State-Based Accounting 101: Ranking Fiscal Condition

States must confront pension costs.



One of the most boring classes I took in college was on accounting. Over the years, however, I've come to understand the importance of proper and transparent accounting. As the disastrous examples of Greece, Puerto Rico, Detroit, and Chicago demonstrate, dodging long-term obligations with rosy forecasts or risky assumptions usually ends badly. Faulty accounting can ruin a nation (Greece), shake an economy (Puerto Rico) and devastate a city (Detroit, Chicago).

New research by my Mercatus Center colleague Eileen Norcross reveals that more fiscal disasters loom in the United States. She ranks each state's financial health using data from standardized and audited Comprehensive Annual Financial Reports (CAFRs) that show short- and long-term debt along with key fiscal obligations, including unfunded pensions and health-care benefits. Beyond the ranking itself and the disastrous fiscal health of several states, the study points to worrisome structural weaknesses shared by most states. Unfortunately, she notes, these issues are mostly overlooked by ignorant or unscrupulous state officials who are blinded by poor accounting techniques.

First, let's look at the states with the best and worst fiscal conditions. At the top of the list are: Alaska (1), North Dakota (2), South Dakota (3), Nebraska (4), and Florida (5). Norcross explains, "these states are considered fiscally healthy relative to other states because they have significant amounts of cash on hand and relatively low short-term debt obligations." The bottom of the list includes: Illinois (50), New Jersey (49), Massachusetts (48), Connecticut (47), and New York (46). These states face large debt obligations and have very little cash on hand to pay short-term bills.

Norcross cautions that these numbers can be misleading. "While most have enough cash and revenues to cover the short term of the fiscal year and a relatively low level of government obligations and debt," she explains, "the long term is shakier in many states due to unfunded pension obligations and non-pension benefits—known as 'Other Post-Employment Benefits.'"

That's where the lack of proper accounting is problematic. In most states, pension liabilities are far larger than lawmakers recognize. States that skipped, reduced or issued bonds to cover pension payments are visibly and already in trouble: that's New Jersey, Illinois, Connecticut, New York, and Massachusetts.

However, even states that may look great on a cash basis, like Ohio, must still confront pension costs. Ohio is ranked seventh overall, but comes in 48th for "trust fund solvency"—an indicator that includes pensions. Unfunded pensions (on a market-valuation basis) represent 52 percent of personal income in Ohio. That's hardly sound financial ground even though the threat may be less visible for now. Montana is another state that does well overall—ranked 10th for fiscal solvency—but again, unfunded pensions represent 30 percent of its personal income.

This is why Norcross' analysis is so important. She actually digs into trust-fund solvency measures, which are often overlooked by state officials and watchdog groups alike. As she notes in her paper, this measure alone is a serious warning that without structural changes to pension systems, more states will be facing the same budgetary problems now confronting Illinois and New Jersey, where pension costs are rising rapidly in poorly funded plans.

In the end, most states won't face the same crises confronting Greece, Puerto Rico, New Jersey, and Illinois. But that will require making some adjustments today and no longer discounting the long-run or thinking that it's in a state's interest to downplay balance-sheet risks. These measures of trust fund solvency exist for a reason. Lawmakers should use them!

For the health of their finances and economies, it is essential that states measure debts with accurate accounting and better financial reporting. The good news is many states still have time to make improvements to pensions and health-care plans and put themselves on the best possible footing. As for me, I wish I paid more attention during my accounting class.