The State Pension Time Bomb

Poor accounting rules and flagrant irresponsibility have sped up the states' day of reckoning.

For decades state officials have encouraged adults to believe in the financial equivalent of the Tooth Fairy: that state pensions can yield high returns while being risk-free. Now taxpayers are in for a serious toothache.

Nearly every state offers defined-benefit pension plans for public employees. Financed through a mix of employee and employer contributions along with the investment returns on pension funds, a defined-benefit plan represents a contractual obligation to dole out a set amount in annual payments for as long as the recipient lives, regardless of whether there are sufficient assets in the fund at the time of the employee's retirement.

One would think this obligation to pay no matter what would have led states to invest conservatively and plan ahead. Instead, they have been following accounting rules that pretty much guarantee the funds will be unsustainable.

First, by law, states are not required to pony up regular contributions to pension systems. Lawmakers generally jump on any opportunity to be fiscally irresponsible, so many states have deferred pension payments and used their share of the contribution to increase spending in other areas.

Second, government accounting standards systematically underestimate fund liabilities, which in turn encourages pension deferrals. Eileen Norcross, my colleague at the Mercatus Center at George Mason University, argued in a December 2010 paper that the difference between government and private-sector accounting rules is at the root of the unfunded liability crisis.

For accounting purposes, private pension plans use the market value of their liabilities. This rule requires future liabilities to be discounted at an interest rate that matches the risks associated with the assets; the resulting value represents the amount a private insurance company would demand to issue annuities covering all the benefits owed by a given plan. By contrast, states calculate the value of pension liabilities based on the returns they expect from investing pension assets. And on average, the states assume an unrealistically high 8 percent annual return on pension investments while the actual rate should be closer to the yield of 15-year treasury bonds. Here is why that's so problematic.

Pension funds need to assume a certain rate of return on their current assets in order to gauge whether or not the assets held today will be enough to pay future benefits. Obviously, the assumed interest rate or rate of return has a major impact on whether a pension plan is adequately funded. Most pension plans would rather play it conservatively and assume a lower rate of return, so that they ensure that the assets they have today will be enough to cover tomorrow's promised benefits. But the states would rather put less money up front today, so they're pinning all their hopes of being able to pay benefits tomorrow on an 8.5 percent annual growth rate. If that 8.5 percent growth rate doesn't come to fruition, either tomorrow's beneficiaries will see a cut in their benefits or taxpayers will be asked to pick up the tab. It would be much more prudent to assume an adequate risk-adjusted rate of return closer to the rate offered on 15-year Treasury bonds—3.5 percent, say—and fund their plan accordingly.

An unrealistically high discount rate also means that states are highly discounting the likelihood of future payments. In other words, the states are essentially stating that there's a low probability that they'll have to pay their pensioners. That is silly.

State officials not only failed to set aside sufficient money to fund future benefits, but they also illogically assumed that the riskier the investment, the better funded the plan would be. Illinois, for example, borrowed $10 billion in 2003 and used the money to invest in its pension funds. After the recession sent its investment returns below its expected target in 2010, The New York Times reported in December, Illinois sold an additional $3.5 billion worth of pension bonds. This year alone the state is planning to borrow $3.7 billion more for to repay those pension bonds, with interest.

How big are the shortfalls? State officials estimated their plans' unfunded liabilities at $452 billion, with total liabilities of $2.8 trillion. But when economist Andrew Biggs of the American Enterprise Institute calculated the figure with the methods used by private-sector pensions, he found that total liabilities amount to over $5 trillion, with the unfunded liability at $3 trillion. (See Figure 1.)

Since much of government pension liabilities is off the books, most states and cities underestimate their actual debt. In Figure 2, Joshua D. Rauh, an associate professor of finance at Northwestern University, and Robert Novy-Marx, an assistant professor of finance at the University of Rochester, add Connecticut's unfunded liability to the state's debt. As you can see, the state's reported debt is roughly $23 billion. The estimated value of its unfunded pension liabilities is $48.4 billion. To that amount we should add another $28.2 billion in underestimated liabilities due to poor accounting standards.

While all states' pension plans are in bad shape, some are worse than others. Figure 3 shows the first 10 states scheduled to run out of cash.

Once the pension plans run out of money, the payments will have to come out of general funds, meaning taxpayers' pockets. If states want to avert that, they need to push through reforms as soon as possible. A first step would be to switch to accounting methods that show the true market value of their liabilities. Once these methods are in place, lawmakers could consider moving away from defined benefit pensions. Otherwise, taxpayers will discover too late that the Tooth Fairy of their dreams is actually the Wicked Witch of the West. 

Contributing Editor Veronique de Rugy ([e-mail]) is a senior research fellow at the Mercatus Center at George Mason University.