State public pension plans are the future, and often current, greatest liabilities that state governments must tackle. Promises made to employees in the past, and politicians kicking the problem further into the future have made the problem spiral out of control. Economists agree that the current discounting of liabilities leaves much to be desired. State Budget Solutions has long been an advocate for using fair market valuation.
But it isn’t just discount rates that cause these pension liabilities to climb. Here is our guide to some of the other popular tricks used by politicians and actuaries that hide the true cost of delaying pension reform.
Outdated Life Expectancy Assumptions
When public pension funds were first established, the average life expectancy was much lower than it is today. The problem is that some pension funds have not adjusted for this change. The calculations for determining liabilities take demographics into consideration. If this is not updated, it means that the pension fund is planning to pay out benefits to retirees for a shorter time. TheInternational Monetary Fund recognized this issue, concluding that “if everyone lives three years longer than now expected–the average underestimation of longevity in the past–the present discounted value of the additional living expenses of everyone during those additional years of life amounts to between 25 and 50 percent of 2010 GDP.”
- California: CalPERS has been assuming that government employees, especially police and fire personnel, are more likely to die on the job. This allowed the system to require smaller contributions into the system. But it isn’t true, because government has expanded that definition to include several causes of death that are not directly related to the job, such as heart attack. The result is that CalPERS actuaries are now asking for a 10% increase in contributions to make up the difference for the faulty assumption.
- New Study: How Will Longer Lifespans Affect State and Local Pension Funding?
Inflated Discount Rates
The discount rate is used to determine the amount of funding necessary in a public pension fund today in order to reach the predicted funding needed in the future to provide retiree benefits. Most public pensions use the expected investment rate of return as the discount rate. This rate is often 7-8%, and sometimes higher. This means that pension fund managers must be willing to take greater risk in order to match the discount rate and ensure that there is sufficient money in the fund at a later date. This also requires that the necessary contributions are made every year, and also requires that all actuarial assumptions are accurate. Pension benefits, however, are considered guaranteed assets to the retirees who are vested in the system and therefore must be paid. This obligation puts taxpayers on the hook for trillions of dollars if the discount rate is not met.
A study by Moody’s Investor Services showed that from 2004-2012, the top 25 public pension funds were “on-target” for rate of returns but still accrued nearly $2 trillion in unfunded liabilities. This is because using the rate of return in lieu of a market-valued discount rate is not a proper reflection on the liabilities. The discount rate should reflect similar liabilities, such as those paid out in government bonds yields. The State Budget Solutions annual report on public pensions showed that if public pension funds used a more appropriate discount rate, the collective unfunded liability of all state plans would be $4.7 trillion.
Overly Aggressive Investment Assumptions
Legislators are tempted to assume a higher annual rate of return on investments, meaning that they can put fewer dollars into pensions in the current budget. Although related to inflated discount rates, this issue is an independent problem.
Underfunding Pension Contributions
An underfunded state pension plan has more liabilities than assets. By continually underfunding pensions, pension accounts become less stable, and there is less assurance that the state can effectively cover distribution amounts when pension benefits become due. The Annual Required Contribution (ARC) is the amount of money required to sustain the pension fund based on the discount rate and other assumptions. When the ARC is skipped, or even reduced, that means that pension funds will need to make up for the lost expected growth, as well as the actual contribution in today’s dollars. This compounds the unfunded liabilities.
- New Jersey: Governor Chris Christie has made a habit of underfunding the state pension fund, repeating the sins of many of his predecessors. Most recently, Christie’s administration is arguing that its own reforms to the pension system, which required full contributions each year, are unconstitutional. Courts have said that he must follow the 2011 law.
Pension Obligation Bonds
As more states recognize the whopping unfunded liabilities in public pension funds, some policymakers have opted to borrow money now in order to make up the difference. When interest rates are low, the logic follows that if a state borrows money today at a lower rate, it can invest that money, have a greater rate of return, and be able to pay off the bond debt and also assist in paying down unfunded liabilities. But this maneuver also allows the state to automatically assume that this new funding will hit the higher rate of returns, often at 7-8% annually. That means that even less money needs to be put into the pension funds now, or at least according to this accounting trick. Another challenge is when a state issues pension obligation bonds, they underfund the annual required contribution in the budget and in some cases (i.e. Illinois) use the pension obligation bonds to “balance” the current budget and thus not put the money into pensions.
- Kansas: Kansas has approved a $1 billion pension bond that will put cash directly into the coffers of the system to be used for investment. Because of the investment assumptions, the state has also decided to lower the contribution to the pension plan by $64 million over two years, which will help “balance” the budget.
- Illinois: “In just ten years, the Illinois General Assembly pushed the burden of billions in government spending onto Illinois’ future generations. Official estimates put Illinois’ unfunded pension liability at $85.6 billion. But that amount does not take into account the $25.8 billion in pension obligation bond (POB) payments still outstanding, which have a net present value of approximately $17.2 billion”
Rolling Amortization and Smoothing
In order to make the contributions by the employer–the government–more stable and predictable year over year, pension funds engage in actuarial gimmicks that allow contributions to remain low. The spirit of this idea is admirable, as it intends to ignore the potential volatility on Wall Street and still ensure proper contributions into the pension fund. In reality, the result has been the opposite. This tactic has allowed pension funds to ignore their incorrect assumptions on investment returns and discount rates and maintain contributions that do nothing to meet the true liabilities.
Liberal Vesting Requirements
In order to receive a pension benefit, government employees must meet certain requirements regarding their employment, including length of service. In some cases, state and local governments have made it easy for employees to meet those requirements, known as “vesting.” If vesting is easy, then too many retirees will be receiving benefits in the future, straining the system. Vesting requirements may also be expanded by the courts, adding greater liabilities to the pension plans. These liberal vesting requirements also make reforms more difficult. The more employees that are considered to be vested while employed, the more limited the reforms can be as it is often the case that vested employees may not have their benefits altered.
Not Planning For The Future
It is so easy for legislators to promise benefits tomorrow but not pay for them today. This is the essential flaw in the current public pension system that allows for defined benefit plans. Those who control the levels of benefits are politicians who must worry about re-election. This is not a system that rewards future planning over present results. If politicians were divorced from the process and employees and retirees had control over their retirement, a good number of these gimmicks would not be necessary to have a sustainable system.
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About the Authors:
Joe Luppino-Esposito is the editor and general counsel of State Budget Solutions. Joe’s current research focuses on public employee pensions, Medicaid expansion, state debt, budget gimmicks, and many other state budget reforms. Prior to joining SBS, Joe was a researcher for Berman and Company, and previously served as a Visiting Legal Fellow at the Heritage Foundation, specializing in criminal and constitutional law.
Bob Williams is President of State Budget Solutions. He is a former state legislator, gubernatorial candidate an auditor with the U.S. Government Accountability Office (GAO). Bob is a national expert in fiscal and tax policies, election reform and disaster preparedness. Because of his unique experience and expertise, Bob is a frequent guest on talk radio and at public forums. His commentary on state budget solutions appears frequently in newspapers, journals and online publications.
This article originally appeared on the website of State Budget Solutions and is republished here with permission.