PODCASTBy their own accounting, state and local government pension plans are in bad shape. In total they face an estimated shortfall of $628 billion. But that reckoning is off by five-fold. If the rosy accounting rules used by pension funds are stripped away, the real funding gap is closer to $3 trillion--a debt in excess of all outstanding state and local government bonds.
But bad pension accounting has done more than hide a huge debt. It has driven bad policy decisions that have increased the cost of public-employee pensions--and it has encouraged pension-fund managers to take unreasonable amounts of risk in the stock market. Unless the accounting is right, many proposed pension reforms will fall short, and the fundamental problems of high cost and high risk will remain.
Current public-pension accounting rules allow plans to "discount" their future liabilities based on their expected asset returns. The higher the expected return, the lower the present cost of liabilities due in the future--and the less money a plan needs to hold in order to call itself "fully funded." This reward for higher return targets has led pension managers to embrace more risk.
Today, 70 percent of public pension portfolios are in equities, exposing funds to steep value losses when the stock market performs poorly. CalPERS lost $500 million in the financial collapse of the Stuyvesant Town-Peter Cooper Village real estate venture in 2009. In spite of this, to avoid raising the contribution rate for state agencies, CalPERS is expanding its equities holdings from 49.1 percent of 53.1 percent.
It's a decision made under the false notion that investment risk has no cost, since governments don't go out of business. But a pension benefit is a certainty. When a pension portfolio is made up of volatile investments, it reduces the chance there will be enough to pay the obligation when it's due.
The high discount rate also keeps employer-contribution rates artificially low, worsening pensions' financial positions. Even worse, in boom years excess assets make regular funding seem unnecessary, and can even can lead governments to forgive employees' required contributions. Starting in 2002, San Francisco "picked up" the 7.5 percent contribution of 9,883 employees, at an annual cost of $60 million.
The City now realizes, "based on claims by officials and labor groups that it would cost nothing, these errors may now be constitutionally irreversible." In 2010, the SEIU agreed to pay its 7.5 percent contribution again, but only in exchange for a 6 percent wage increase. The "swap" was described as cost-neutral on San Francisco's books.
And when pensions look cheaper than they really are, it's easier for public employees to argue that they deserve compensation increases. In 1999, California gave public safety officers 3 percent of their salary per year-of-service in retirement. The pension benefit was undervalued on paper, allowing unions to press for salary increases, also helping to raise the final pension payout. The average pay of a police officer in Sacramento grew 50 percent between 2000 and 2008, far greater than inflation.
Measuring a pension liability based on wishful thinking may encourage other bad practices. New Jersey is now trying to reverse a 9.09 percent increase in pension benefits granted on the eve of the 2001 election-- a benefit hike legislators claimed was "free" because the state's pension plans were overfunded. But they only appeared overfunded because of an aggressive 8.25 percent discount rate for liabilities.
On top of this, pension assets were inflated via a paperwork mirage--in 2001, New Jersey abandoned its practice of "smoothing" asset returns and revalued assets at their market values as of June 30, 1999. That was near the peak of the tech bubble; in reality, New Jersey's pension assets had lost $2.4 billion in value between 1999 and 2001. The maneuver is part of the Securities and Exchange Commission's charges against the state for selling bonds based on fraudulent disclosures.
The damage done by bad accounting has a real price to be borne by taxpayers. Legally, accrued benefits are considered untouchable. The size of the bill is shocking and is rightly leading many to worry that states will get a federal bailout for reckless choices.
To preempt this possibility, Rep. Paul Ryan (R-Wis.), Rep. Daniel Nunes (R-Calif.), and Rep. Darrell Issa (R-Calif.) have proposed the Public Employee Pension Transparency Act. The bill requires state and local governments to accurately report their liabilities, or be denied the ability to issue tax-free municipal debt. The hope is that a better understanding of the real cost of pensions will make legislatures think twice before making big promises. But, do states really want the federal government so involved in their fiscal affairs?
Regardless of federal action, states ought to improve pension transparency for the benefit of their own taxpayers. States should enact legislation that requires pension plans to report the market value of pension liabilities. The obligation, and what is owed annually to workers, should be projected forward for thirty years and be reported as part of a state's budget and fiscal reports. Anything less is tacit participation in an accounting fiction with the potential to devastate the economy.
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