Legislators Present Public Pensions as Next Big Debt Crisis

In Part I of a series of articles titled States of Bankruptcy, Joint Economic Committee Vice Chairman U.S. Representative Kevin Brady (R-Texas) and Senator Jim DeMint (R-South Carolina) note according to their own figures, state and local pension systems are in trouble, but, they contend, under private sector accounting methods, the situation is much worse.  

Most states and localities conform to rules of the General Accounting Standards Board (GASB). According to the report, the problem with GASB, however, is unlike FASB (the Financial Accounting Standards Board) and ERISA (the Employee Retirement Income Security Act), which govern private sector pensions and accounting, GASB primarily specifies disclosure standards and other guidelines as opposed to strict rules. For example, GASB allows states desiring higher investment returns to assume those returns simply by investing in riskier assets. It also allows plans to delay full accounting and reporting of assets over a number of years to minimize the impact of large market swings (as a result, the consequences of the 2008-2009 downturn will not be fully reported on pension balance sheets until as late as 2014).  

The average rate of return assumed by state and local government plans is 8%. While this may not be far off from historical returns, the recent financial crisis and predicted slower-than-normal future economic growth in the U.S. and industrialized world is likely to produce a much lower rate of return. Economists Joshua Rauh of the Northwestern University Kellogg School of Business and Robert Novy-Marx of the University of Rochester calculate a one-third probability that a portfolio which has an “expected return” of 8% will actually achieve that return, while the probability of achieving a return of 6% or lower is 50%. If states were forced to use private sector market value liabilities (MVL), their projected unfunded liabilities would rise exponentially over time, the report said.  

According to the report, a study by the Congressional Budget Office (CBO) looked at the effects of using different discount rates on states’ pension liabilities. With an 8% discount rate, unfunded liabilities amounted to $700 billion for state and local pension plans. If the discount rate were 5%, the unfunded liability more than triples to $2.2 trillion (55% funded) and with a discount rate of 4%, the unfunded liability more than quadruples to $2.9 trillion (less than 50% funded).  

The CBO says the appropriate discount rate was 4% in 2010 and 5% in 2006 before the financial crisis. CBO estimates the total 2009 unfunded liability of state and local pensions to be $2-$3 trillion, based on an accounting approach that, “more fully accounts for the costs that pension obligations pose for taxpayers.” 

According to the report, measuring states’ unfunded pension liabilities as a percentage of state GDP provides perspective on states’ abilities to handle these unfunded pension liabilities. Using estimates of market-based unfunded liabilities and 2009 state GDP by Andrew Biggs of the American Enterprise Institute (AEI), the legislators report the median pension debt-to-GDP ratio among the states was 21%, with Nebraska having the lowest ratio of 9% and Ohio having the highest at 41%. Given the deterioration in most state pensions since 2009, as well as budget cuts contributing to a decline in the number of state employees paying into pensions, proper accounting standards are likely to show that some states’ unfunded pension liabilities are already approaching 50% of GDP.  

Because these unfunded liabilities are essentially sunk costs, they can effectively be added on to states’ existing debt levels, which in 2009 had a median value of 17.5% of GDP. Thus, the combined median level of existing debt plus unfunded pension liability debt was 38.5% of GDP.  

The combination of existing state debt, unfunded pension liability debt and the 100% of GDP federal debt makes the U.S. debt load worse than that of Europe, the report concluded.  

Future reports will examine the prospects for pension reform (including promising measures to confront existing unfunded liabilities and to establish fully sustainable pension plans), roadblocks that have prevented credible reform, and possible preemptive actions by the federal government to prevent a taxpayer bailout for irresponsible state and local governments.