Faulty accounting practices stipulated by the Government Accounting Standards Board have allowed state retirement systems to dramatically underestimate their pension deficits. In most states, the trustees of these funds have not provided the right data or even agreed to release it. This cover-up stands in the way of designing the reforms needed to fix the most serious calamity facing state and local finances.
A pension deficit is the shortfall between a fund’s assets and liabilities. The amount needed to pay benefits in the future is discounted to determine how much money needs to be set aside today. GASB instructs pension funds to discount their liabilities using the expected return on their assets; in other words, how well they expect their investments to perform.
But these pensions are defined benefits, not defined contributions, and so their return is conceived as a risk-free guarantee rather than an investment return like a 401(k). The right discount rate is a risk-free rate of return such as the yield off a U.S. Treasury note.
What’s the difference between discounting liabilities using an 8 percent rate of return projection and a 3.5 percent risk-free Treasury rate? Trillions of dollars in pension debt. Thanks to studies done by experts such as Andrew Biggs of the American Enterprise Institute and Joshua Rauh of Northwestern University, we have estimates for the true values of the unfunded pension liabilities using the risk-free discount rate.
In a report published a year ago, Biggs calculated that by mid-2008 the states’ collective unfunded pension liabilities exceeded $3 trillion. The state pension funds reported $438 billion at the time.
This projection gap is the difference between a pension problem and a pension crisis, as Frank Keegan of Watchdog.org put it. How severe is the crisis? Biggs calculated in the same report that the average pension plan has only a 16 percent probability of being able to pay off its liabilities as presently constructed. Incremental reforms will not fix this picture. States need to remake their pension systems by restructuring benefits and switching to the defined contribution method of compensation.
Working with several states on these proposals, I’ve seen firsthand how faulty accounting and missing data are getting in the way of real pension reform. Legislators and executive officials don’t have the proper unfunded liability projections from the retirement system, don’t get any data from it at all, or don’t even get their phone calls returned. Without the right numbers, they can’t draft the legislation needed to overhaul public pensions in their states.
Last year, GASB proposed modifying its accounting principles to use the high-grade municipal bond yield as the discount rate for unfunded liabilities. It took public comments and has yet to issue a ruling. In Congress, Rep. Devin Nunes, R-Calif., introduced a bill to require public pension plans to report liabilities using the U.S. Treasury yield curve.
The simplest way to implement this transparency reform is for the states to do it themselves and instruct their retirement funds to report the right numbers and score the pension proposals that lawmakers introduce.
Utah state Sen. Dan Liljenquist, who championed successful pension reform in that state last year, advises colleagues around the country to “demand data.” This means comprehensive, long-term financial projections based off the correct accounting assumptions.
The complex data make plain the simple reality that so many public pension plans are going bust. With the right numbers on their side, reformers will have the edge in tackling the most significant state and local fiscal issue of our time.
Rich Danker is project director for economics at American Principles in Action. This is first in a series for the Washington Examiner.