Understanding the True Cost of State and Local Pensions

From NCPA

In a time where national attention is on budget shortfalls in all levels of government, it is crucial to recognize the impending troubles to be faced by public-sector retirement funds. Routinely underfunded and plagued by overly optimistic economic assumptions, the funds are managed in such a way that will almost certainly require a government bailout down the road, says Andrew G. Biggs, a resident scholar at the American Enterprise Institute.

• According to standard actuarial accounting, the average public pension was 76 percent funded in 2009, down from 95 percent in 2001.
• Likewise, annual required contributions, which track relative costs per year for funds, were over $74 billion in 2009, up from around $29 billion in 2001.
• Overall, public pensions reported underfunding of $660 billion as of mid-2009, the most recent date for which complete information is available.

This information suggests that pension funds could be in a great deal of trouble in future years, when retiring workers demand compensation from near-bankrupt governments. However, the truly troubling feature of the current system is that these figures understate the liabilities of the funds and allow for minimal protection against future outlays.

In accounting their funds and assessing their financial health, government analysts discount future payouts (a commonly accepted procedure), but they do so using the rate of return they expect to gain from their invested assets. Thus, the financial strength of the fund can be augmented simply by adopting a more risky investment portfolio, as this will increase returns and projected future revenue streams. This accounting feature is dangerous and misleading, and would not be used in the private sector by managers of a similar fund. Instead of discounting assets, they would discount liabilities and incorporate the risk factor of assets.

• Joshua Rauh of Northwestern University estimates that, when correctly discounted, total unfunded liabilities for public-sector pensions as of October 2011 are roughly $4.4 trillion, sharply higher than the aforementioned figure of $660 billion as of mid-2009.
• This amount exceeds total outstanding state and local government debt and is equal to nearly 30 percent of annual gross domestic product.

Source: Andrew G. Biggs, "Understanding the True Cost of State and Local Pensions," American Enterprise Institute, February 13, 2012.