The bankruptcy of Detroit is an unusual event, but its uniqueness lies mainly in its severity. Municipal governments across the nation are struggling to bring their own finances under control, and for many of them, unfunded pension obligations are a huge driver of deficits. If other municipalities want to avoid a similar fate (even if in milder form), they first need to get a handle on the size of the problem.
The good news is that this is possible. The bad news is that efforts to clarify the pension obligations picture will meet stiff resistance from government employee unions. Yet, the union can only kick against fiscal reality for so long.
In Detroit, a major point of dispute between public pension funds and the city’s state-appointed emergency manager is just how large is the pension gap — specifically, how it is calculated. Pension officials have argued that they are adequately funded, but those claims appear based on overly optimistic projections of future investment returns.
In July, emergency manager Kevyn Orr argued that the city’s pensions face a shortfall of at least $3.5 billion — five times the figure of previous estimates, according to The Wall Street Journal. But the shortfall is likely much greater.
The city manager’s office revised calculations using discount rate based on a 7 percent rate of return on the pension funds’ investments, down from an 8 percent rate. But the 7 percent rate is most likely still too optimistic, because a report prepared for the emergency manager’s office (by the consultancy Milliman) projects Detroit’s pension funds to earn returns of 6.3 percent to 6.57 percent a year, according to the Journal. And the pension funds and unions are still fighting the revision down to 7 percent.
This scenario will likely be repeated in cities across the nation. Many public pension funds determine the contributions to meet future obligations based on discount rates that are themselves based on overly optimistic investment return projections such as those used by the Detroit funds.
A change to public sector accounting standards made last year by the Government Accounting Standards Board (GASB) calls for underfunded pension plans to use a lower discount rate — based on investment return projections of 3 to 4 percent a year. However, the new rules let pension plans that are supposedly adequately funded — 80 percent is the accepted threshold — to continue to use high investment return projections.
While the new GASB standards may force better reporting on some severely underfunded pension plans, they give more marginal plans — those in the 70 to 80 percent range — an incentive to invest in riskier assets in search of the higher future yields that can put them in well-funded territory, based on projections.
As Bloomberg’s James Grieff points out:
Most funds still count on a return of 7 percent to 8 percent. This might have been a realistic range back in the dot-com era, but the figures bear little resemblance to reality today. Just one example: The Standard & Poor’s 500 Index had no gain between the end of 2000 and the end of 2012. Of course, the higher a pension fund’s assumed return, the less taxpayer money it needs.
The new rules will require governments to say how they calculate the discount rate and assumed returns. But the rulemakers still let local governments pick and choose numbers that don’t add up.
To help local, along with state, governments to get a clear picture of the pension obligations they face, GASB should issue stricter standards, with no room for playing games with the numbers.
Congress can help as well, by holding hearings on the state of public pension accounting in America, thus bringing needed attention to the problem.