s still paying a much higher effective rate than, say, the guy who picks up his garbage).

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As expected, Governor Paterson has sent the state Legislature yet another version of his proposal to cap local property taxes.

Replicating the language he submitted as part of the 2010-11 Executive Budget, the governor’s latest program bill also hews closely to his original 2008 proposal to cap school district tax levies, which in turn was based on the recommendations of the Suozzi Commission.   (More background on the cap issue can be found here.)

Tax levy growth under the governor’s bill would be limited to 4 percent a year or 1.2 times inflation, whichever is less.  Exceptions would be allowed only for property taxes on new construction and for capital expenditures previously approved by voters.   Otherwise, school boards could not override the levy cap without the approval of district voters, with the required approval percentage ranging up to 60 percent in cases where state aid to the district is projected to increase by 5 percent or more.  District voters could also petition for a referendum on whether “underride” the cap in any given year–setting a lower limit than the law would require.

Paterson’s bill also resurrects a provision to extend the property tax cap to all local governments, including special-purpose districts, outside New York City.  Unlike school districts, however, the cap on local government and special district taxes could be overridden without voter approval, via a two-thirds vote by their governing bodies.

The property tax cap apparently is destined for a vote in the Senate, where an earlier version passed in August 2008.  However, it is not expected to see action in the Assembly.

Attorney General Andrew Cuomo, the Democratic candidate for governor, is calling for a 2 percent annual cap on property tax levies by all school districts and local governments, allowing override by voters only.    Former U.S. Rep. Rick Lazio, who has the official Republican Party endorsement in the governor’s race, has endorsed a 2.5 percent annual cap on property tax levy growth.  Carl Paladino, challenging Lazio in the GOP primary,  has called for tax cuts without specifically advocating a property tax cap.