The Ticking Time Bomb in State Pensions
(Boston Globe Op-Ed)
"Longer term, states will probably follow in the footsteps of the corporate
sector and both freeze their defined benefit plans and shift employees to
defined contribution plans. While not as economically advantageous in the long
term, the latter are often more popular among workers and are more transparent.
Under defined contribution programs, politicians would not have the luxury of
granting employees generous pension allowances that state plans are ill-equipped
to afford, or to consistently defer contributions."
THOMAS J. HEALEY
The ticking time bomb in state pensions
November 28, 2006
PRESIDENT BUSH recently signed into law the Pension Protective Act of
2006 in an effort to strengthen the financial health of corporate defined
benefit pension plans. However, little attention is paid to a retirement sector
in even greater financial straits: state government pension plans. These plans
are facing a $1.3 trillion shortfall that presents a serious threat to their
very survival -- as well as to every taxpayer in the country.
State pension programs -- which cover 12.8 million Americans and manage assets
worth $2.3 trillion -- are a pillar of the nation's retirement system. By
comparison, corporate defined benefit pension plans cover
44.1 million participants but possess fewer assets -- about $1.7 trillion.
At first glance, state plans seem to be nearly as healthy as their corporate
counterparts: they face a shortfall of $348 billion under current accounting
rules, according to the National Association of State Retirement Administrators
. This implies they are 86 percent funded, versus 90 percent for corporate
plans.
However, these projections are misleading. The real shortfall of state-defined
benefit pension programs is closer to $1.3 trillion, which translates into the
plans being 64 percent funded. This alarming gap could set off a crisis whose
magnitude would dwarf the $200 billion government bailout of the savings and
loan industry in the 1980s. Just as disturbing, this threat is largely ignored
because of opaque accounting.
Opaque accounting dramatically distorts the liability side of the pension
ledger. The key question is whether pension plan liabilities are being properly
measured. The liabilities of defined benefit pension plans are measured by using
a discount -- or interest -- rate.
Unlike corporate plans, which must use high-quality corporate bond rates as
their discount rate, state pension plans are allowed to use the much higher
expected return on the assets they manage, artificially shrinking their
liabilities.
This practice perniciously disguises the actual health of state-funded pension
programs. As with corporate plans, state plans should be discounted using
long-term corporate bond rates instead of the expected rate of return on assets,
which is the current practice of most state governments.
Consider how distorting this practice is. Specifically, the average expected
return on assets across state pension plans today is about 7.89 percent,
according to the NASRA. Based on this return, their liabilities are estimated at
$2.5 trillion. If, however, the plans use as their discount rate the more
credible 10-year Treasury rate, at about 4.9 percent, their liabilities would
weigh in at $3.5 trillion -- a whopping
42 percent increase.
Startling as this finding is, it simply stems from applying to state-defined
benefit pension plans the same accounting principles that corporate plans must
live by.
In New York City, the chief actuary recently released supplemental financial
projections that show that instead of its public pension plan being 100 percent
funded, the level is only 60 percent if the more realistic accounting principles
of corporations are used. This would leave New York City with a pension deficit
of $49 billion.
States must be honest about their pension liabilities and the true value of plan
underfunding. They must then take assertive steps to close the gap through a
combination of benefit reductions, tax increases, and tapping other sources of
non recurring revenues. Issuing bonds to fund pension liabilities, for example,
doesn't solve the problem, but it makes it more visible by moving the obligation
onto the state's balance sheet, thus encouraging more responsible management.
Longer term, states will probably follow in the footsteps of the corporate
sector and both freeze their defined benefit plans and shift employees to
defined contribution plans.
While not as economically advantageous in the long term, the latter are often
more popular among workers and are more transparent. Under defined contribution
programs, politicians would not have the luxury of granting employees generous
pension allowances that state plans are ill-equipped to afford, or to
consistently defer contributions.
And that would be a relief to taxpayers, once they become aware of the
$1 trillion pension bombshell headed their way.
Thomas J. Healey is a retired partner of Goldman Sachs & Co., and currently a
senior fellow at Harvard University's Kennedy School of Government. He served as
assistant secretary of the Treasury under President Reagan.
