New CBO Pension Report: Underfunding Could Be Higher

That state and local governments  face serious pension funding problems isn’t a particularly controversial contention. However, the question of how much they’re underfunded by is much more contentious.

Last week, the Pew Center on the States released a report that estimates the nation’s total public pension underfunding at $1.26 trillion, based on the discount rate which  the Government Accounting Standards Board (GASB) allows fund managers to use in order to determine their level of contributions needed to meet future obligations. The Pew report is significant in that it acknowledges the arguments that the GASB-based estimate may be too low.

Now a new report by the Congressional Budget Office (CBO) follows suit, and goes further. It discusses in some detail the “fair-value approach” advocated by some GASB critics, and estimates what total pension underfunding would be using lower discount rates.

  • For assets, the fair value is what an investor would be willing to pay for them—that is, the current market value (or an estimate when market values are unavailable); it is not the averaged, or smoothed, market values that are reported under GASB guidelines.
  • For pension liabilities, the fair value can be thought of as what a private insurance company operating in a competitive market would charge to assume responsibility for those obligations.

In the case of state and local pension plans, the discount rate for future benefit payments using the fair-value approach is lower—and, therefore, the estimated present value of those payments is higher—than under the GASB approach. Under the fair-value approach, future cash flows are discounted at a rate that reflects their risk characteristics. Hence, for pension liabilities, the discount rate reflects the fact that the cash flows associated with accrued liabilities are fixed and carry little risk; it is very unlikely that the liabilities will not be honored. By contrast, under the GASB approach, the discount rate used for liabilities reflects the greater risk associated with pension funds’ assets. Under the fair-value approach, one way to approximate the discount rate applied to future benefit payments is by using the interest rate on municipal securities adjusted to remove the effect of tax deductibility): In 2010, the discount rate would have been about half as large as the median discount rate of 8 percent under the GASB guidelines. (For additional discussion of discount rates, see Box 1 on page 6.)

A study published last year that examined the sensitivity of estimates of underfunding to discount rates for pension plans in the Public Fund Survey illustrates the large difference between the GASB and fair-value approaches. Unfunded liabilities in 2009 amount to about $0.7 trillion when liabilities are discounted at 8 percent but total $2.2 trillion when liabilities are discounted at 5 percent and $2.9 trillion when they are discounted at 4 percent (see Table 1). Those unfunded liabilities, as calculated on a fair-value basis, indicate funded ratios of roughly 55 percent and less than 50 percent, respectively.

The uncertainty over state and local government pensions funds’ total shortfall underscores the difficulty of addressing the underfunding problem, but addressed it must be. Better identifying the problem helps, and the CBO joining the discussion goes some way toward that. However, the policies it lays out here are problematic.

First, the report notes that, while shifting new employees to defined contribution retirement plans, such as 401(k) accounts can help stem the growth of future obligations, it will not make existing obligations, which are already huge, go away.

Then the CBO argues for a solution that, while probably viable politically, is timid, and would keep taxpayers on the hook for the next time things go wrong.

[T]here is no necessary connection between the information provided by the fair-value approach and the determination of a sponsor’s annual contributions to the plan, which could be calculated on a different basis. For instance, to take into account the higher expected returns on riskier portfolios, annual contributions could continue to be based on the GASB guidelines for measuring liabilities, and volatility in annual contributions could be reduced by basing contributions on shortfalls averaged over several years. If adequately funded, such a strategy would offer a significant likelihood that a plan’s assets would be sufficient to cover its liabilities, but that strategy would be accompanied by the risk of a significant shortfall that could burden future taxpayers.

Worse, the need for greater returns could encourage risky investment strategies, which could lead to a vicious cycle of taxpayer exposure and ever -greater risk-taking.

From a policy perspective, the new CBO report leaves much to be desired. However, it provides a major contribution in helping advance public understanding of the depth of the nation’s public pension underfunding problem, and in that regard, it is a welcome step.

For more on public employee pensions see here.