Unfunded pension liabilities have become an increasingly troubling problem for states across the country. Each state pension plans establishes its own accounting practices it uses to determine and report the value of its assets and size of its unfunded liability. As a result, many states don’t even know how much pension debt they truly have.
Increasing pension liabilities are complicated by the fact that in many instances, the regulators controlling pension funds have overestimated the value of future investments and the rate of return they can expect from the investments held by the pension fund. For years, in addition to regular tax revenue pension funds relied on strong investment returns to allow them to reduce yearly government contributions to the fund. If the estimated rate of return for these pension funds continues to fall short of expectations then pension systems across the country may be in even more trouble than is currently thought.
According to a new study published by the Reason Foundation, when a sounder method for determining pension liabilities is applied to state pensions, states’ liabilities appear far worse than state governments often claim. Most states use inflated assumed rates of return as the discount rate when determining the value of future promised pension benefits; these assumptions assume investment returns that are unrealistic and are unlikely to provide the funds expected to cover these liabilities in the future.
The Reason study argues it is more appropriate to use an approach that ignores expected investment earnings and instead relies on current market interest rates to determine the value of future liabilities. The study analyzed the actuarial valuations of the top 649 pension plans in the country to compare their reported value of unfunded liabilities using both methods. Their results found that while some states reported sound funding ratios, their actual fiscal health was not as solid as reported.
One example the study used was South Dakota, which currently has the highest reported funded ratio in the nation: 102.97 percent (2015). When the state’s 7.5 percent discount rate was replaced by the 3 percent market value, the size of South Dakota’s unfunded liabilities increased by more than 60 percent. An analysis of Arizona’s pension system yields similar results: When the market value was applied, the reported value of unfunded liabilities at the end of 2015 increased from $15.6 billion to $62.3 billion.
The Reason study also notes New Jersey’s funding ratio did not move much during the researchers’ analysis because the state is already using the new Governmental Accounting Standards Board (GASB) rules, which apply a much lower discount rate.
Fortunately, both pension fund regulators and lawmakers are beginning to notice many of the serious problems facing pensions and are moving toward setting more reasonable expectations for investment returns, similar to those applied in New Jersey. However, this strategy is complicated by the fuzzy math that many governments use to balance their budgets. Some state and local governments have used accounting gimmicks to hide debts and liabilities on their accounting sheets.
Encouraging states to adopt GASB rules and make their budgets more transparent will hold policymakers accountable for their spending and inform lawmakers and taxpayers about their state’s true financial status.
States should either adopt market valuation of liabilities or lower their assumed investment return rate to a more realistic level. Pension experts recommend states use an expected rate of return between 2.3 and 3.1 percent, which is based on Treasury bond yields. Even if state and local pension funds begin to reach the current high return rate assumptions, it would take large-scale increases to bring their funds into actuarial balance.
The following articles examine state pension reform from multiple perspectives.
Which States Are Hiding the Most Pension Debt
Zachary Christensen of the Reason Foundation analyzes the actuarial valuations of the top 649 pension plans in the country to compare their reported value of unfunded liabilities to the pension debt calculated using a market value of liabilities. The results show many states are underreporting the liabilities they face.
Hidden Debt, Hidden Deficits: 2017 Edition
In this study, Joshua D. Rauh of the Hoover Institution applies market valuation to pension liabilities for 649 state and local pension funds and says that despite the introduction of new accounting standards, the vast majority of state and local governments continue to understate their pension costs and liabilities by relying on investment return assumptions that range from 7 percent to 8 percent per year.
Properly Funding a Defined-Benefit Plan Requires Solid Average Returns and Some Luck
Adam Millsap of the Mercatus Center discusses the problems created by overly optimistic investment-return assumptions and how they add risk to defined-benefit pension plans. “The risks associated with the variability in returns is another reason why many pension reform advocates recommend defined contribution plans rather than defined benefits plans. Defined contribution plans don’t promise a specific amount of benefits, which means they are not subject to the same underfunding risks as defined benefit plans,” wrote Millsap.
Public Pension Investments: Risky Chase for High Returns
Truong Bui writes in Budget & Tax News about a recent Pew report that shows there has been a systematic shift with many public pension plans. Over the past 30 years, an increasing number of public pensions have moved away from fixed-income investments and toward equities and alternative investments.
Keeping the Promise: State Solutions for Government Pension Reform
This report from the American Legislative Exchange Council describes the variety of pension plans governments use today and the advantages and disadvantages of each plan. It also provides several tools legislators can use to ensure governments can affordably fund retirement benefits for their employees.
Research & Commentary: Defined Contribution vs. Defined Benefit Pensions
John Nothdurft of The Heartland Institute provides a bullet-point comparison of defined-benefit pensions and defined-contribution retirement plans.
The State Public Pension Crisis: A 50-State Report Card
The Heartland Institute examines problems facing public pension systems, including the enormous burdens they pose in some locations. The report ranks each state on the operation and disposition of its pension plans and suggests ways to solve states’ pension system problems.
Research & Commentary: Public Pensions and the Assumed Rate of Return
Heartland Institute Senior Policy Analyst Matthew Glans examines the problems facing state and local pension funds, how assumed rates of return affect pension fund debt, and proposals to change the projected rates of return on pension fund investments.
Pension Funds Expected Rates of Return: Biggest Lie in Global Finance
The Illinois Policy Institute examines the high expected rates of return on pension investments used by state and local governments, arguing the high rates are misleading taxpayers into believing pension funds are more stable than they actually are.
Nothing in this Research & Commentary is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit the Budget & Tax News website, The Heartland Institute’s website, and PolicyBot, Heartland’s free online research database.
The Heartland Institute can send an expert to your state to testify or brief your caucus; host an event in your state, or send you further information on a topic. Please don’t hesitate to contact us if we can be of assistance! If you have any questions or comments, contact John Nothdurft, Heartland’s director of government relations, at [email protected] or 312/377-4000.