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New Estimate: Public Pensions Underfunded by $4.1 Trillion

One of the challenges in addressing the underfunding of public pensions is determining how big the funding gaps are. Estimates vary because of disagreement over accounting methods. State pension actuaries calculate pension plans' future funding using discount rates based on high rates of expected returns on investments. State officials have an incentive to engage in this kind of fudging because higher expected returns tomorrow mean lower contributions into the pension funds today.

This has resulted in states low-balling their future pension obligations. Now a new State Budget Solutions (SBS) report goes some way toward clarifying the picture. The report, by SBS' Cory Eucalitto, estimates the nation's state-level defined benefit pension plans to be underfunded by $4.1 trillion, with a funding ratio of only 39 percent -- well below the 73 percent shown through official reporting.

The SBS report arrived at this estimate by focusing not on expected investment returns, but on the fixed nature of the liability itself:

Current public sector practices involve discounting a liability according to the assumed investment returns of plan assets, typically around 8 percent. Yet with discount rates tied to expected investment performance, plan sponsors can easily take on greater risk in order to make liabilities appear smaller. This reduces the resources required today to pay for the promises of tomorrow.

Accurately accounting for a pension system’s liability requires incorporating the nearly certain nature of benefits. That is, once promised, the chances that benefits will not have to be paid are extremely low.

A fair-market valuation does away with optimistic investment return assumptions and instead uses a rate that reflects the risk of the liability itself. One common approach, taken here, is to discount liabilities according to the yield of a 15-year Treasury bond.

The SBS report calculates plan liabilities using a discount rate based on a Treasury bond yield as of August 21, 2013 - 3.225 percent.

Thus, it is not enough for state pension reforms to cut a couple of percentage points off their discount rates; they need to slash expected rates of return by half or more.

But even then, reforms to how pension liabilities are calculated may not stick, as politicians will always have an incentive to divert funds away from future retirees to the present-day constituencies that lend them support, such as public sector  unions. A more lasting solution would be to move away from defined benefit pensions toward defined contribution plans, such as 401(k) accounts.