Today, the Governmental Accounting Standards Board (GASB) voted to approve new government accounting standards that will provide a clearer picture of the liabilities taxpayers across the nation face regarding pensions for state and local government employees. That’s the good news. The bad news is that those liabilities may turn out to be much worse than anticipated.
Here’s why. In a new report released this month, the Pew Center for the States estimates a nationwide state pension budget shortfall of $757 billion (plus $627 billion for retiree health care costs). However, the total funding gap may be much larger. As the Pew report states, “the pension ratings are based on a state’s projected investment rate of return, which for most states is 8 percent.”
And therein lies the rub. While returns for some funds might average around 8 percent over several years, in many years they will fall well short of that. Meanwhile, pension obligations keep on growing without interruption. As Eileen Norcross of the Mercatus Center and Andrew Biggs of the American Enterprise Institute explain in a 2010 study:
From the government’s perspective, it is appealing to use a higher discount rate to estimate plan liabilities because it produces a lower annual contribution. By contrast, a low discount rate will result in a higher annual contribution required by the employer (in this case, the government) to fund pension obligations.
Over the past decade, state pension liabilities have been valued using an average discount rate of 7.97 percent. This may seem reasonable, since the median investment return for pension assets over the past 20 years has been around 8 percent. However, returns on market investments are not guaranteed, as the market downturn of 2001?2002 and the crash of 2008 demonstrate. Even if plans accurately predicted average market returns over a very long period, the majority of plans’ obligations are payable over the next 15 years, in which average market returns would be more uncertain. There is significant possibility—and in some cases, a probability—that a “fully funded” plan would be unable to meet its obligations even if the plan accurately projected average market returns.
Now the ability of underfunded pension plans to carry on by projecting unrealistic future gains is coming to an end. Reuters reports:
The biggest change affects how the pension funds project rates of return on their investments. Pension funds that are considered adequately funded could continue forecasting investment returns in line with their historic averages, usually around 8 percent, under the new GASB rules. It defined those pension systems as having sufficient assets to pay the pension of current employees and retirees, but did not set a funding ratio.
Funds lacking sufficient assets to cover future benefits must lower their projected investment rate to about 3 to 4 percent. Sp ecifically, the investment rate would have to match “a yield or index rate on tax-exempt 20-year, AA-or-higher rated municipal bonds,” an information sheet on the changes said. On Friday, the yield for AA-rated municipal bonds due in 20 years was 3.12 percent, according to Municipal Market Data.
Although it sounds like a technical accounting move, this change is key to the pension wars.
Investment earnings provide 60 percent of pension fund revenue. When the investments fail to meet the forecasts, governments – essentially taxpayers – and employees must pitch in money to fill the void.
For New Jersey alone, notes Norcross, “If it were to fully fund the system by GASB’s new guidance it could easily mean a jump to contributions of $5 billion a year. On a fully risk-adjusted basis it’s likely closer to $10 billion a year.”
The question now facing taxpayers around the country is how those increased shortfalls will be addressed. Many states already face serious pension deficits, so recent history is a good indication of how different states are likely to react. Pew rates 32 states in the “serious concerns” category — again, using the states’ own optimistic investment return projections. As the figures for those states’ pension deficits get bigger, reform in many states may accelerate, with some acting as boldly as Utah and Rhode Island have already.
Unfortunately, some state lawmakers beholden to government unions — California, Illinois, and Maryland come to mind — likely will use the increased pension shortfalls to call for more tax increases. Thankfully, those states’ residents can vote against being fleeced any further — not only at the ballot box, but also with their feet, by moving to more fiscally sane jurisdictions.
For more on public pensions, see here.