For Public Pensions, the Future Is Now

The hazard of public-sector defined-benefit plans is that they have come to rely on investment risk, rather than on prudent long-term planning, using the state’s power to tax to cover for past mistakes. Let’s hope there are no more budget crises before we learn the lessons that are already right in front of us.

For the better part of a decade economists have been sounding the alarm on U.S. public pension practices that are unsustainable. This message isn’t popular, and defenders of the status quo often portray the economic critique of pension accounting as a conspiracy to weaken public pensions. In reality, economists are pointing to the need to protect worker benefits from the risks many of these plans currently ignore. 

Such plans base their accounting decisions on the projected returns of risky assets in their investment portfolios. Nobel-Prize winning economist William F. Sharpe didn’t mince words in describing this system, calling it a “crisis of epic proportion.”

Professor Sharpe is by no means alone. A 2014 survey at the University of Chicago Booth School of Business found that 96 percent of economists agree that by discounting pension liabilities at high discount rates, state and local plans are vastly understating the costs and liabilities of their pensions.

Accounting subterfuges in the form of risky discounting, long amortization periods, and asset smoothing practices are the equivalent of pumping a cloud of fog over the books. They mask the true size of our pension plans’ liabilities and the hefty annual contributions that are needed to fully fund promised benefits to workers — pushing those costs into the future. 

In response to this long-standing critique, the Governmental Accounting Standards Board (GASB) recently issued a new set of accounting guidelines, known as GASB 67 and GASB 68, intended to help clear up the obfuscation in pension reports. The guidelines advise governments to use a “blended” discount rate to measure the present value of plan liabilities and calculate what must be paid into the system to fund future benefits. 

Here’s how it works. The higher, riskier expected rates of return may still be used, but only for those portions of plan liabilities that are backed up by assets. For the unfunded portions of their liabilities, plans must use “risk-free” rates (or the close-to-guaranteed rate of return on tax-exempt 20 year municipal bonds). The upshot is that as long as a system does not expect to run out of assets, it can continue to apply the higher, more aggressive discount rate, which keeps the present value of its liabilities and annual contributions artificially low.

The new GASB guidance can help prevent plans from hiding their financial obligations. However, Truth in Accounting CEO Sheila Weinberg and I recently looked at 144 pension plans and found that only 13 of them applied GASB 67 in 2015. One of those was the beleaguered state of New Jersey, who reported pension liabilities doubled in size. New Jersey was alone among states in reporting its obligations honestly and rigorously.

The remaining states that applied GASB 67 used a dose of wishful thinking to project plan solvency. For instance, Illinois — a state known for its intractable pension problems — reckoned that its Teachers Retirement System would not run out of assets until 2065, thereby lowering the pension liabilities from $61.5 billion to $60.8 billion.

In the case of Kentucky’s Employee Retirement System and California’s Teachers Retirement System, plan administrators reasoned they did not need to apply the new GASB guidance at all because their legislatures promised to make sufficient contributions to fund the plans in the future. According to that specious logic, a promise to pay unfunded debts sometime in the future is tantamount to not holding that debt at all.

If early implementation of GASB 67 is any guide, it’s likely that municipalities will continue to find ways to present optimistic pension-funding scenarios premised on the idea that a plan’s liabilities can be kept low by projecting high returns in the stock market. But this idea should give us pause: A pension does not owe its existence to a bullish stock market.

In reality, a pension only requires that an accurately calculated amount be contributed each year to pay the promised benefits in the future. Conflating the value of the promised benefit with swings in investment performance is precisely what has made traditionally safe and guaranteed pensions a risky proposition for taxpayers and beneficiaries alike. 

This flawed idea means that all U.S. public plans rest on shaky ground. Consider Ohio, whose overall financial position is healthier than most states. Ohio enacted reforms in 2012 that increased employees’ contribution rates and raised the age of retirement. And these measures — which must have been challenging, politically — may have helped. But without more substantive policy changes, Ohio still faces serious funding challenges in the future. According to new research by economists Erick Elder and David Mitchell, if nothing changes, Ohio’s four largest plans have a 25 to 51 percent chance of solvency 20 years from now.

This scenario may seem overly dire. A common argument against such bleak forecasts is to point to the average investment returns of the system over 10 or 20 years. For example, one of Ohio’s plans, OPERS, has an average investment return of 8.51 percent over 30 years. Plan administrators often cite such long-run returns to put to rest any uncertainty about whether there will be enough money on had to pay out benefits. 

But there’s a catch.

Consider a hypothetical retiree who is promised $10,000 in three years. At an 8 percent rate of return per year, it would take $2,860 each year to accumulate $10,000. But the stock market fluctuates. No one can count on 8 percent every year, so plan administrators must assume that they’ll realize that goal over a longer period.

But suppose, in our example, that returns over a three-year period are 16 percent, 12 percent, and -4 percent, for an average return of 8 percent. How much money does that leave the system? $9,388. That’s less than the $10,000 promised to the retiree. Meanwhile, a different order of returns — say -4 percent, 16 percent and 12 percent — would result in $10,486 after three years. In other words, even though the pension met its annual average return goal of 8 percent in both scenarios, the system could wind up short $612 or with a surplus of $486. 

This is not specific to our example. As long as pensions are investing in risky assets, there is always a chance that they will fall short of their investment goals. That’s because no one — including pension fund managers — can predict what series of returns will actually be realized. 

Of course, such shortfalls can always be made up by increasing future contributions. But in a well-functioning and fully funded defined benefit plan, future contributions are meant to fund future liabilities — not to make up for past shortfalls. As a result, the only way to make up for funding shortfalls is to increase employee and employer contributions going forward — an increasingly common and unfortunate solution. 

The hazard of public-sector defined-benefit plans is that they have come to rely on investment risk, rather than on prudent long-term planning, using the state’s power to tax to cover for past mistakes. Let’s hope there are no more budget crises before we learn the lessons that are already right in front of us.