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Faulty Public Pension Accounting: A Problem too Big to Ignore

One reason the ongoing debate over collective bargaining for government employees has been so loud is that the stakes are so high -- for unionized government employees on one side and for taxpayers on the other.

For years, public sector collective bargaining enabled government employee unions, especially at the state and local level, to aggressively lobby for generous compensation in exchange for political support for the politicians who grant such largess.

Those politicians, seeking to avoid taxpayer wrath today, deferred many of the costlier elements of that compensation well into the future, including pensions. To make matters worse, states underfunded those pensions for years, and the accounting methods they used hid the funding gaps.

Today, however, much as the budget crises affecting state government around the country has brought public attention to the bad bargain for taxpayers that is public sector collective bargaining, state pension accounting standards face considerable public scrutiny, from across the ideological spectrum.

The Pew Center on the States made headlines with a new entry into this debate this week. State employee pension funds are underfunded by at least $1.26 trillion, according to a new Pew study. Staggering as that figure is, some analysts have noted that it may in fact be too low, because it is estimated based on state pension managers' faulty accounting methods -- which helped obscure the extent of underfunding for years in the first place.

However, now the critique of the numbers is gaining wider attention. As The Washington Post reports:

In making its calculations, Pew used the states’ assumptions for what their pension funds would earn in annual investment returns, typically 8 percent — a figure that states have mostly met in recent decades but that some analysts think is now overly optimistic.

If states calculated their investment returns the same way that private firms are required to for their pensions, their obligations would balloon to $1.8 trillion, the report said. If states pegged their returns to 30-year Treasury bonds, an even more conservative standard, the liability would be $2.4 trillion.

Pew, to its credit, acknowledges the controversy in its new study, and allows for the possibility that its estimate may be on the low end.

At the heart of the debate surrounding the appropriate discount rate assumption is whether states should calculate the current value of these long-term promises using an expected rate of return. In other words, if investment returns are disappointing and do not meet expectations, states are still required to pay retirees the benefits they have earned. Therefore, some experts recommend that states employ a “riskless rate” that might be analogous to a 30-year Treasury bond when valuing their future pension liabilities, arguing that pension obligations are legally binding and guaranteed to recipients. Based on the Treasury bond’s rate of 4.38 percent as of mid-March 2011, the states’ cumulative liability for pension benefits would grow to $4.6 trillion, with an unfunded liability of $2.4 trillion.

Another benchmark suggested by some experts is the investment return required by the Financial Accounting Standards Board (FASB), a private counterpart to the Government Accounting Standards Board. FASB requires that private sector defined benefit plans use investment return assumptions based on the rate on corporate bonds: 5.22 percent as of mid-March 2011. Based on this assumption, states’ pension benefit liabilities would grow to $4.1 trillion, $1.8 trillion of which would be unfunded.

The dangers of the GASB standard and the value of FASB one are explained in greater detail by Josh Barro of the Manhattan Institute (who is cited in the Pew study), in the current issue of National Affairs.

Governmental Accounting Standards Board rules allow public-pension plans to set their liability discount rates equal to the investment returns they expect to achieve on their assets. Among major public-sector pension plans in the United States, that rate ranges from approximately 7.5% to 8.5%, with 8% being the most common choice. These rates reflect the fact that pension funds typically invest most of their assets in equities, which can achieve relatively high returns.

But those higher returns carry a downside: volatility. With the right investment mix, pension funds can, over time, average returns in the neighborhood of these targets; indeed, they have historically achieved such rates, even when one factors in the recent crash. The problem is that they cannot reliably yield such returns in any given year: In some moments, investments will produce windfalls that far exceed expectations; at other times, as in the period from 2008 to 2009, the funds' returns will come in far behind.

State governments expect to exist in perpetuity, which means they tend to take a very long-term view of their pension obligations — longer than, say, a corporation that has to worry about remaining profitable. But that doesn't mean governments can simply wait around for investments to bounce back after a stock-market crash while continuing to pay out benefits at the same level. If they do, they risk allowing a pension-fund balance to run all the way down to zero.

As a result, when pension funds lose money, taxpayers must step in to make up the difference. For example, in a recent report, my Manhattan Institute colleague E. J. McMahon and I estimated that employer — i.e., taxpayer — contributions to the New York State Teachers' Retirement System will more than quadruple over the next five years, principally as a result of recent stock-market declines. In this sense, taxpayers provide valuable insurance to public-employee pension plans, guaranteeing equity-like investments with bond-like certainty.

By contrast, pension plans in the private sector — governed by the separate Financial Accounting Standards Board — are not allowed to choose a discount rate based on expected returns on assets. Instead, they choose a discount rate based on a principle called the "market value of liabilities." Under this principle, a payment due in the future should be discounted at an interest rate consistent with the risk experienced by the creditor (which, in the case of a pension plan, is the worker or retiree). The amount of the liability is unaffected by either the nature or quantity of the assets the pension plan holds. For most private-sector pension plans, the market-value approach produces a discount rate between 5% and 6% — noticeably lower than the 8% presumed by the public sector.

The wisdom of the private-sector approach over that of the public sector is illustrated by an example from Novy-Marx and Rauh. Let's say that a person owns a home that has a mortgage on it, and he also has significant liquid investments that he intends to use to gradually pay off the mortgage. Now imagine that he re-allocates his investment portfolio away from bonds to stocks, increasing his expected return. Would we say that this change in his investment strategy has caused his mortgage balance to fall? Of course not. But that is what public pension plans do, by using expected asset returns as a component of the calculation of liabilities.

The problem is too big to ignore -- so much so that many Democratic politicians are taking on their states' government unions in order to rein in runaway costs. Even in deep-blue Massachusetts, lawmakers voted this week to curb public sector collective bargaining. Political support can't do you much good when you're broke.

Meanwhile, government employee union leaders' response to date has been simply to blame the recent stock market downturn and say there's nothing to see here. American Federation of State, County & Municipal Employees head Gerald McEntee told The Washington Post that state pension funds " are not only persevering but are well on their way to full recovery." If you believe that, I've got a bridge to sell you.

For more on government employee pensions, see here.